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Management accounting--decision management: marginal costing is a useful decision-making tool, but it needs to be handled with care to avoid oversimplifying a business's situation.

The concepts under which differential costs, opportunity costs, sunk costs etc are identified were largely developed before World War II by economists, who illustrated their ideas using simple business settings. Today's firms operate in a more complex environment and they have to consider the effects of proposed actions in the short, medium and long term.

Marginal costing ignores cash flows that won't be affected by a proposal, since they are deemed irrelevant, but this can take a naive view of prepaid sunk costs or future committed costs when applied to short-term decisions, since firms must cover all their costs in the medium to long term to make a profit. Prepaid or committed costs can't be ignored when preparing quotations just because a company has decided for good business reasons to buy an asset outright rather than leasing it, for example. The application of marginal costing in these circumstances could result in the setting of lower prices, which could trigger a price war and drive down profitability in an entire sector.

Most companies rarely have only a single potential contract on the table at any one time. In reality, many business opportunities will be available to them. The decision to accept one of these may affect a firm's ability to accept another that could be more profitable. As a result, it needs to find contracts that provide not only a contribution but also an acceptable profit. If one opportunity does not provide an adequate return, other avenues must be explored. Although marginal costing can be more safely applied to "one-off" orders, even these can have a sting in the tail. There's one apocryphal story of a UK firm in the early eighties that sold components at a knock-down price to an eastern bloc company, only to find that its customer had resold the entire order at a profit back into the UK.

The simplistic application of marginal costing can also conceal the commercial implications of a proposal. For example, a company may be thinking about offering a special price to win business from a new customer or to retain the custom of an existing one. It's important to remember that when it grants a discount to one customer it is subsidising one of its other customers' competitors. This will produce a negative reaction from the company's unsubsidised customers if the discount becomes public knowledge: they will agitate for the same price.

Time also affects the classification of costs for short-term decision-making, since costs that are fixed over the short term can become variable over the longer term. Consider the following scenario: a company has a long-term contract for the supply of a fixed quantity of materials every month and it has surplus stocks of these materials owing to a downturn in the market. A potential customer for the surplus has been identified, but it isn't prepared to buy it unless a significant discount is granted. The correct short-term decision would be for the company to negotiate an acceptable discount with the potential customer, because the cost of the goods is irrelevant--the company must buy the contracted items no matter what it does. But the situation changes at the end of the contract period, since the company is in a position to negotiate a variable supply of materials--ie, the cost of the goods becomes relevant.

Marginal costing underpins other management accounting techniques. Limiting-factor analysis, for example, is used when a company has a short-term internal constraint, such as a lack of skilled labour, in order to determine the short-term profit-maximising sales mix. It identifies the short-term contribution in terms of the limiting factor for each product affected by that constraint. Absorption costing cannot be used for this analysis, since it includes production overheads--ie, costs that are fixed in the short term. Although limiting-factor analysis will indicate which products should be made to maximise short-term profits, other factors--ie, contractual obligations and long-term strategic considerations--must be taken into account in order to reach an informed decision.

Most companies operate in complex, dynamic environments and are under pressure to achieve obJectives in the short, medium and long term. Decisions to accept or reject proposed investments also open and close paths to the future, so marginal costing must be used with care to avoid simplistic short-term analyses that produce incorrect or flawed decisions.

P2 Recommended reading

H Johnson and R Kaplan, Relevance lost: The Rise and Fall of Management Accounting, Harvard Business School Press, 1991.

C Wilks, Management Accounting--Decision Management Study System, 2005 edition, CIMA Publishing, 2004.

Grahame Steven is a lecturer at Napier University, Edinburgh.
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Title Annotation:Paper P2
Author:Steven, Grahame
Publication:Financial Management (UK)
Date:Jul 1, 2005
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