In certain situations where we have to make a choice between two alternative courses of action, it can be useful to set the costs for each Marginal costing
alternative side by side and look at the overall difference in total costs or profit. This technique is often termed differential costingbecause we are looking at the differences in costs/revenues between the alternatives.
Example
You plan to make a journey to Edinburgh city centre by yourself for fun and have a choice of going by train or by car. Cost is the only consideration in this case and the relevant costs for each alternative are:
By train By car Difference
£ £ £
Local travel to station 2.00 nil +2.00
Train fare 25.00 nil +25.00
Car travel (variable costs only) nil 16.40 –16.40
Car parking fee nil 3.00 –3.00
27.00 19.40 +7.60
Ignoring all other aspects but cost, your decision will be to travel by car as it has the advantage of being £7.60 cheaper. This is the total difference in cost between the two alternatives. Notice that car travel is priced at marginal cost on the grounds that road fund licence, insurance and most depreciation are time-based fixed costs and are incurred regardless of this decision. The variable costs of this journey are fuel, servicing and tyre wear.
However, if you were negotiating with an employer for reimbursement of car expenses for journeys taken for work purposes, you would regard some, if not all, of these fixed costs as relevant and require reimburse- ment for them. Sometimes a compromise rate is agreed whereby the employer pays for all variable costs and makes some contribution towards the fixed costs; thereby both parties gain something.
Make or buy
Differential costing can be applied to so-called make or buydecisions where, ignoring non-cost considerations, buying-in can be justified by a company when the purchase price from outside is cheaper than the marginal cost of production. The term make or buy does not just refer to physical products but also to service activities, for example:
ᔢ employing own catering staff or franchising out;
ᔢ employing own cleaners or putting function out to tender;
ᔢ employing own legal staff or hiring professional firm.
Example
An organization’s office cleaning is contracted out at present, for an annual fee of
£12,500. As an alternative, the organization could employ its own part-time cleaners at a cost of £9,000 excluding employer’s NICs. Cover for sickness and holidays would add another 10 per cent to this figure. In either case the organization pays for the permanent hire of equipment at £80 per month and would have to buy cleaning materials costing
£500 per annum if it used its own cleaning staff. The following differential cost analysis will assist us in making a decision.
Own Contract Difference
£ £ £
Cleaning materials 500 nil -500
Contract fee nil 12,500 +12,500
Cleaners’ wages 9,000 nil –9,000
Holiday/sickness cover 900 nil –900
Hire of equipment 960 960 nil
Totals 11,360 13,460 +2,100
The conclusion from this differential cost analysis is that the organization should employ its own cleaners because using a contract cleaner has an additional annual cost of £2,100.
The above example may be criticized on the grounds that it does not take all costs into account when employing one’s own cleaners. Staff have to be recruited and trained both initially and when someone leaves. This is a cost bearing on the personnel function. Staff also have to be paid and records maintained even if they are not eligible for income tax and national insurance. This is a cost bearing on the payroll section of the accounting function. There are also likely to be other costs relating to demands for supervision, purchasing, insurance and other functions.
In this example these are likely to be small incremental additions to overheads and therefore difficult to cost. In a larger make or buy situa- tion, we may have to cost incremental effects on overheads or we would not be making a valid comparison.
Where capital expenditure is involved in a make or buy decision, then investment appraisal techniques will have to be employed to allow for the capital expenditure and the time value of the money invested.
These topics are discussed in Chapter 17.
Outsourcing
Throughout the past decade there has been a marked increase in the divestment of support activities and facilities management to other Marginal costing
organizations. This may not necessarily be on cost grounds alone, but to enable management to concentrate on core activities.
When manufactured items are concerned, the decision to outsource is of strategic importance, particularly if it is made before any invest- ment takes place. The advantages of using a contract manufacturer for components or finished products include:
ᔢ reduced investment in fixed assets and working capital;
ᔢ no set-up, development and training costs;
ᔢ commercial risk reduced in uncertain markets;
ᔢ quality assurance to relevant British Standards where appropriate;
ᔢ management freedom to concentrate on marketing and strategic issues.
There can also be a downside. A company’s ability to innovate and develop its product range may be weakened by outsourcing if the necessary know-how is retained by the contract manufacturers. The features of the traditional buyer-supplier relationship is a short-term adversarial one with each trying to get the best price with little sharing of ideas between the two parties.
More recently, the move has been towards partnership sourcing as an alternative to straightforward outsourcing, with a consequent big reduc- tion in the number of suppliers. Key features of partnership sourcing are:
ᔢ long-term relationship;
ᔢ pooling of technical information;
ᔢ sharing of the risks and rewards.