Cost Accounting · Marginal Costing

Decision Making Using Marginal Costing

Updated 10 October 2026 · Fact-checked

Decision making using marginal costing means choosing the option that adds the most contribution, ignoring costs that stay the same whichever option you pick. Compare contribution (selling price less variable cost) for make or buy, special orders, pricing and shutdown. With a limiting factor, rank products by contribution per unit of the scarce resource.

Understand Decision Making Using Marginal Costing

A business decision is about the future. Only the costs and revenues that change because of the decision matter. These are called relevant costs. Costs that stay the same whatever you decide are irrelevant, even if they look large in the books.

Marginal costing helps because it splits cost into variable and fixed. Variable cost changes with each unit, so it is usually relevant. Fixed cost usually does not change in the short run, so it is usually irrelevant. This is why contribution (sales less variable cost) is the key figure. If an option adds positive contribution and no extra fixed cost, it improves profit.

A limiting factor (key factor) is a resource that restricts output, such as machine hours, scarce material or labour hours. When one exists, contribution per unit can mislead you. You must find contribution per unit of the scarce resource and make the highest-earning products first.

The same logic covers each decision. In make or buy, compare the variable cost of making with the buying price. In a special order, accept if the price is above variable cost and there is spare capacity, and the order does not damage regular sales. In shutdown, continue if contribution covers the fixed costs that would be saved by closing. In pricing, the variable cost is the floor for a one-off price, while the normal price must recover all costs.

Always add an opportunity cost when the decision uses a resource that has a better alternative use. Then state your decision in words, with the figure that supports it.

Key rules to remember

Contribution: Contribution = Sales − Variable cost; Use per unit or in total. This is the base for every decision here.
Contribution per unit of limiting factor: Contribution per unit ÷ Units of scarce resource used per unit; Rank products in descending order of this figure and allocate the scarce resource in that order, subject to maximum demand.
Make or buy rule: Make if relevant cost of making < buying price; otherwise buy; Relevant cost of making = variable cost + avoidable fixed cost + opportunity cost of capacity used. Unavoidable fixed cost is excluded.
Special order rule: Accept if offer price > variable cost + any extra specific fixed cost + opportunity cost; Valid when spare capacity exists and regular sales are not affected. If capacity is full, include the contribution lost on regular sales.
Shutdown rule: Continue if Contribution > Avoidable (shutdown-saved) fixed costs; Short-run rule. Fixed costs that continue after shutdown are ignored. Consider the long term and non-financial effects too.
Total profit after the decision: Profit = Total contribution − Fixed costs; Use it to check that your chosen plan beats the alternatives.

How to solve Decision Making Using Marginal Costing questions

Use this order for any marginal costing decision question in the exam.

1Read the question and name the decision: make or buy, special order, product mix, pricing or shutdown.
2Separate costs into variable and fixed. Mark which fixed costs are avoidable or specific to the decision.
3Cross out irrelevant items: unavoidable fixed costs, absorbed overheads and sunk costs.
4Compute contribution (total and per unit). If a scarce resource exists, compute contribution per unit of that resource.
5Apply the rule: rank by contribution per scarce unit, compare variable cost with the buying price, or compare contribution with avoidable fixed cost.
6Add opportunity cost where capacity or a resource has an alternative use. Respect demand limits and capacity.
7Show a proof, such as total contribution less fixed cost, or the net saving of the chosen option.
8Write the decision in one sentence, with the number that justifies it and any non-financial points, such as quality, supplier reliability or the effect on regular customers.

Quickest way: Contribution table and one-line verdict

When to use it: Use when time is short and the question gives many cost items. It works for all five decision types.

Draw a small table with selling price, variable cost and contribution per unit for each option.
For a limiting factor, add one more row: contribution per scarce hour or kg. Rank and fill the capacity from the top, capping at demand.
For make or buy, ignore the fully absorbed cost. Compare variable cost (plus avoidable fixed cost) with the quote.
For special orders and shutdown, ask only one question: does extra contribution exceed extra fixed cost or lost contribution?
Write the verdict and the rupee gain or loss in one line.

Common mistakes in Decision Making Using Marginal Costing

Using fully absorbed (total) cost to decide make or buy.
Cost sheets show total cost per unit, so it looks like the cost of making.
Fix: Use only variable cost plus avoidable fixed cost. Unavoidable fixed overhead continues whether you make or buy, so leave it out.
Ranking products by contribution per unit when a limiting factor exists.
Students habitually pick the product with the highest contribution or P/V ratio.
Fix: Rank by contribution per unit of the scarce resource, and then apply the demand limit for each product.
Ignoring opportunity cost of spare or released capacity.
The question gives the alternative use as a separate line, and students treat it as extra information.
Fix: If making uses capacity that has another use, add the contribution lost to the cost of making. If buying releases capacity, add the contribution gained to the benefit of buying.
Rejecting a special order because the price is below the normal cost.
Students compare the offer price with total cost per unit.
Fix: Compare the price with variable cost. With spare capacity and no effect on regular sales, any price above variable cost (plus specific fixed cost) adds profit.
Shutting a plant because it shows a loss after fixed costs.
Students look at net loss, not contribution.
Fix: Compare contribution with the fixed costs that would actually be saved. If contribution is higher, continue, because it covers part of the fixed costs that continue.
Giving a number but no decision statement or non-financial comments.
Students stop after the calculation.
Fix: End with a clear recommendation. Mention relevant qualitative factors, such as supplier reliability, quality and the effect on regular customers, in a line.

Worked examples

Example 1

Ranjit Products makes two products, A and B, using the same machine. Only 6,000 machine hours are available. Data per unit: Product A: selling price ₹100, variable cost ₹60, machine hours 4. Product B: selling price ₹80, variable cost ₹50, machine hours 2. Maximum demand: A 1,000 units, B 2,000 units. Fixed costs are ₹40,000. Find the profit-maximising mix and the profit.

Show the solution

Contribution per unit: A = 100 − 60 = ₹40. B = 80 − 50 = ₹30.
Contribution per machine hour: A = 40 ÷ 4 = ₹10. B = 30 ÷ 2 = ₹15.
Rank: B first (₹15), then A (₹10).
Make B up to maximum demand: 2,000 units × 2 hours = 4,000 hours. Hours left = 6,000 − 4,000 = 2,000.
Use the remaining hours for A: 2,000 ÷ 4 = 500 units, which is within demand of 1,000.
Contribution: B = 2,000 × 30 = ₹60,000. A = 500 × 40 = ₹20,000. Total = ₹80,000.
Profit = 80,000 − 40,000 = ₹40,000.
Check: if A is made first (1,000 units, 4,000 hours), B gets 2,000 hours = 1,000 units. Contribution = 40,000 + 30,000 = ₹70,000, which is lower.

Answer: Make 2,000 units of B and 500 units of A. Total contribution is ₹80,000 and profit is ₹40,000.

Example 2

Kaveri Engineering makes 10,000 units of a component each year. Cost per unit: material ₹40, labour ₹30, variable overhead ₹10, fixed overhead absorbed ₹20 (total ₹2,00,000, all unavoidable even if the component is bought). An outside supplier offers the component at ₹90 per unit. (a) Should the company make or buy? (b) If buying would release capacity that can earn a contribution of ₹1,50,000 a year from another product, what is the decision?

Show the solution

(a) Variable cost of making = 40 + 30 + 10 = ₹80 per unit. Fixed overhead is unavoidable, so it is irrelevant.
Relevant cost of making = ₹80 per unit, against the buying price of ₹90.
Annual saving from making = (90 − 80) × 10,000 = ₹1,00,000. Total absorbed cost of ₹100 should not be used.
(b) Buying would cost ₹1,00,000 more per year than making (10 × 10,000).
Released capacity earns ₹1,50,000 contribution.
Net benefit of buying = 1,50,000 − 1,00,000 = ₹50,000.
Check: the opportunity cost of making is ₹1,50,000. Relevant cost of making = 8,00,000 + 1,50,000 = ₹9,50,000. Cost of buying = 9,00,000. Buying is cheaper by ₹50,000.

Answer: (a) Make, which saves ₹1,00,000 a year compared with buying. (b) Buy, which gives a net gain of ₹50,000 a year, provided the supplier is reliable and the quality is acceptable.

Exam tips

In make-or-buy and shutdown questions, always list which fixed costs are avoidable. Many marks go for correctly leaving out irrelevant costs.
For limiting factor problems, show a ranking table with contribution per unit, scarce units per product, contribution per scarce unit and rank. Then show allocation of hours step by step to earn step marks.
In MCQs, check the trap before choosing: absorbed fixed overhead, sunk costs and the demand cap are the usual traps. Do a quick variable cost versus price comparison.
Write a final recommendation line with the rupee figure and one qualitative factor. Examiners usually award a mark for interpretation.
If two limiting factors appear, do not use a simple ranking. Check whether the question expects a simple comparison of feasible plans or another method and show your working clearly.

Practice questions from Marginal Costing

Decision Making 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.

Decision Making Using Marginal Costing: frequently asked questions

What is a limiting factor in marginal costing?

A limiting factor is a scarce resource that restricts output, such as machine hours, labour hours or a raw material. When it exists, you rank products by contribution per unit of that resource, not by contribution per unit of product.

Should fixed cost be considered in a make or buy decision?

Only if it is avoidable when you stop making the item. Fixed cost that continues anyway is irrelevant. Include avoidable fixed cost and any opportunity cost of the capacity used.

When should a special order be accepted below normal cost?

Accept it when there is spare capacity, the price is above variable cost plus any extra specific fixed cost, and regular customers will not be affected. If capacity is full, you must also deduct the contribution lost on regular sales.

Should a loss-making product or plant be shut down?

Not always. If the product or plant gives positive contribution that exceeds the fixed costs saved by closing, continue it in the short run. Shut down only when contribution is less than the avoidable fixed costs, or when there are strong strategic reasons.