Management Accounting · Marginal Costing (Management Accounting)

Marginal Costing in Decision Making for CMA Inter

Updated 10 October 2026 · Fact-checked

Marginal costing in decision making means choosing the option that gives the highest extra contribution, using only relevant costs. Ignore sunk and unchanged fixed costs. Compare contribution (or cost saved) across options. If a resource is scarce, rank products by contribution per unit of that scarce resource.

Understand Marginal Costing in Decision Making

A decision is about the future. So only costs and revenues that change because of the decision matter. These are relevant costs. A sunk cost is already spent and cannot be recovered by any choice, so it is ignored. A fixed cost that stays the same under every option is also ignored.

Marginal costing helps because it separates variable cost from fixed cost. Contribution = Sales − Variable cost. Contribution first covers fixed cost, and what is left is profit. If an option adds contribution and fixed costs do not change, profit rises by that amount.

The same idea works for all common decisions. In make or buy, compare the variable cost of making (plus any avoidable fixed cost) with the buying price. In a special order, accept if the price is above marginal cost and there is spare capacity. In shut-down or drop-a-product decisions, continue while contribution exceeds the avoidable fixed cost. In pricing, the marginal cost is the floor price for extra business.

When a resource is limited (labour hours, machine hours, material), the key factor (limiting factor) decides the mix. Rank products by contribution per unit of the key factor, not by contribution per unit of product. Also count opportunity cost: if a resource is used for one job, the contribution lost elsewhere is a relevant cost.

Marginal costing gives a short-term answer. Check non-financial points too: quality, supplier reliability, effect on regular customers and long-term pricing.

Key rules to remember

Contribution: Contribution = Sales − Variable cost; Per unit or in total. Fixed cost is not deducted when comparing options.
Profit: Profit = Contribution − Fixed cost; Use for the final profit under the chosen option.
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, if any.
Special order rule: Accept if price > marginal cost (with spare capacity and no fixed cost change); Add any extra fixed cost and opportunity cost of the order to marginal cost.
Shut-down rule: Continue if Contribution > Avoidable fixed cost; Unavoidable fixed cost is ignored because it continues either way.
Key factor ranking: Contribution per unit of key factor = Contribution per unit ÷ Units of key factor per unit; Allot the scarce resource in the order of highest ranking, subject to demand limits.
Opportunity cost: Contribution forgone from the next best use of a scarce resource; Include it only if the resource is scarce.

How to solve Marginal Costing in Decision Making questions

Use this order for any decision question. It keeps you on relevant figures and shows clear steps to the examiner.

1Read the question and name the decision: make or buy, special order, shut-down, key factor or pricing.
2Check for a limit. Is there spare capacity, or is a resource scarce?
3List the relevant items. Cross out sunk costs, allocated fixed costs that will not change and past figures.
4Compute variable cost, contribution and any avoidable fixed or opportunity cost for each option.
5Compare options on contribution or on cost. For scarce resources, rank by contribution per unit of key factor.
6Show the final profit or the gain or loss from the decision, if asked.
7Write a clear recommendation in one line, and add one or two non-financial points.

Quickest way: Contribution comparison in a two-column table

When to use it: Use when the question gives a full cost sheet with many items and asks for a yes or no decision.

Write two columns: Option A and Option B (or Continue and Stop).
Enter only the items that differ between the columns.
Total each column and take the difference.
Add one line for fixed costs that really are avoidable or newly incurred.
State the recommendation with the rupee gain.

Common mistakes in Marginal Costing in Decision Making

Including the full absorbed fixed cost in the make-or-buy comparison
Students copy the total cost per unit from the cost sheet.
Fix: Use only variable cost plus fixed cost that can be avoided if you buy. Absorbed overhead that continues is ignored.
Rejecting a special order because the price is below total cost
Students compare price with full cost including fixed overhead.
Fix: Compare with marginal cost when there is spare capacity. Accept if there is positive contribution and no effect on regular sales.
Ranking products by contribution per unit when a resource is scarce
Per-unit contribution is the first number visible.
Fix: Divide by units of the key factor used per product, and rank on that.
Shutting down a unit because it shows a loss
The loss is after allocated fixed costs that continue anyway.
Fix: Compare contribution with avoidable fixed cost. Continue if contribution is higher.
Treating sunk cost as relevant, such as past machine cost or depreciation
These items appear in the cost sheet and look important.
Fix: Ignore past cost and depreciation. Only the future resale or disposal value, if given, is relevant, as an opportunity cost.
Forgetting opportunity cost when capacity is full
Students stop once they find variable cost.
Fix: If the order or product uses scarce resources, add the contribution lost from the next best use.

Worked examples

Example 1

Rathi Engineering makes 10,000 units of a component. Cost per unit: material ₹40, labour ₹30, variable overhead ₹10, fixed overhead ₹20 (total ₹2,00,000). A supplier offers to supply at ₹85 per unit. If bought, fixed cost of ₹50,000 would be saved and the capacity would be idle. Should the company make or buy?

Show the solution

Variable cost per unit = 40 + 30 + 10 = ₹80.
Total variable cost of making = 80 × 10,000 = ₹8,00,000.
Add avoidable fixed cost = ₹50,000. Relevant cost of making = ₹8,50,000.
Cost of buying = 85 × 10,000 = ₹8,50,000.
Both options cost the same, ₹8,50,000.
The remaining fixed cost of ₹1,50,000 continues either way, so it is ignored.

Answer: The costs are equal at ₹8,50,000, so there is no financial gain either way and the decision rests on non-financial factors such as quality, supply reliability and control. Make if these favour in-house production. Buy if the supplier is reliable. If the freed capacity could be put to another use (an assumption, not given in the problem), the extra contribution from that use would tilt the decision towards buying.

Example 2

Kaveri Ltd makes two products with 6,000 labour hours available. Product X: selling price ₹100, variable cost ₹60, 4 hours per unit, demand 1,000 units. Product Y: selling price ₹70, variable cost ₹40, 2 hours per unit, demand 2,000 units. Fixed cost is ₹50,000. Find the best mix and the profit.

Show the solution

Contribution per unit: X = 100 − 60 = ₹40; Y = 70 − 40 = ₹30.
Contribution per labour hour: X = 40 ÷ 4 = ₹10; Y = 30 ÷ 2 = ₹15.
Labour hours are the key factor, so Y ranks first.
Make Y up to demand: 2,000 units × 2 = 4,000 hours.
Remaining hours = 6,000 − 4,000 = 2,000. Make X = 2,000 ÷ 4 = 500 units (below demand of 1,000).
Contribution: Y = 2,000 × 30 = ₹60,000; X = 500 × 40 = ₹20,000. Total = ₹80,000.
Profit = 80,000 − 50,000 = ₹30,000.

Answer: Make 2,000 units of Y and 500 units of X. Total contribution is ₹80,000 and profit is ₹30,000.

Exam tips

Start every answer by naming the decision and the relevant-cost rule. Examiners give marks for the method.
Show a clear working table. Mark each item as relevant or not, and give a short reason for the ones you ignore.
In MCQs, check first for spare capacity, scarce resources and avoidable fixed costs. These decide the answer in most questions.
End with a one-line recommendation and one non-financial factor. A bare number can lose marks.

Practice questions from Marginal Costing (Management Accounting)

Marginal Costing in Decision Making in other exams

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

Marginal Costing in Decision Making: frequently asked questions

What is the difference between relevant cost and sunk cost?

A relevant cost is a future cost that changes with the decision. A sunk cost is already spent and cannot be changed by any option, so it is ignored. Past purchase cost of a machine is a typical sunk cost.

When should a company accept a special order below total cost?

Accept it when there is spare capacity, the price is above marginal cost, no extra fixed cost arises and regular customers will not demand the same low price. The extra contribution adds to profit.

How do I solve a key factor problem?

Find contribution per unit, divide by units of the scarce resource used, and rank products. Allot the resource to the top-ranked product up to its demand, then to the next, until the resource is used up.

Should a loss-making product always be dropped?

No. Drop it only if its contribution is less than the fixed cost that would be saved. If it has positive contribution above avoidable fixed cost, dropping it reduces total profit.