Marginal Costing and Decision Making
Marginal costing versus absorption costing
Marginal cost is the variable cost of one additional unit. Under marginal costing, stock and work-in-progress are valued at variable cost only, fixed costs are written off against contribution, and profit = contribution − fixed cost. Under absorption costing, fixed production overhead is absorbed into product cost, so profit differs whenever stock levels change; the difference equals the fixed overhead carried in closing stock minus that in opening stock.
Decision rules
- Special order: accept if incremental revenue exceeds incremental cost, and spare capacity exists.
- Make or buy: compare variable cost of making with purchase price, adding avoidable fixed costs.
- Discontinue a product: drop only if its contribution is less than the fixed costs that disappear with it.
- Key factor: rank products by contribution per unit of the limiting factor, not contribution per unit.
- Shut down: compare contribution with avoidable fixed costs.
Worked example
Normal selling price ₹30; variable cost ₹18; fixed cost already absorbed. An export order for 2,000 units at ₹22 arrives. With spare capacity, contribution = 2,000 × (₹22 − ₹18) = ₹8,000, so accept. At full capacity, 2,000 units of normal sales would be sacrificed, losing contribution of 2,000 × ₹12 = ₹24,000 against a gain of ₹8,000, so reject. Reasoning: fixed cost is irrelevant because it does not change; the sacrificed contribution is the relevant opportunity cost.
Traps that cost marks
Using total cost including fixed overhead to judge a special order; ignoring opportunity cost when there is no spare capacity; treating sunk costs as relevant; ranking by contribution per unit when a key factor exists; assuming apportioned fixed costs disappear when a product is dropped.