We know that a manufacturing concern engaged in the production of various products is interested in the study of the relative profitability of its products. This is so because it may suitably change its production and sales policies in case of those products which it considers to be less profitable or unproductive.
This is where the concept of P/V ratio, provided by the marginal costing technique, is much helpful in understanding the relative profitability of products. It is always profitable to encourage the production of that product which shows a higher P/V ratio.
You can also be at ease when sometimes the management is confronted with a problem of loss and has to decide whether to continue or abandon the production of a particular product which has resulted in a net loss. Marginal costing technique properly guides the management in such a situation. If a product or department shows loss, the absorption costing method would hastily conclude that it is of no use to run the department and it should be closed down.
Or sometimes, this type of conclusion will mislead the management. The marginal costing technique would suggest that it would be profitable to continue the production of a product if it is able to recover the full marginal cost and a part of the fixed cost.
On the basis of above information, we understand that the company management is thinking to discontinue with the production of product Z which has shown loss. The management seeks your expert opinion on the issue before they take a final decision. You are required to comment on the relative profitability of the products.
Selling and Admn.
Profit-Volume (P/V) ratio is the ratio of contribution to sales. It is expressed in terms of percentage. After preparing the above statement and analysis, we can make the following recommendations:
As discussed in the marginal cost statement, the contribution of product Z is Rs. 6,500 which goes toward the recovery of fixed cost of Rs. 9,800. If the production of product Z is discontinued, the company will lose the marginal contribution of Rs. 6,500 while it will have to incur the fixed cost of Rs. 9,800. The total profit of Rs. 57,000 will be reduced to Rs. 50,500 (57,000 - 6,500). Thus, it is advisable that the production of Z should not be discontinued. As regards the relative profitability, product X is more profitable than Y and Z as the P/V ratio in this case is highest. The production and sales of product X should, therefore, be encouraged.
A firm producing more than one product has to ascertain the profitability of alternative combinations of units or values of products and select the one which maximizes profits. How marginal cost analysis helps the management in this regard is illustrated with the help of the following example:
Fixed expenses......... Rs. 1,300
Sales price per unit
Profit from Different Sales Mix
1. 400 units of P and 400 units of Q
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