Cost and Management Accounting · Marginal Costing

Marginal Costing in Decision Making

Q: Why are fixed costs ignored in marginal costing decisions?

Fixed costs that stay the same whichever option you choose do not change the result of the decision. Only costs and revenues that differ between options are relevant. If a fixed cost can be avoided or is newly incurred, include it.

Q: How do I solve a limiting factor problem?

Find contribution per unit, divide by the units of the scarce resource each product uses, and rank products. Allocate the resource to the top rank up to its demand, then to the next. Compute total contribution and subtract fixed cost for profit.

Q: When should a firm accept a special order below full cost?

Accept it when spare capacity exists, the price exceeds variable cost, and it will not disturb regular sales or prices. If capacity is full, the price must also cover the contribution lost on regular sales. Any extra fixed cost caused by the order must be covered too.

Q: When should a product or plant be shut down?

In the short run, shut down only if contribution is lower than the fixed cost that can be avoided by closing. Fixed costs that continue anyway are ignored. Also weigh effects on other products, employees and customers.

Updated 4 October 2026 · Fact-checked

Marginal costing in decision making means choosing between alternatives by comparing contribution (sales less variable cost), not full cost. Fixed costs that do not change are ignored. Pick the option with the higher total contribution, or the higher contribution per unit of the scarce resource when a limiting factor exists.

Understand Marginal Costing in Decision Making

Marginal costing splits cost into variable and fixed. Variable cost changes with output. Fixed cost stays the same in total within the relevant range. Contribution = Sales − Variable cost. It is the amount each unit adds towards covering fixed cost and then making profit.

In a decision, ask one question: what changes if I choose this option? Only relevant costs matter. These are future costs that differ between the alternatives. Fixed costs that continue whatever you decide are irrelevant. Full cost per unit (which includes fixed overhead) can therefore mislead you.

So you compare contribution. A product with a loss on a full-cost basis may still give positive contribution. If it does, and the fixed cost cannot be avoided, dropping it makes the firm worse off.

When something is scarce, such as machine hours, material or labour hours, it is a limiting (key) factor. Then total contribution is not enough. You rank products by contribution per unit of the scarce resource, and use the resource in that order.

The usual exam decisions are make or buy, accepting a special order, product mix with a limiting factor, shutdown of a product or plant, pricing, and sales-mix changes. The logic is the same for all: find the incremental contribution, then adjust for any fixed cost that really changes or any opportunity cost.

Key rules to remember

Contribution: Contribution = Sales − Variable cost; Per unit or in total. Fixed cost is never deducted when comparing options.
Profit: Profit = Contribution − Fixed cost; Use it to check the final result of the chosen plan.
Make or buy rule: Buy only if purchase price < variable cost of making (plus any avoidable fixed cost per unit); If capacity freed has an alternative use, add the contribution lost or gained from that use.
Special order rule: Accept if price per unit > variable cost per unit (and spare capacity exists); Add any extra fixed cost caused by the order. If capacity is full, add the opportunity cost of lost contribution.
Limiting factor ranking: Contribution per unit of key factor = Contribution per unit ÷ Units of key factor per unit of product; Allocate the scarce resource to the highest ranking first, subject to demand limits.
Shutdown rule (short run): Continue if contribution > avoidable fixed cost; shut down if contribution < avoidable fixed cost; Unavoidable fixed cost is ignored. Consider also qualitative factors and effect on other products.
Marginal cost pricing floor: Minimum price = Variable cost per unit (plus opportunity cost, if any); Used for special orders, slack periods and export offers. Not suitable as a long-run price.
Break-even sales: BEP (units) = Fixed cost ÷ Contribution per unit; Useful to test a sales-mix or pricing change.

How to solve Marginal Costing in Decision Making questions

Use this sequence for any decision question. It keeps your working clean and earns step marks.

1Read the question and name the decision: make or buy, special order, product mix, shutdown, price or sales mix.
2Prepare a per-unit statement: selling price, variable cost and contribution for each product or option.
3Mark each fixed cost as relevant (avoidable or newly incurred) or irrelevant (continues anyway). Write this down.
4Check for a limiting factor. If one exists, compute contribution per unit of that factor and rank. If not, compare total contribution.
5Build the plan: allocate the scarce resource in rank order, respecting maximum demand, then compute total contribution and profit.
6Add opportunity cost where capacity is full or released capacity has another use.
7Compare the options in a short table or lines, and state the decision clearly.
8Add one line of non-financial factors if the question asks, such as quality, supplier reliability, goodwill and employee morale.

Quickest way: Contribution-first shortcut for MCQs and written answers

When to use it: Use when time is short. It works for most MCQs and for the first half of a written decision answer.

For MCQs, ignore fixed cost at once unless the question says it is avoidable or extra. This removes most wrong options.
Compute contribution per unit. If any contribution is negative, eliminate that product or order first.
If a scarce resource is mentioned, divide contribution by resource used and rank. Do not rank by contribution per unit alone.
In make or buy, compare the buy price with variable cost of making. Adjust only for avoidable fixed cost and for the opportunity cost.
In written answers, use a fixed layout: per-unit table, ranking or comparison, decision line. Show each formula once and then the numbers.
Always write the final decision in one sentence with the reason, since examiners award marks for the conclusion.

Common mistakes in Marginal Costing in Decision Making

Including unavoidable fixed cost in a make-or-buy or shutdown comparison.
Students are used to full-cost statements where fixed overhead is part of unit cost.
Fix: List fixed costs and mark each as avoidable or not. Only avoidable ones enter the comparison.
Ranking products by contribution per unit when a limiting factor exists.
Contribution per unit looks like the natural measure of profitability.
Fix: Divide contribution by units of the scarce resource per product, then rank on that figure.
Rejecting a special order because price is below full cost.
Students compare price with total cost per unit, including fixed overhead.
Fix: Compare the price with variable cost, and with opportunity cost if capacity is full. Accept if there is positive incremental contribution.
Ignoring opportunity cost when released or spare capacity has another use.
The question gives it as a side remark and students skip it.
Fix: Whenever capacity is used for one option, ask what the next best use would earn, and include it.
Dropping a product that shows a loss in the absorption statement.
Fixed cost allocated to it makes its profit negative, even though contribution is positive.
Fix: Check contribution against avoidable fixed cost. If contribution is higher, keep it.
Allocating the scarce resource without checking demand limits.
Students fill the best-ranked product with all resources and forget maximum sales.
Fix: Cap each product at its demand, then pass remaining resource to the next rank.

Worked examples

Example 1

A firm makes a component at a variable cost of ₹40 per unit: material ₹20, labour ₹12 and variable overhead ₹8. Fixed overhead absorbed is ₹10 per unit on 10,000 units, so total fixed overhead is ₹1,00,000, of which ₹30,000 can be saved if the component is bought. A supplier offers it at ₹46 per unit. The released capacity has no other use. Should the firm make or buy?

Show the solution

Cost of making relevant to the decision = variable cost + avoidable fixed cost.
Variable cost for 10,000 units = ₹40 × 10,000 = ₹4,00,000.
Avoidable fixed cost = ₹30,000. Relevant cost of making = ₹4,30,000.
Relevant cost per unit of making = ₹4,30,000 ÷ 10,000 = ₹43.
Cost of buying = ₹46 × 10,000 = ₹4,60,000.
Making is cheaper by ₹4,60,000 − ₹4,30,000 = ₹30,000.
The remaining ₹70,000 of fixed overhead continues in either case, so it is ignored.

Answer: Make the component. It costs ₹43 per unit in relevant terms against ₹46 to buy, saving ₹30,000 a year.

Example 2

A firm makes products A and B using one machine, which is limited to 6,000 hours. Data per unit: A: selling price ₹100, variable cost ₹60, machine hours 4. B: selling price ₹90, variable cost ₹60, machine hours 2. Maximum demand: A 1,000 units, B 2,500 units. Fixed cost is ₹40,000. Find the best product mix and profit.

Show the solution

Contribution per unit: A = 100 − 60 = ₹40. B = 90 − 60 = ₹30.
Contribution per machine hour: A = 40 ÷ 4 = ₹10. B = 30 ÷ 2 = ₹15.
Rank: B first (₹15), then A (₹10).
Produce B up to demand: 2,500 units × 2 hours = 5,000 hours.
Hours left = 6,000 − 5,000 = 1,000. A needs 4 hours per unit, so A = 1,000 ÷ 4 = 250 units, within demand of 1,000.
Contribution from B = 2,500 × 30 = ₹75,000.
Contribution from A = 250 × 40 = ₹10,000.
Total contribution = ₹85,000. Profit = ₹85,000 − ₹40,000 = ₹45,000.

Answer: Make 2,500 units of B and 250 units of A. Total contribution is ₹85,000 and profit is ₹45,000.

Exam tips

In every numerical, write per-unit contribution first. Examiners give marks for that table even if later steps go wrong.
Read for the words avoidable, extra, specific fixed cost and alternative use. They decide whether fixed cost or opportunity cost enters the answer.
For limiting factor questions, check demand caps and any minimum supply commitments before allocating the resource.
State the decision in one clear sentence and add one or two qualitative factors where the question asks for comments.
In MCQs, test each option against the contribution rule. Options that rely on full cost per unit are usually the trap.

Practice questions from Marginal Costing