76 UNIT-4

UNIT-4
Decisions Involving Alternate Choices
 Introduction

Marginal costing is an important tool for cost control, business decision making and to solve multiple
business problems. It is also recognized as variable costing technique. Generally, the total cost of a
business is divided into two parts fixed cost and variable cost. Fixed cost is also known as period cost
because it is not change with the change in production up to a certain level. On the other hand, variable
cost changes directly with the change in production and thereby termed as product cost. This variable cost
is termed as marginal cost which is based upon the principle that fixed cost is uncontrollable andnot
included in cost of production for taking decisions. Therefore, in marginal costing technique valuation of
closing stock is done on the basis of variable cost.

Marginal Costing

Marginal costing is a technique of calculation of marginal cost and the result of change cost and profit
with change in volume. The decision is taken after considering the variable cost. The basic difference
between marginal and absorption costing is that in absorption costing, value of closing stock is calculated
on the basis of total cost whereas, in marginal costing, value of closing stock is calculated on the basis of
marginal or variable cost.

For example, if a company produce 100 units at variable cost of Rs. 20 per unit and fixed cost of
Rs. 1000, then total cost will be Rs. 2000 + Rs. 1000 = Rs. 3000, but if company produces one extra unit
then only variable cost will change, fixed cost remains the same. Now total cost will be Rs. 2020 +
Rs. 1000 = Rs. 3020. So, the decision will be taken on the basis of variable cost. This technique is known
as marginal costing and extra cost of production of one unit i.e. Rs. 20 is known as marginal cost.

According to the Institute of Cost and Management Accountants, London, “Marginal Costing is the
ascertainment, by differentiating between fixed costs and variable costs, of marginal cost and of the effect
of profit of changes in the volume or type of output.”

Marginal costing has a positive relationship between variable cost and production units. It depends upon
the rule that variable cost must be realised. The difference between the sale and variable cost is known
as contribution. The profit under marginal costing is calculated as follow:

Sales ××××××
Less: Variable cost (××××××)
Contribution ××××××
Less: Fixed cost (××××××)
Profit/Loss ××××××
 Marginal cost equation

S – V – F = ±P
S–V=F±P
S–V=C=F±P
Where, S = Sales

V = Variable cost
F = Fixed cost
C = Contribution
P = profit

Characteristics of marginal costing technique

Marginal costing technique separates the fixed and variable cost and take decision on variable cost basis.
The major features of marginal costing technique are as follow:
 It divides total cost into fixed and variable cost.
 It is not an independent costing method such as job costing, process costing. It is an important
tool for management decision making.
 Variable cost is known as product cost whereas, fixed cost is termed as period cost.
 In marginal costing contribution is a significant concept used for decision making
 Valuation of closing stock and work in progress is done on the basis of variable cost.
 Decision Making
Decision making is defined as a cognitive process of taking decisions by choosing best option among
different alternatives. It is a method to identify the various alternatives related to problem solving and
selecting the best one. It is a process which makes decisions more deliberate and profitable. Marginal
costing technique is used by the management to make rational decisions. For example, decision related
to make or buy any product, deciding the optimum sales or product mix, etc.

Although, environment is dynamic and no decision is helpful in every situation. Decision making is an
iterative and continuous process. It is the duty of top management to take appropriate decision in uncertain
or risky situations which require knowledge, skills and experiences.

Process of decision making

Management has to follow systematic approach to take worthy decisions. No method of decision making
fits to every situation. The following steps may be adopted while taking a decision in business:
Defining
the
problem

Post Identification
implementat of different
ion review alternatives

Implementing
the decision

Figure: Process of decision making

1. Defining the problem: While taking a decision, it is necessary to identify the problem
first. If problem is well defined, then fifty per cent of solution may be achieved. The
problem should be clear and measurable so that timely decision may be taken.

2. Identification of different alternatives: After defining the problem relevant information

is collected to identify the potential solutions to the problem. There may be more than one
alternative for the solutionof a problem which can be identified through market research,
consultant advices or various external sources. Management has to consider all possible
alternatives to take appropriate decisions.
 3. Selection of the best alternative: The next step is to evaluate and selecting the best
alternative among different ones on the basis of risk return or cost benefit analysis. Various
quantitative and qualitative measures based upon the facts and statistics should be
considered to select the best alternative.

4. Implementing the decision: After identifying the most suitable solution to the problem,
the decision is implemented to sort out the problem.

5. Post implementation review: The next step is to appraise the result after the execution
of the decisionto see whether the problem is solved or not. If there are any discrepancies,
suitable action should betaken to rectify the errors.

Cost Related With Decision Making

While taking decisions in the business, various costs are associated with the decisions, some of
whichare as follow:

 Relevant Cost: These are future costs which can be affected by change in decision of
management. The relevant cost is variable cost which may be incremental or avoidable.
While comparing different alternatives, if cost changes, then that particular cost will be
relevant cost. For example, if a firm purchased machinery costing Rs 10,000 and now its
book value remains Rs 1,000. The machinery became obsolete but, can be sold for Rs 2000
after modification which will cost Rs 500. Here, Rs. 2000 and Rs. 500 both will be relevant
cost.

For example, a company truck carrying some goods from city A to city B, is loaded with one more ton of
goods. The relevant cost is the cost of loading and unloading the additional cargo, and not the cost of the
fuel, driver salary, etc. It is due to the fact that the truck was going to the city B anyhow, and the expenditure
was already committed on fuel, drive salary, etc. It was a sunk cost even before the decision of sending
additional cargo.

 Differential Cost: It can be defined as an increase or decrease in total cost after the decision
of management. It may be incremental or decremental cost. It is an important term for
decision making. If total cost increases, when decision is changed from one alternative to
another, it is termed as incremental differential cost. Conversely, if total cost decreases,
 when decision is changed from one alternative to another, it is termed as decremental
differential cost.

 Opportunity Cost: Opportunity cost may be termed as benefit sacrificed while choosing
one alternative over other. If while choosing alternative profits are forgone, such sacrificed
profit is known as opportunity cost. For example, a producer can produce either chair or
table. The value of one chair is Rs. 500 and value of table is Rs. 700. The producer
decides to manufacture chair instead of table as resources are limited. The sacrificed
value of table Rs. 700 over chair is known as opportunity cost.

 Shut down Cost: It is fixed cost which is incurred during the closing down of a division,
department or business. Since if production is not done, variable cost is not incurred. But,
some fixed cost is related with the business such as salary, depreciation etc. which are
unavoidable, are defined as shut down cost.

 Sunk Cost: It is the cost which cannot be affected by any future decision. These costs are
irrelevant for management decisions since they have been incurred. The decisions which
are irreversible, cost associated to them are known as sunk cost.

Irrelevant or sunk costs are to be ignored when deciding on a future course of action. Otherwise, these costs
could lead to a wrong decision. For example, at the time of decision to replace typewriters by computers, all
corporations ignored the cost of typewriters, even though some of them were bought just some time before
the decision. If the cost of typewriters had been taken into consideration, some of the corporations could
have erred and delayed the computerization decision.
Decision Involving Alternate Choices
Managers have to take various timely decisions out of various alternatives. Marginal costing is a
technique to take effective decision such as profit planning, deciding optimum product policy, make or
buy decision of a product, etc. Following are some important management problems regarding which
management has to take decision:
1. Make or buy decision
2. Expand or buy decision
3. Expand or contract decision
4. Change vs. status quo
5. Retain or replace
6. Exploring new markets
7. Optimum product mix
8. Adding and dropping a product
1. Make or buy decision
A firm has to take decision whether to purchase a product or manufacture it itself. If a firm manufactures
a product or part, thereof then it has to incur some fixed or variable costs and if, firm purchases the same
from market, it has to choose the supplier by taking into consideration the availability of material, financial
soundness, regular supply and reliability of supplier. The decision should be taken aftercomparing the cost
and benefit received by two alternatives. If cost of purchase is less than the marginal cost of manufacturing,
then it is advisable to purchase the product from the market instead of manufacturing it by the firm.
Example 4.1 A company finds manufacturing cost of a product in its firm is Rs. 10 each and if purchase
from the market, then cost will be Rs. 8 each with regular supply. Give the suggestions to the company
whether to make or buy the product. The cost component of making a product is as follow:
Rs.
Direct Material 4
Direct Labour 2
Variable expenses 1
Fixed expenses 3
Total 10
Solution: By putting aside the fixed cost which has to incur, the decision should be taken on the basis of
marginal cost.
Marginal cost of product manufactured
Rs.
Direct Material 4
Direct Labour 2
Variable expenses 1
Total 7
Since the marginal cost of product manufacturing i.e. Rs. 7 is less than the cost of purchase i.e. Rs. 8, it
is advisable to manufacture the product as it gives some contribution to the firm.
2. Expand or buy decision
Due to limited capacity, a company may purchases some component of its product from market, but if it
wants to expand its capacity, then such decision will be taken after considering the cost and benefits
involved in such decision. Since expansion requires huge capital expenditure as well as opportunity cost,
the decision should be taken if expansion yields definite return.
3. Expand or contract decision
When firm expands its business operations, it results in various economies such as reduction in fixed cost,
increased capacity, maximising the consumer specification, etc. On the contrary, a firm will do contraction
in its operations if it results into diseconomies. The expansion or contraction may further create various
problems such as communication barriers, increase in cost, division of authority and responsibilities etc.
The decision of expansion should be taken if it results in profits as expansion includes some fixed cost
also.
Example 4.2 A firm wants to expand its plant which increases its fixed cost by Rs. 20,000. The present
fixed cost is Rs. 50,000. The current capacity of plant is to produce 10,000 units in a year which increased
by 50% after expansion. Presently, the variable cost is Rs.10 per unit which will go down by
20 percent after expanding plant capacity. Selling price remains unaffected via expansion which amounts
to Rs. 20 per unit. You have to suggest whether the firm should expand its plant capacity or works with
its present capacity.
Solution: The profit of two alternatives is computed as follow:
Unit produced after expansion = 10,000 + 10,000 × 50% = 15,000 units
Variable cost after expansion = 10 - 10 × 20% = Rs. 8 per unit
Fixed cost after expansion = Rs. 50,000 + Rs. 20,000 = Rs. 70,000
 Present Position After Expansion
Rs. Rs.
Sales
10000 × 20 2,00,000
15000 × 20 3,00,000
Less: Variable cost
10000 × 10 1,00,000
10000 × 8 80,000
Contribution 1,00,000 2,20,000
Less: Fixed cost 50,000 70,000
Profit 50,000 1,50,000
It is clear from the example that profit after expansion increased, so the firm should take the decision of
expansion of its plant.
4. Change vs. Status quo
Sometimes management has to take decision regarding its policies whether they should be changed or not.
For example decision regarding change in selling price, asset purchase or hire on lease, to accept or reject
a specific order, make capital expenditure or not. For such decisions, a manager should take into
consideration the different costs and benefit derived by change in policy. Differential cost may be
interest on capital, depreciation. Increase in variable and fixed cost, etc. and differential gain may be tax
benefits, cost saving and increase in contribution, etc.
Example 4.3: XYZ Ltd. Produces 10,000 pens and its cost budget is given below:
cost
Rs.
Material 4
Wages 2
Manufacturing expenses 3
Variable overhead 1
Total 1,00,000

₹
Fixed overheads
60,000
Selling Price 20
If company increases its selling price by 10% to do saving in manufacturing expenses by Rs. 1 per unit
and variable expense by Rs. 0.5 per unit, then sale will go down by 20%.
On the other hand if company decreases its selling price by 5% to increase the sale, then sales volume will
increase by 10 percent, but additional sales will increase its fixed cost by Rs. 7000 and reduce its material
cost per unit to Rs. 2. Suggest which proposal should be accepted.
Solution:
Present position Proposal I 8000 Proposal II 11000
10000 units units units
Selling price per unit ` 20 ` 22 ` 19
Sale
2,00,000 1,76,000 2,09,000
Less: Material
40,000 32,000 22,000
Wages
20,000 16,000 22,000
Manufacturing expenses
30,000 16,000 33,000
Variable overhead
10,000 4,000 11,000
Contribution
1,00,000 1,08,000 1,21,000
Less: Fixed expenses
60,000 60,000 67,000
Profit
40,000 48,000 54,000

If selling price is reduced, then, profit will be maximized. So, proposal II should be accepted.
5. Retain or replace
Sometimes management has to decide whether to retain or replace an asset in the business. Such problem
can be solved through differential benefit and cost analysis. Differential cost may be interest on owner’s
capital, depreciation on assets, increase in variable and fixed cost, etc. and differential benefits may be tax
saving, cost saving and increase in contribution, etc. Besides that, social cost and benefit should also be
considered in such type of decisions.
Example 4.4: A firm purchased machinery worth Rs. 50,000 one year ago having no scrap value and
useful life of five years. Firm charged depreciation on straight line basis. Now the firm wants to replace
its old machinery to new one to reduce its operating cost Rs. 30,000 p.a. The cost of new machinery is Rs.
70000 with no salvage value and useful life of four years. The present level of sales and variable cost per
annum is Rs. 1, 50,000 and Rs. 1, 10,000 respectively. Evaluate the profitable proposal.
Solution:
The present value of old machine is Rs. 40,000. If firm replaces the old machinery, then this Rs. 40,000
will be treated as loss.
Statement of comparative profitability of the two proposals for a period of four years
Old machinery New machinery
(`) (`)
Sales (A) 6,00,000
6,00,000
Variable cost 3,20,000
4,40,000
Loss on writing off old machinery 40,000 40,000
Depreciation -- 70,000
Total cost (B) 4,30,000
4,80,000
Profit (A-B) 1,70,000
1,20,000

The total profits of four years will be increased by Rs. 50,000 (Rs. 1, 70,000 – Rs. 1, 20,000) or Rs.
12,500 per year. Therefore, it is appropriate for the firm to replace the old machinery to new one.
6. Exploring new markets
If plant capacity of a firm remains unutilised, then a firm should accept the additional order of production
to enjoy the benefit of mass production. A firm should accept the additional order on lessthan the
market price because there is no additional fixed cost incurred in such order and the decision should be
taken on the basis of marginal cost, if total profits increased after accepting the order, firm should choose
to take new order. The firm can utilise its idle capacity to fulfil the order from foreign market or from new
domestic market.
Example: 4.5
BKL Ltd Company works on 50% capacity and sells 10000 units per month at a price of Rs. 100 per unit.
Cost per unit of the product is given below:

Rs.
Direct Material 30
Direct Labour 20
Variable expenses 10
Total 60
The fixed expenses incurred by the company are Rs. 200000. Now, the company received an order of
10000 units from foreign market at a price of Rs. 80 per unit. If company accepts the order, the fixed
expenses will increased by 10%. State whether the company should accept the order or not?
Solution:
Presently, the company is working on 50% capacity, to produce additional 10000 units; it will have to
work at 100% capacity.
Statement of comparative profitability

At Present Additional
capacity 10000 order 10000
units Rs. units Rs. Total

Selling price per unit 100 80

Sale 10,00,000 8,00,000 18,00,000

Less: Direct Material 3,00,000 3,00,000 6,00,000

Direct Labour 2,00,000 2,00,000 4,00,000

Variable expenses 1,00,000 1,00,000 2,00,000

Contribution 4,00,000 2,00,000 6,00,000

Less Fixed Cost 2,00,000 20,000 2,20,000

Profit 2,00,000 1,80,000 3,80,000

The company should accept the order because total profits will increase after accepting the order.
7. Optimum product mix
If a firm produces more than one product then the problem arises regarding the product mix which
maximises profits. The firm has to face this problem due to limited resources or capacity. A firm should
adopt a sale mixture which generates higher profit or maximum contribution. While selecting theprofitable
mix, key or limiting factor should also be considered.
Example 4.6: The sales/production mix of a company is as follow:
1. 1000 units of product A and 1000 units of product B
2. 2000 units of product C
3. 1000 units of product A, 500 units of product B and 500 units of product C
The cost and sale per unit is given below:
A B C
Rs. Rs. Rs.
Direct Material 4 4 5
Direct Labour 2 4 3
Variable expenses 3 4 2

Selling Price 15 25 20

The fixed cost is Rs. 2,000. Calculate the profitable product mix.
Solution:
Statement of Marginal Cost
A B C
per unit per unit per unit
Rs. Rs. Rs.
Selling Price 15 25 20
Less: Direct Material 4 4 5
Direct Labour 2 4 3
Variable expenses 3 4 2
Contribution Per unit 6 13 10

Selection of profitable mix

1. 1000 units of product A and 1000 units of product B
Contribution
A = 1000 × 6 6,000
B = 1000 × 13 13,000
Total Contribution 19,000
Less Fixed Cost 2,000
Profit 17,000

2. 2000 units of product C

Contribution
C = 2000 × 10
20,000
Less Fixed Cost 2,000
Profit 18,000

3. 1000 units of product A, 500 units of product B and 500

units of product C
Contribution
A = 1000 × 6
6,000
B = 500 × 13
6,500
C = 500 × 10 5,000
Total Contribution
17,500
Less Fixed Cost 2,000
Profit 15,500
Conclusion: The product mix 2 is more profitable as compared to other product mixes as it earns higher
profit of Rs. 18000.
8. Adding and dropping a product
When a firm manufactures more than one product and one product has to be discontinued, then
management should take decision on the basis of the contribution, effect on sales of other products and
plant capacity, etc. Marginal costing technique helps in management decision making of adding or
dropping a product or product line. The product which gives lesser contribution should be discontinued.
Example 4.7: Pearl Ltd. makes three products X – 6000 units, Y – 4000 units and Z – 2000 units. The
cost per unit of each product is as follow:

X Y Z
Rs. Rs. Rs.
Raw Material 3 4 5
Direct wages 2 5 4
Variable overhead 4 3 2
Fixed expenses 6 5 7
Total cost 15 17 18

Selling Price 20 25 22

The firm decides to discontinue a product, and by doing so then the production of other products will go
up by 50%. You are required to compute which product should be discontinued.
Solution:
Total fixed expenses of each product
Rs.
X (6000 × 6) 36000
Y (4000 × 5) 20000
Z (2000 × 7) 14000
70000

Contribution per unit of each product per unit

Rs.
X (20 - 9) 11
Y (25 - 12) 13
Z (22 - 11) 11

(1) If product X is discontinued, production of Y and Z will be increased by 50% each. Production of Y
and Z would be 6000 units and 3000 units respectively.
 Contribution Rs.
Y = 6000 × 13 78,000
Z = 3000 × 11 33,000
Total Contribution 1,11,000
Less: Fixed Cost 70,000
Profit 41,000

(2) If product Y is discontinued, production of X and Z will be increased by 50%

each. Production of Xand Z would be 9000 units and 3000 units respectively.

Contribution Rs.

X = 9000 × 11 99,000

Z = 3000 × 11 33,000

Total Contribution 1,32,000

Less: Fixed Cost 70,000

Profit 62,000

(3) If product Z is discontinued, production of X and Y will be increased by 50%

each. Production of Xand Y would be 9000 units and 6000 units respectively.

Contribution Rs.

X = 9000 × 11 99,000

Y = 6000 × 13 78,000

Total Contribution 1,77,000

Less: Fixed Cost 70,000

Profit 1,07,000

If product Z is discontinued then profit will be maximum i.e. Rs. 1, 07,000.