Marginal Costing for

Short Run Decision

Analyses
 MARGINAL COSTING
The term ‘marginal cost’ is defined as the amount at any given volume of output
by which aggregate costs are charged if the volume of output is increased or
decreased by one unit.
It is a variable cost of one unit of a product or a service i.e., a cost which would
be avoided if that unit was not produced or provided.
Costs are classified into fixed and variable costs.
Variable costs charged to cost units
Fixed costs period cost
SALES = VARIABLE COST + FIXED COSTS+
PROFITS

SALES – VARIABLE COST = CONTRIBUTION

CONTRIBUTION = FIXED COSTS + PROFIT

CONTRIBUTION – FIXED COSTS = PROFIT

 COST-BENEFIT ANALYSIS
SUNK COSTS: Costs that have already been incurred. They do not affect any
future cost and cannot be changed by any current or future action. These are
irrelevant to current decisions.
DIFFERENTIAL COSTS: Technique used in preparation of information in which
only costs and benefits differences between alternative courses of action are
taken into consideration. It is based on absorption costing.
 COSTS:
Future Costs: These are the costs expected to happen under an assumed set of
conditions.
Relevant Costs: These are the costs which would change as a result of the decision.
Opportunity Costs: These are the monetary benefits foregone for not pursuing the
alternative course. An opportunity foregone to exercise another option.
Sunk Costs: Costs already incurred such as depreciation.
Avoidable costs : Which can be avoided in future as a result of managerial choice.
Differential Costs: Include variable costs and additional fixed costs resulting from
particular decision.
 Key Features of Relevant Information:
Past (historical) costs may be helpful as a basis for making predictions. However, past costs
themselves are always irrelevant when making decisions.
Different alternatives can be compared by examining differences in expected total future
revenues and expected total future costs.
Not all expected future revenues and expected future costs are relevant. Expected future
revenues and expected future costs that do not differ among alternatives are irrelevant and
hence can be eliminated from the analysis.
The key question is always, wht difference will an action make?
Appropriate weight must be given to qualitative factors and quantitative nonfinancial
factors.
 APPLICATION OF MARGINAL
COSTING AS A TOOL FOR
DECISION MAKING:
• KEY OR LIMITING FACTOR
• PROFIT PLANNING
• ACCEPT OR REJECT OFFER
• SELECTION OF PRODUCT MIX
• MARKET EXPANSION
• MAKE OR BUY
• INTRODUCTION OF NEW PRODUCT
• DISCONTINUATION OF A PRODUCT
DECISION SITUATIONS:
1. One- Time- Only Special Orders
2. Sales Volume Related
3. Sell or Further Process
4. Make or Buy / Insourcing vs. Outsourcing
5. product Lines/ divisions/ departments
6. Short- Term use of scarce resources
7. Joint outputs of common processing operations
8. Operate or shut-down
9. Product Mix Decisions with capacity Constraints
Decisions and Performance Evaluation:
 Key Limiting Factor

In cases where firm produces two or more products and the firm has
the key limiting factors, the decision has to be taken about the product
that should be produced more to make the optimal utilization of the
limiting factor.
The impact will be seen on the overall profitability.
 Question:
Girish Ltd. produces three products A , B and C. The firm has a limiting factor of
10,000 labor hours. A maximum of 10,000 units of Product B and 6,000 units of
product C are required. No restriction on quantity of product A.
The firm produces 20,000 units in all and 2 units of product are produced in 1
labor hour.
How to allocate 10,000 labor hours to get optimum production?
 Solution:
Contribution Analysis:
Contribution per Labor Hr.
Product A 20
Product B 50
Product C 30
Key Limiting Factor Analysis:
Product Contribution Per Labor Hr. Allocation of Labor Hrs. No. of Units to be produced

A 20 2,000 4,000
B 50 5,000 10,000
C 30 3,000 6,000
Make or Buy Decisions:
 Make or Buy Decisions:
•Decisions about whether a producer of goods or services will insource or
outsource are called make-or-buy decisions.
•Firms may have to choose between manufacturing certain components
themselves or acquiring them from the outside suppliers.
•Incremental analysis provides solution to these kind of decision- problems.
•The relevant input information is the committed/ avoidable costs if the firm has
adequate idle capacity to make the components.
•If however, there is need to enlarge the capacity of existing plant, or the existing
capacity of plant is diverted for the production of the components, opportunity
cost in terms of lost contribution will be relevant to the decision analysis.
 Make or Buy Decisions/ Insourcing vs.
Outsourcing:
Sometimes, however, qualitative factors dominate management’s
make-or-buy decision.
For example, Dell Computer buys the Pentium chip for its personal
computers from Intel because Dell does not have the know-how and
technology to make the chip itself.
 In contrast, to maintain the secrecy of its formula, Coca-Cola does not
outsource the manufacture of its concentrate.
 QUESTION:
XYZ Ltd. produces most of its tube parts in its own plant. The company is at present considering the
feasibility of buying a part from an outside supplier for Rs. 4.5 per part. If this were done, monthly
costs would increase by Rs. 5,000.
The part under consideration is manufactured in department 1 along with numerous other parts. On
account of discontinuing the production of this part. Department 1 would have somewhat reduced
operations. The average monthly usage production of this part is 20,000 units. The costs of producing
this part on per unit basis are as follows:
◦ Rs.

Material 1.80
Labour (half-hour) 2.40
Fixed overheads 0.80
Total cost 5.00
 Ques. (contd.)
The company follows the practice of applying manufacturing
overheads on the basis of direct labour-hours. Normal production
volume in Department 1 is 1,50,000 hours per month, and current
actual production is at about the same level. Discontinuation of
production of this part would cause an unfavourable volume
variance of Rs. 16,000 per month.
◦ How would you advise the management in this regard.
 Solution: DECISION ANALYSIS
PARTICULARS MAKE COSTS BUY COSTS
TOTAL (Rs.) PER UNIT(Rs.) TOTAL (Rs.) PER UNIT(Rs.)
RELEVANT COSTS:

MATERIALS 36,000 1.80 - -

LABOUR 48,000 2.40 - -

PURCHASING COSTS - - 90,000 4.50

ADDITIONAL COST OF PURCHASING - - 5,000 0.25

FROM OUTSIDE
84,000 4.20 95,000 4.75
DIFFERENTIAL COSTS FAVOURING 11,000 Per month 0.55 PER UNIT
MAKING OF THE PARTS
HENCE, THE COMPANY SHOULD CONTINUE THE PRACTICE OF PRODUCING THE PART IN DEPARTMENT 1
 Question:
The Soho Company manufactures a two-in-one video system consisting of a DVD player
and a digital media receiver (that downloads movies and video from internet sites such
as Netflix). Columns 1 and 2 of the following table show the expected total and per-unit
costs for manufacturing the DVD-player of the video system. Soho plans to
manufacture the 250,000 units in 2,000 batches of 125 units each. Variable batch-level
costs of Rs. 625 per batch vary with the number of batches, not the total number of
units produced.
Broadfield, Inc., a manufacturer of DVD players, offers to sell Soho 250,000 DVD players
next year for $64 per unit on Soho’s preferred delivery schedule. Assume that financial
factors will be the basis of this make-or-buy decision. Should Soho make or buy the
DVD player?
Solution:
To make a decision, management needs to answer the question, “What is the
difference in relevant costs between the alternatives?”
Suppose (a) the capacity now used to make the DVD players will become idle
next year if the DVD players are purchased and (b) the $3,000,000 of fixed
manufacturing overhead will continue to be incurred next year regardless of the
decision made. Assume the $750,000 in fixed salaries to support materials
handling and setup will not be incurred if the manufacture of DVD players is
completely shut down
 Total relevant costs Relevant cost per unit
Relevant Items Make Buy Make Buy
Outside Purchase Of Parts (Rs. 64 × 250,000 Units) 160,00,000 64
Direct Materials 90,00,000 36
Direct Manufacturing Labor 25,00,000 10
Variable Manufacturing Overhead 15,00,000 6
Mixed(variable And Fixed) Materials Handling And Setup OH 20,00,000 8
Total Relevant Costs 150,00,000 160,00,000 58 64

Difference In Favor Of Making DVD Players 10,00,000 4

The Rs. 3,000,000 of plant-lease, plant-insurance, and plant-administration costs could be included under both alternatives.
Conceptually, they do not belong in a listing of relevant costs because these costs are irrelevant to the decision. Practically,
some managers may want to include them in order to list all costs that will be incurred under each alternative.
Solution:

 Soho will save $1,000,000 by making

DVD players rather than buying them
from Broadfield.
Hence, Making DVD players is the
preferred alternative.
Question(1/2):
The Philips Company Ltd. Produces most of its tube parts in its own
plant. The company is at present considering the feasibility of buying
a part from an outside supplier for Rs. 4.5 per part. If this were done,
monthly costs would increase by Rs. 1,000.
The part under consideration is manufactured in department 1 along
with numerous other parts. On account of discontinuing the
production of this part, Department 1 would have somewhat reduced
operations. The average monthly usage production of this part is
20,000 units. The costs of producing this part on per unit basis are as
follows:
Question(2/2):
The company follows the practice of applying manufacturing overheads on
the basis of direct labor- hours. Normal production volume in Department
1 is 1,50,000 hours per month, and current actual production is at about
the same level. Discontinuation of the production of this part would cause
an unfavorable volume variance of Rs. 16,000 per month in this
department.
How would you advise the management in this regard?
Rs.
Material 1.80
Labour (half- hour) 2.40
Fixed OH 0.80
Total Costs 5.00
Solution:
Operate or Shut Down:
 Operate or Shut Down:
• The decision criterion in such a situation will be based on the
comparison of the shut- down losses and the losses associated with
continuing operations. In case, shut-down losses are more than the
losses from the continuing operations, it would be beneficial for the
firm to continue its business operations. In case, shut down losses are
less than the losses from the continued operations, it would be
profitable for the firm to shut- down its operations.
• Thus, shut- down point may be defined as a point at which losses from
continued operations are equal to the shutdown costs.
Question:
Solution:
 Question: Product-Mix Decisions with
Capacity Constraints
Power Recreation assembles two engines, a snowmobile engine and a boat engine, at its
Lexington, Kentucky, plant.
Assume that only 600 machine-hours are available daily for assembling engines. Additional
capacity cannot be obtained in the short run. Power Recreation can sell as many engines as it
produces. The constraining resource, then, is machine-hours. It takes two machine-hours to
produce one snowmobile engine and five machine-hours to produce one boat engine. What
product mix should Power Recreation’s managers choose to maximize its operating income?

Snowmobile Engines Boat Engine

Selling Price 800 1000
Variable Cost per unit 560 625
Contribution margin per unit 240 375
Contribution margin % (240/800; 375/1000) 30% 37.5%
 Solution:
In terms of contribution margin per unit and contribution margin percentage,
boat engines are more profitable than snowmobile engines. The product that
Power Recreation should produce and sell, however, is not necessarily the
product with the higher individual contribution margin per unit or contribution
margin percentage. Managers should choose the product with the highest
contribution margin per unit of the constraining resource (factor). That’s the
resource that restricts or limits the production or sale of products.
The number of machine-hours is the constraining resource in this example
and snowmobile engines earn more contribution margin per machine-hour
($120/machine-hour) compared to boat engines ($75/machine-hour).
 Solution:
Snowmobile Engine Boat Engine
Contribution Margin per unit 240 375
Machine hours required to produce one 2 machine- hours 5 machine- hours
unit

Contribution margin per machine- hours Rs. 120/ machine hour Rs. 75/machine-hour
[240 per unit / 2 machine hr p.u.] [375 per unit/ 5 machine hr p.u.]

Total Contribution Margin for 600 machine- 72,000 45,000

hours [Rs. 120 per machine- hr x 600 hr ] [Rs.75 per machine hr x 600 hrs]

Therefore, choosing to produce and sell snowmobile engines maximizes total contribution margin (Rs.
72,000 versus Rs. 45,000 from producing and selling boat engines) and operating income.
One- Time- Only Special Orders
 Question: One- Time- Only Special
Orders
Surf Gear manufactures quality beach towels at its highly automated Mumbai plant. The plant has
a production capacity of 48,000 towels each month. Currently monthly production is 30,000
towels. Retail department stores account for all existing sales. The expected results for the coming
month are given in the table below. (these amounts are predicted on the past costs) We assume all
costs can be classified as either fixed or variable with respect to a single cost driver. (units of
output)
Azelia, a luxury hotel chain approached Surf Gear for a one time order to buy 5,000 towels at Rs.
110 per towel. The fixed manufacturing costs are to be based on 45,000 towels production normal
capacity, i.e., fixed manufacturing cost relate to the production capacity available and not the
actual capacity used.
No marketing costs will be necessary for the 5,000 unit one time only special order.
No subsequent sales to Azelia are anticipated. Accepting the special order is not expected to affect
the selling price or the quality of towels sold to regular customer.
 Total Per Unit
Units Sold 30,000

Revenues 60,00,000 200

Cost Of Goods Sold (Manufacturing Costs)
Variable Manufacturing Costs 22,50,000 75
Fixed Manufacturing Costs 13,50,000 45
Total Cost Of Goods Sold 36,00,000 120
Marketing costs
Variable marketing costs 15,00,000 50
Fixed marketing costs 6,00,000 20
Total marketing costs 21,00,000 70
Full costs of product 57,00,000 190
Operating income 3,00,000 10
Variable Manuf. Cost p.u.= Direct Material cost p.u.+ Direct Manufacturing Labor Cost p.u. + Variable Manuf. OH Cost p.u.
= 60 + 5 + 10 = 75
Fixed Manuf. Cost p.u.= Fixed Direct Manufacturing Labor Cost p.u. + Fixed Manuf. Overhead Cost p.u.
= 15 + 30 = 45
Solution(1/2):
The calculations are done on an absorption costing basis (both fixed
and variable manufacturing costs are included in inventoriable costs
and cost of goods sold ).
Per unit Costs including both variable and fixed costs.
Manufacturing cost per unit = Rs. 120
Marketing costs per unit = Rs. 70
 Without special order With the special Difference:
order relevant amounts
30,000 units to be sold 35,000 units to be For the 5,000
Solution: Per unit (Rs.) Total
sold
Total Units special order
(1) (2)= (1)x30,000 (3) (4)=(3)-(2)
Revenues 200 60,00,000 65,50,000 5,50,000 5000 units x 110 p.u. =
Variable Costs: Rs. 5,50,000
Manufacturing 75 22,50,000 26,25,000 3,75,000 5000 units x 75 p.u.= 3,75,000
Marketing 50 15,00,000 15,00,000 0
Total variable costs 125 37,50,000 41,25,000 3,75,000
Contribution 75 22,50,000 24,25,000 1,75,000
margin
Fixed costs
Manufacturing 45 13,50,000 13,50,000 0
Marketing 20 6,00,000 6,00,000 0
Total fixed costs 65 19,50,000 19,50,000 0
Operating income 10 3,00,000 4,75,000 1,75,000
Sales Volume Related Decisions:
Such decisions cover :
1. Acceptance of special/ extra sales orders
2. Disposing of inventories
3. Loss Leaders
Special Orders:
One decision- situation relates to increase in sales volume outside
the normal marketing pattern.
If such special sales does not affect the normal sales, the accept-
reject decision would be based on the incremental contribution.
In case, the special sale would affect the future sales volume and/ or
selling price, the opportunity cost in terms of lost revenue will also
be relevant to decision making.
 Question(1/3): [Pricing Special Order]
Assume that Royal Industries Ltd. Has excess capacity. The
normal plant capacity is 3,00,000 units per year and current
production is 2,00,000 units. There is no alternative use for the
idle facilities. The company receives an offer from a foreign
customer to buy 1,00,000 units at Rs. 10 a unit. The regular
market price is Rs. 14 a unit. The current manufacturing and
selling costs are:
 Question(2/3):
Particulars Per Unit Total
Total VC :
Direct Labour 2 4,00,000
Direct Material 3 6,00,000
Variable OH 2 4,00,000
Manufacturing Cost 7 14,00,000
Variable Selling Costs 1 2,00,000
8 16,00,000
Fixed Overheads:
Manufacturing 2.5 5,00,000
Selling .5 1,00,000
Total Cost 22,00,000
Question(3/3):
A. Should the offer be accepted assuming that shipment
charges of Rs. 50,000 are to be borne by the seller? There will
be a special packing of the products which will involve
packing cost of Rs. 0.25 per unit. Being an export order, the
management is convinced of the fact that the regular market
price of Rs. 14 a unit will not be affected.
B. Assume that the order is from a local supplier and
therefore, should the order be accepted, all products in
future are to be offered at the special order price.
 Solution(1/2): Decision Analysis
Particulars Without special order Amount With Special Order Amount
Sales (2,000 x Rs 14) 28,00,000 (2,00,000 x Rs. 14) Rs. 28,00,000
(1,000 x Rs. 10) 10,00,000
28,00,000 38,00,000
Less incremental Cost:
Direct Labour (2,00,000 x Rs. 2 ) 4,00,000 (3,00,000 x Rs. 2) 6,00,000
Direct Material (2,00,000 x Rs. 3) 6,00,000 (3,00,000 x Rs. 3) 9,00,000
Variable Overheads (2,00,000 x Rs. 2) 4,00,000 (3,00,000 x Rs. 2) 6,00,000
Packing Costs - - (1,00,000 x Rs. 0.25) 25,000
Selling costs (2,00,000 x Re. 1) 2,00,000 (2,00,000 x Re 1) 2,00,000
Shipment Costs - - 50,000
Contribution 12,00,000 14,25,000
 Solution(2/2): (b). Decision Analysis
Particulars Amount (in Rs.)
Sales (3,00,000 x Rs. 10) 30,00,000
Less relevant costs
Manufacturing variable costs (3,00,000 x Rs. 7) 21,00,000
Packing Costs (1,00,000 x Rs. 0.25) 25,000
Variable selling costs (2,00,000 x Re. 1) 2,00,000
Shipment Costs 50,000 23,75,000
Contribution 6,25,000

Since the contribution has declined, the order from the local supplier should not be accepted.
 Addition/ Elimination of Product
Lines/ Divisions/ Shifts/ Departments

• When a firm is divided into multiple sales outlets, product lines,

divisions, departments (segments), it may have to evaluate their
individual performances to decide whether or not to continue
operations of each of these segments or add a new segment.
• The decision criterion would be the segment margin.
• The segment margin equals segments contribution margin less
fixed costs that are directly traceable to that segment.
 Question(1/2):

Uffa Ltd produces a single product in its plant. This product sells for Rs.
100 per unit. The standard production cost per unit is as below.
Rs.
Raw material (5 kg @ Rs. 8) 40
Direct labour (2 hours @ Rs. 5) 10
Variable manufacturing overheads 10
Fixed manufacturing overheads 20
80
 Question(1/2):
The plant is currently operating at full capacity of 1,00,000 units per year on a single shift.
This output is inadequate to meet the projected sales demand and the sales manager has
estimated that the firm will loss sales of 40,000 units next year if the capacity is not
expanded.
Plant capacity could be doubled by adding a second shift. This would require additional
out-of-pocket fixed manufacturing overhead costs of Rs. 10,00,000 annually. Also, a night
work wage premium equal to 25% of the standard wage would have to be paid during the
second shift. However, if annual production volume were 1,30,000 units or more. The
company could take advantage of 2% quantity discount on its raw material purchases.
You are required to advise whether it would be profitable to add the second shift in order
to obtain the sales volume of 40,000 units per year?
 Solution: Decision Analysis
Particulars Profit without expansion Profits with expansion

Sales Revenue 1,00,00,000 1,40,00,000

Less: Variable Costs

Raw material (Rs. 39.20 x 1,40,000) 40,00,000 54,88,000

Direct Labour 10,00,000 15,00,000

Variable manufacturing OH 10,00,000 14,00,000

Contribution 40,00,000 56,12,000

Less: fixed costs (Rs. 1,00,000 x 20) 20,00,000 30,00,000

Net Income 20,00,000 26,12,000
 Short- term use of scarce
resources:
•Incremental analysis can also be used to allocate the resources that are limited in
quantity (key factors). The key factors refers to scarce resources which may be raw
material, skilled labor or machine capacity. If the machine capacity is inadequate to
permit manufacture of all products, the most profitable course of action is to use the
available machine capacity/ hours to make the products which contribute the
maximum contribution margin per machine hour. If materials are in short supply, the
management should produce according to the largest contribution margin per input of
material.
•Thus, the contribution per unit of the key factor of production is to be determined
and the products ranked according to the descending order of contribution per unit of
key factor. This will maximize the total contribution of the firm.
 Question(1/2):
Precision Engineers Pvt. Ltd. are producing to specific orders. Their factory capacity is limited by one major
machine forming a criterial cost centre through which all products pass. The factory normally works for 250
days in a years on 24 hours, 3 shifts a day and 5 days a week basis. The maximum achievable capacity is 80%,
corresponding to the average level of activity in the critical cost centre. The operating results summarised for
management in previous year are as follows (Rs. In lakh).
Rs. Rs.
Sales 48
Less costs:
Materials 18
Labour- variable costs 5.75
Factory- variable costs 6.25
Factory- fixed costs 3
Selling and administration costs 10 43
Profit 5
 Question(2/2):
The average profitability experienced during the previous years is being maintained during the current year
also.
The company has an opportunity of taking any one of the two large contracts either of which will substitute
for a large amount of current production without affecting the hourly variable production costs. Details of the
contracts are:
Contract X Contract Y
Materials cost per unit 375 1,750
Machine-hours (critical cost centre) per unit 2 3
Contract price per unit 1,500 3,750
Extra selling expenses per unit 25 50

Prepare a report for the managing director making your recommendations as to which of the two contracts should be
preferred.
 Solution:
Particulars Contract X Contrat Y
2,400 units (4,800 / 2) 1,600 units (4,800 / 3)
Per Unit Total Per Unit Total
Contract Price 1,500 36,00,000 3,750 60,00,000
Less: incremental costs
Material Costs 375 9,00,000 1,750 28,00,000
Other variable production costs 500 12,00,000 750 12,00,000
Additional selling expenses 25 60,000 50 80,000
Contribution 600 14,40,000 1,200 19,20,000
Contribution per machine- hour (Key factor) 300* 400**
Less fixed costs
factory overheads 3,00,000 3,00,000
Selling and administration (assumed ) 10,00,000 10,00,000
Profit 1,40,000 6,20,000
Present Profit 5,00,000
*(Rs. 600 / 2); **(Rs. 1,200 / 3)
 Solution:
The managing director is advised to accept contract Y, as its contribution margin per machine- hour
as well as profits is higher.
Working Notes:
1. Machine- hours available = (Working days x 24 hours) = 250 x 24 = 6,000 hours
2. Variable production costs (other than materials) per hours: (Rs. 5,75,000 + Rs. 6,25,000) / 4,800
hours = Rs. 250 per hour.
3. It is assumed that the company at present is operating at its maximum achievable capacity, that
is 4,800 hours. In operational terms, the variable production costs (labour and other variable costs)
are at the level of 4,800 hours.
4. The company would be in a position to sell all the units of Y contract.
5. Selling and administration overheads are assumed to be fixed.
 Opportunity Cost Approach:

•Deciding to use a resource in a particular way causes a manager to forgo

the opportunity to use the resource in alternative ways.
•This lost opportunity is a cost that the manager must consider when
making a decision.
•Opportunity cost is the contribution to operating income that is forgone
by not using a limited resource in its next-best alternative use.
Question: Carrying Costs of Inventory

Soho Ltd. has to buy DVD players, for which it has two
purchasing alternatives. Soho will pay in cash for the DVD
players it buys. Soho has, on average, Rs. 3,960,000 of cash
available to invest. From the following information, decide
which purchasing alternative is more economical for Soho?
 Question: Carrying Costs of Inventory
Annual estimated video-system DVD player requirements for next year 2,50,000 Units
Cost per unit when each purchase is equal to 2,500 units Rs. 64
Cost per Unit when each purchase is equal to or greater than 125,000 units; Rs. 64 minus 1% Disc.
Cost of a purchse order Rs. 500
Alternatives under consideration:
A. Make 100 purchases of 2,500 units each during next year
B. Make 2 purchases 125,000 units during the year
Average Investments in inventory:
A. (2,500 units x Rs. 64 p.u.) / 2 80,000
B. (125,000 units x Rs. 63.36 per unit) / 2 3,90,000
Annual rate of return if cash is invested elsewhere at the same level of risk as investment in inventory 9%
SOLUTION:
Total Alternatives Approach:
SOLUTION:
Opportunity Cost Approach
Thank You!