Fundamentals of Financial and Cost Accounting · Application of Cost Accounting for Business Decisions

Managerial Decisions Using Marginal Costing: Make or Buy, Special Orders and Key Factor

Updated 10 October 2026 · Fact-checked

Marginal costing helps managers decide using contribution (sales minus variable cost), not full cost. Compare only relevant, extra costs and revenues. Accept an order or continue a segment if contribution is positive and covers avoidable fixed costs. With one scarce resource, rank products by contribution per unit of that resource.

Understand Managerial Decisions Using Marginal Costing

Every business decision asks one question: how will profit change if we do this? Marginal costing answers it by looking only at what changes. Variable costs change with output. Most fixed costs do not, in the short run. So the key measure is contribution = sales − variable cost.

Fixed costs already committed will be incurred whichever option you choose. They are not relevant. Including them, for example by using full absorption cost, can push you to reject a good order or close a useful product.

The core rule: choose the option that gives the higher total contribution, after adjusting for any fixed costs that really change (avoidable or extra fixed costs). Costs that change because of the decision are relevant costs. Costs that stay the same are not.

The five common decisions are: make or buy (compare the variable cost of making with the buying price), special order (accept if the price exceeds variable cost and spare capacity exists), product mix (choose the mix with the best contribution), shutdown (close only if the segment's contribution does not cover its avoidable fixed costs) and key factor (when one resource is scarce, maximise contribution per unit of that resource).

Remember that these rules suit the short run and spare or limited capacity. Long-run decisions also need to cover fixed costs, and non-financial factors such as quality, supplier reliability and customer goodwill also matter.

Key formulas to remember

Contribution: Contribution = Sales − Variable cost; Per unit or in total. Profit = Contribution − Fixed cost.
Make or buy rule: Make if variable cost of making (plus avoidable fixed cost, if any) < buying price; Ignore unavoidable fixed costs. If capacity is limited, use the key factor rule instead.
Special order rule: Accept if offer price > variable cost per unit (and spare capacity exists, no extra fixed cost); If the order needs extra fixed cost, deduct it from the total extra contribution.
Key factor ranking: Contribution per unit of key factor = Contribution per unit ÷ Key factor units per product unit; Rank products from highest to lowest and allocate the scarce resource in that order, up to demand.
Shutdown rule: Continue if Segment contribution > Avoidable fixed cost of the segment; Shut down if segment contribution is less than the fixed costs saved by closing it.
Key factor (limiting factor): Maximise total contribution subject to the single scarce resource; Valid with only one limiting factor. More than one needs linear programming.

How to solve Managerial Decisions Using Marginal Costing questions

Use this same routine for any marginal costing decision question.

1Identify the decision type: make or buy, special order, product mix, shutdown or key factor.
2List the variable cost per unit for each option and compute contribution per unit.
3Separate fixed costs into those that change with the decision (avoidable or extra) and those that do not. Ignore the second group.
4Check for a scarce resource, such as machine hours, labour hours or material. If one exists, compute contribution per unit of it.
5Apply the rule: compare contribution, buying price against variable cost, or segment contribution against avoidable fixed cost.
6Compute total contribution or total profit effect for the chosen option, allowing for demand limits.
7State the decision clearly and match the answer to the MCQ option.

Quickest way: Contribution first, fixed cost last

When to use it: Use it for any MCQ where costs are given per unit and you have about a minute per question.

Cross out total cost and absorbed fixed cost figures unless told they are avoidable.
Work out contribution per unit in one line.
If a scarce resource is named, divide contribution by units of the resource used per product.
Rank, allocate resource by rank, and multiply by units.
Check the answer against the options. Eliminate any that use full cost.

Common mistakes in Managerial Decisions Using Marginal Costing

Using full cost (including absorbed fixed overhead) to compare make with buy.
Cost sheets show a total cost per unit, so it looks like the natural figure to use.
Fix: Use only variable cost plus any fixed cost that can really be saved if you stop making.
Ranking products by contribution per unit when a resource is scarce.
The product with the highest unit contribution feels best.
Fix: Rank by contribution per unit of the scarce resource, such as per machine hour.
Rejecting a special order because the price is below total cost.
Students compare price to absorbed cost and ignore that fixed costs are already incurred.
Fix: Accept if price exceeds variable cost, there is spare capacity and no extra fixed cost arises.
Shutting down a loss-making product that still has positive contribution.
The profit statement shows a loss after allocated fixed costs.
Fix: Compare contribution with avoidable fixed cost. If contribution covers it, continue.
Producing more than market demand in a key factor problem.
Students allocate all resource to the top-ranked product without checking the demand limit.
Fix: Produce the top product only up to its maximum demand, then move to the next rank with the remaining resource.

Worked examples

Example 1

A firm makes a component at a variable cost of ₹40 per unit. It also incurs ₹20,000 of fixed cost, of which ₹8,000 can be saved if production stops. Annual need is 1,000 units. A supplier offers it at ₹50 per unit. Should the firm make or buy?

Show the solution

Cost of making = variable cost + avoidable fixed cost = 1,000 × ₹40 + ₹8,000 = ₹48,000.
Cost of buying = 1,000 × ₹50 = ₹50,000.
The remaining ₹12,000 of fixed cost is unavoidable, so it stays in both options and is ignored.
Making is cheaper by ₹50,000 − ₹48,000 = ₹2,000.

Answer: Make the component. Making costs ₹48,000 against ₹50,000 for buying, saving ₹2,000.

Example 2

A factory has 1,200 machine hours available. Product X: contribution ₹60 per unit, 2 hours per unit, maximum demand 400 units. Product Y: contribution ₹45 per unit, 1 hour per unit, maximum demand 600 units. Find the mix that maximises contribution and the total contribution.

Show the solution

Contribution per machine hour: X = 60 ÷ 2 = ₹30. Y = 45 ÷ 1 = ₹45.
Y ranks first. Produce Y up to demand: 600 units use 600 hours.
Hours left = 1,200 − 600 = 600. X needs 2 hours per unit, so X = 600 ÷ 2 = 300 units (within demand of 400).
Contribution from Y = 600 × ₹45 = ₹27,000.
Contribution from X = 300 × ₹60 = ₹18,000.
Total contribution = ₹27,000 + ₹18,000 = ₹45,000.

Answer: Produce 600 units of Y and 300 units of X for a maximum contribution of ₹45,000.

Exam tips

Read the question for words like avoidable, unavoidable, spare capacity and scarce. They tell you which costs to include.
In key factor questions, always check demand limits before allocating the resource.
If the question gives total cost per unit and variable cost per unit, use the variable figure unless fixed costs are stated to be avoidable.
Under time pressure, compute contribution per unit first. Most options can be eliminated from that one figure.
There is no negative marking, so attempt every question. Eliminate options that rely on full cost and then choose.

Practice questions from Application of Cost Accounting for Business Decisions

Managerial Decisions Using Marginal Costing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Managerial Decisions Using Marginal Costing: frequently asked questions

Why are fixed costs ignored in marginal costing decisions?

Fixed costs that will be incurred whatever you decide do not change the outcome, so they are not relevant. Only fixed costs that are avoidable or newly incurred because of the decision matter.

When should a loss-making product be continued?

Continue it if its contribution is positive and covers the fixed costs that would be saved by closing it. Closing it would otherwise reduce overall profit, since the unavoidable fixed costs would remain.

What is a key factor or limiting factor?

It is the scarce resource that limits output, such as machine hours, labour hours or raw material. When there is one key factor, rank products by contribution per unit of that resource.

Can a special order be accepted below normal selling price?

Yes, if the price is above variable cost, there is spare capacity and the order does not disturb regular sales or require extra fixed costs. The order then adds to total contribution.