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Decision-Making using Marginal Costing-I

Decision-Making using Marginal Costing-I

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Lesson-17
Decision-Making using Marginal Costing-I
Learning Objectives
\u2022
To apply marginal costing technique to decision-making
\u2022
To use the knowledge of contribution analysis and CVP analysis for a single firm and
understand its utility and limitations
\u2022
To use the knowledge of contribution analysis and CVP analysis for a multi-product firm
and understand its utility and limitations
Introduction
In this lesson, we will be dealing with practical problems and cases related to CVP analysis and
multi-product situations.
Understanding Decision-Making for Multi-Product Firm
1. Ascertaining Relative Profitability of Products

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.

Let us look at an example to understand this.
Illustration 1
A company manufactures three products X, Y and Z. It has prepared the following budget for the
year 2003:
Total
Product X Product Y Product Z
Sales
4,20,000
80,000
2,50,000
90,000
Factory Cost
Variable 2,90,500
40,000
1,74,000
76,500
Fixed
29,500
5,000
16,000
8,000
Production Cost
3,20,000
45,000
1,90,000
85,000

Selling and
Administration Cost
Variable

35,000
14,000
14,000
7,000
Fixed
8,000
3,500
3,200
1,300
Total Cost
3,63,000
62,500
2,07,200
93,300
Profit
57,000
17,500
42,800 - 3,300 (loss)

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.

Solution
The information contained in the budget may be rearranged in the form of a marginal cost
statement as shown below:
Marginal Cost Statement
Particulars
Total
Product X
Product Y
Product Z
Sales
4,20,000
80,000
2,50,000
90,000
Variable Costs:
Factory Cost
2,90,500
40,000
1,74,000

76,500
Selling and Admn.
Cost

35,000
14,000
14,000
7,000
Total Marginal Cost
3,25,500
54,000
1,88,000
83,500
Contribution
94,500
26,000
62,000
6,500
Fixed Costs
37,500
8,500
19,200
9,800
Profit
57,000
17,500
42,800
-3,300 (loss)
Profit-Volume Ratio
22.5%
32.5%
24.8%
7.2%

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.

2. Determining Profitability of Alternative Product Mix
The objective of an enterprise is to maximize profits. The management of business enterprise
would prefer the product mix which is ideal in the sense that it yields maximum profits.
Product mix means combination of products which is intended for production and sales.

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:

Illustration 2
A manufacturing firm supplies you with the following information:
Product P
Product Q
(Rs.)
(Rs.)
Direct material per unit
16
14
Direct wages paid
5
4
Variable expenses (100% of wages)
5

4
Fixed expenses......... Rs. 1,300
Sales price per unit

32
26
Sales-mixtures are as follows:
\u2022
400 units of product P and 400 units of product Q
\u2022
500 units of product P and 300 units of product Q
\u2022
600 units of product P and 200 units of product Q
You are required to prepare the marginal cost statement to show contribution per unit and suggest
the sales mix which optimizes profits.
Solution
Marginal Cost Statement
Product A
Product B
(Rs.)
(Rs.)
Sales Per Unit
32
26
Direct Material Per Unit
16
14
Direct Wages Per Unit
5
5
Variable Expenses
5
4
Marginal Cost Per Unit
26
22
Contribution Per Unit
6

4
Profit from Different Sales Mix
1. 400 units of P and 400 units of Q

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