22.13. Decision-Making Using Marginal Costing

Marginal costing helps in answering managerial questions such as:

• Make or Buy Decisions: Whether to manufacture a component in-house or outsource.

Make or buy decisions involve determining whether it is more cost-effective for a company to produce a product internally (make) or to purchase it from an outside supplier (buy). With marginal costing, managers look at variable costs associated with in-house production versus the price offered by suppliers. If the variable cost of making the item is lower than buying it, the company should manufacture it.

Imagine a bakery deciding whether to make its bread or buy it from a local supplier. If the bakery calculates that making the bread costs $1 per loaf (marginal cost) and the supplier charges$1.50, the bakery would choose to make its own bread to save on costs.

• Product Mix Decisions: Choosing the most profitable combination of products.

Product mix decisions involve selecting the right combination of products to offer based on profitability. Managers analyze contributions per unit from different products, focusing on those that have the highest contribution margin — that is, the difference between selling price and variable cost. The goal is to maximize overall profit by prioritizing high-margin products.

Consider a restaurant that offers various dishes. If spaghetti has a contribution of $5 and lasagna has a contribution of$8 but requires more ingredient costs, the restaurant might decide to offer more lasagna if that maximizes overall profitability, while still serving a well-rounded menu.

• Accepting Special Orders: If offered below normal price but above variable cost.

When companies receive special order requests that may be priced below the normal selling price, marginal costing allows decision-makers to evaluate whether to accept these orders. As long as the price offered covers the variable costs, even if it doesn’t cover fixed costs fully, it can contribute positively to the company's profit since it does not incur additional fixed costs.

Imagine a clothing manufacturer who usually sells shirts for $20 each. A retailer orders 100 shirts for$15 each. If the variable cost to make each shirt is $10, the manufacturer will still earn$5 per shirt from this special order, which contributes positively to the overall profits even though the price is lower than normal.

• Shut Down or Continue: During losses, assess if continuing makes sense.

Companies often face decisions about whether to continue operations when they are incurring losses. Using marginal costing, managers can analyze if the revenue generated is covering variable costs. If the revenue exceeds variable costs, it may be wise to continue operating in the short-term, even if fixed costs aren't being covered, until circumstances improve.

Think of a startup that is losing money but has a product that is gaining traction in the market. If it knows it can make $20,000 in revenue against variable costs of$15,000, it might decide to continue operating to capitalize on future growth, as long as the contribution helps cover fixed costs temporarily.

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