Marginal Analysis

Marginal analysis refers to situations where we use contribution to make decisions. 

The key is that only costs which vary with the decision should be included in an analysis of the decision. 

Marginal analysis can be used in key areas of decision making such as: 

– Accepting/rejecting special contracts

– Closing/continuation decisions.

Each of these will now be considered in turn. 

Accepting/rejecting special contracts: 

The basic decision rule here is that we should calculate: 

Extra revenue received fewer marginal costs of meeting the special contract 

This would typically mean that items such as fixed costs, contracted costs etc. would be ignored in the decision as they would not be affected by the decision. 

Closure or continuation decisions: 

Part of a business, for example a department or a product, may appear to be unprofitable. The business may have to make a decision as to whether or not this area should be shut down. 

The quantifiable cost or benefit of closure: 

The relevant cash flows associated with closure should be considered. For example: 

– The lost contribution from the area that is being closed (= relevant cost of closure)

– Savings in specific fixed costs from closure (= relevant benefit of closure)

– Known penalties and other costs resulting from the closure,e.g.redundancy, compensation to customers (= relevant cost of closure)

– Any known reorganisation costs (= relevant cost of closure)

– Any known additional contribution from the alternative use for resources released (= relevant benefit of closure).

If the relevant benefits are greater than the relevant costs of closure then closure may occur.