This document discusses marginal costing and its use in short-term decision making. It provides examples of how marginal costing can be used to make make-or-buy decisions by considering only variable costs, one-off order decisions by evaluating contribution, product discontinuation decisions by analyzing contribution per product, and limiting factor analysis to determine optimal production levels when there are resource constraints. Fixed costs are generally ignored in short-term decision making unless they are incremental to the decision being considered. Marginal costing allows managers to focus on costs and revenues that change with different short-term business decisions.

1. Relevant costing
and short-term
decision making
INTRODUCTION TO MANAGEMENT
ACCOUNTING
WEEK 8

2. Role of marginal costing
Use of contribution –
Fixed costs can be ignored (unless incremental)
Enables only costs and revenues that change as a result of a
particular course of action to be considered
Can be used for following short-run decisions:
Make or buy,
Acceptance of a one off order,
Discontinuing a product,
Limiting factor/key factor (existence of shortage)

3. Make or buy
The make or buy decision is essentially the choice between
making a product in-house or outsourcing and buying in.
A product should be made in-house if the relevant cost of
making the product in-house is less than the cost of buying the
product externally.
Fixed costs are excluded unless they are incremental with regard
to the decision.

4. Make or buy - example
The following data relates to a company manufacturing modems:
Production 50,000 units
Fixed costs £400,000
£/unit
Material 15.50
Labour 17.50
Variable overhead 21.00
Marginal cost of manufacture 54.00
Fixed costs/unit 8.00 £400,000/ 50,000 units
Total product cost 62.00
External supplier has offered to supply the modems at £59.50/unit. Production
capacity will not be used elsewhere if it were not employed (spare) in the
manufacture of modems. Make or buy?

5. Make or buy – example solution
Fixed cost will be incurred irrespective of whether the modems
are bought or manufactured therefore:
Benefit of manufacture = 59.50 – 54.00 = £5.50/unit

6. Make or buy
If spare capacity exists, the relevant cost of making the product
in-house is the variable cost of internal manufacture.
If spare capacity does not exist, the relevant cost of making the
product in-house is the variable cost of internal manufacture,
plus the opportunity cost of internal manufacture (e.g. lost
contribution from another product)

7. Make or buy - Other issues
Reliability of external supplier: quantity, quality, price,
delivery
Alternative use of resource: outsourcing will free up
resources which may be used in another part of the
business.
Social: will outsourcing result in a reduction of the
workforce? Redundancy costs should be considered.
Legal: will outsourcing affect contractual obligations with
suppliers or employees?
Confidentiality: is there a risk of loss of confidentiality,
especially if the external supplier performs similar work for
rival companies.
Customer reaction: do customers attach importance to the
products being made in-house?

8. Acceptance of a one off order
One off order usually at a lower than normal price
Spare capacity exists therefore normal production would remain unaffected
Cost of the order would be of importance
Fixed costs excluded unless incremental with regard to the decision
Contribution used – Difference between proposed selling price and variable
cost of production

9. One off order – basic example
The following data relates to a company manufacturing keyboards:
Production 10,000 units
Fixed costs £75,000
A new customer wants to purchase 3,000 keyboards at a price of only
£9.00 each. Spare capacity exists. Accept the additional one off order?
£/unit
Selling price 15.00
Material 2.50
Labour 1.50
Variable overhead 3.00
Marginal cost of manufacture 7.00

10. One off order – basic example
SOLUTION
Additional contribution – (£9 - £7) x 3,000 units = £6,000
Effect on profit
On financial grounds, accept one off order
Original Original + one off
order
£000’s £000’s
Sales revenue 150 177
Variable costs (70) (91)
Contribution 80 86
Fixed costs (75) (75)
Profit 5 11

11. One off order – other issues
Possible non-financial factors to be considered –
Reaction of existing customers
Better use of spare capacity – more profitable option?
Effect on the market – change in pricing policy?

12. Discontinuing a product
Company produces several products
Some products no longer considered profitable
Contribution of products evaluated
If discontinued, variable costs no longer incurred
Fixed costs of business as a whole likely to remain unchanged
therefore will have to be borne by remaining products
Products with positive contribution should be continued to help
pay off fixed costs

13. Discontinuinga product - example
A company manufactures four products:
It has been suggested that products 3 and 4 be
discontinued from production as they are both loss making.
Should products 3 and 4 be discontinued?
PRODUCT 1 2 3 4
£’000s £’000s £’000s £’000s
Sales 550 750 200 260
Variable costs 330 550 100 160
Fixed costs 100 75 125 110
Profit/(loss) 120 125 (25) (10)

14. Discontinuinga product - example
SOLUTION
Contribution evaluation -
All products make positive contribution and should
therefore be continued
PRODUCT 1 2 3 4
£’000s £’000s £’000s £’000s
Sales 550 750 200 260
Variable costs (330) (550) (100) (160)
Contribution 220 200 100 100

15. Discontinuinga product - example
Original production plan
Discontinuing products 3 & 4
Effect on profit if products 3 and 4 are discontinued because they are loss
making –
£’000’s
Cont. P 1 220
Cont. P2 200
Cont. P3 100
Cont. P4 100
Total cont. 620
Less F/C 410 (100 + 75 + 125 +
110)
Profit 210
£’000’s
Cont. P 1 220
Cont. P2 200
Total cont. 420
Less F/C 410 (100 + 75 + 125
+ 110)
Profit 10

16. Limiting factor/key factor
(existence of shortage)
A limiting factor or key factor is 'anything which limits the activity
of an entity. An entity seeks to optimise the benefit it obtains
from the limiting factor. Examples are a shortage of supply of a
resource or a restriction on sales demand at a particular price'. -
CIMA Official Terminology
A limiting factor is any factor which is in scarce supply and which
stops the organisation from expanding its activities further, that
is, it limits the organisation’s activities. Example machine
capacity, skilled labour, material

17. Limitingfactor
Contribution per unit of limiting factor (scarce resource) is
used
In a limiting factor situation, contribution will be maximised
by earning the biggest possible contribution per unit of
limiting factor (scarce resource).
The contribution per limiting factor should be maximised as
this will in turn maximise the contribution and hence the
profit of the business as a whole

18. Limiting factor
Points to bear in mind –
Fixed costs will remain the same irrespective of the
production plan
Units of output are divisible and optimal output may
include fractions of units
Limiting factor analysis is a method used for decision
making in the short term with one limiting factor. If there
are two or more scarce resources, then linear
programming should be used instead.
One qualitative factor may be the loss of customer
goodwill due to the company being unable to supply all of
its regular customers.

19. Limitingfactor
The usual objective in questions is to maximise profit. Fixed costs
unchanged in the short run hence contribution maximised
Step 1: identify the scarce resource.
Step 2: calculate the contribution per unit for each product.
Step 3: calculate the contribution per unit of the scarce resource
for each product.
Step 4: rank the products in order of the contribution per unit of
the scarce resource.(highest = 1st)
Step 5: allocate resources using this ranking until scarce resource
is used up (optimal production plan)

20. Limitingfactor - example
Data relates to a company manufacturing four products:
PRODUCT 1 2 3 4
Maximum demand (units) 1,000 1,550 1,250 1,375
£ £ £ £
Sales 30 54 20 25
VARIABLE COSTS:
Material 10 20 6 8
Labour 12 24 5 12
Contribution 8 10 9 5
The same material used for the production of all 4 products is in short supply and costs
£2/kg. Only 21,750kg available for the period in question.
Fixed costs = £12,000 for this period. Determine the optimal production plan to maximise
profits

21. Limitingfactor– example solution
All 4 products have positive contribution
We need 29,750 kg (5x1000+10x1,550+3x1,250+4x1,375)
But material limited to 21,750kg
Therefore contribution per kg of material (limiting factor) for each product –
Ranking –
1st – Product 3
2nd – Product 1
3rd – Product 4
4th – Product 2
PRODUCT 1 2 3 4
Contribution 8 10 9 5
Material needed (kg) 5 10 3 4
Contribution per kg of material 1.6 (8/5) 1 (10/10) 3 (9/3) 1.25 (5/4)

22. Limitingfactor – example solution
Allocating the scarce resource (material) using the ranking
Material limited to 21,750 kg
Optimal Production Plan of material consumption
Left
Product 3 – 1250 units x 3kg = 3,750 kg 18,000
Product 1 – 1000 units x 5kg = 5,000 kg 13,000
Product 4 – 1375 units x 4 kg = 5,500 kg 7,500
Product 2 – 750 units x 10 kg =7,500 kg -
21,750 kg

23. Limitingfactor – example solution
PRODUCT 1 2 3 4 TOTAL
Production plan (units) 1,000 750 1,250 1,375
£ £ £ £ £
Contribution per unit 8 10 9 5
Contribution 8,000 7,500 11,250 6,875 33,625
Fixed costs (12,000)
PROFIT 21,625
Product 3 – 1250 units x 3kg = 3,750 kg
Product 1 – 1000 units x 5kg = 5,000 kg
Product 4 – 1375 units x 4 kg = 5,500 kg
Product 2 – 750 units x 10 kg =7,500 kg
21,750 kg
PROFIT generated using contribution per limiting factor -

24. Limitingfactor – example solution
Production plan and Profit using ranking of contribution only rather than
contribution per limiting factor
Production plan
Product 2 – 1550 units x 10kg =15,500 kg
Product 3 – 1250 units x 3kg = 3,750 kg
Product 1 – 500 units x 5 kg = 2,500 kg
Product 4 – 0 units x 4 kg = 0 kg
21,750 kg
PRODUCT 1 2 3 4
Contribution (£) 8 10 9 5
PRODUCT 1 2 3 4 TOTAL
Production plan (units) 500 1,550 1,250 0
£ £ £ £ £
Contribution 4,000 15,500 11,250 - 30,750
Fixed costs (12,000)
PROFIT 18,750