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Decision Making III

Decision Making III

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Lesson-19
Decision-Making-III
Learning Objectives
\u2022
To know how to apply marginal costing technique to pricing decisions
\u2022
To use the knowledge of contribution analysis for price differentiation
\u2022
To know how to make decisions for alternative choices
\u2022
To understand the decision-making process
\u2022
To know how to apply marginal costing technique to decision-making
\u2022
To know how to apply contribution analysis for decision-making on alternative choices
Introduction
In this lesson, we will be discussing how marginal costing technique helps in decision-making
regarding pricing.

In fact, pricing is the most crucial and complicated decision with which the company is dealing.
This is because on this depend the market strategies, competition, survival and many long- as well
as short-term decisions.

Pricing in Home and Foreign Markets

Before understanding the pricing in different markets, we should first understand the term \u201cpricing.\u201d Pricing of a product is governed primarily by its cost of production and the nature of competition being faced by the production unit. Once market forces fix the price, it remains stable at least in the short-term. During short period when selling price, marginal cost and fixed costs remain the same, an entrepreneur is in a position to establish relationship between them. On the basis of such a relationship, it is easy to fix the volume of sales and selling price during normal and abnormal times in the home market.

Just think how far the prices can be cut. In case of a foreign buyer, to effect additional sales is a
problem which is realistically answered by the marginal costing technique.
Let us go through an example for this problem.
Illustration
A firm is currently producing 20,000 units annually of a product. The cost structure is as under:
Per unit (Rs.)
Materials
4.50
Labor
3.25
Variable expenses
1.25
Variable cost per unit
9.00
Fixed expenses
6,600
Selling price
Rs. 12 per unit

The firm is thinking to reduce the selling price due to severe competition to Rs. 10.80 per unit (10% decrease). How much extra should it produce and sell if the previous level of profit is to be maintained?

Solution
Marginal Cost Statement (20,000 units)
Cost
Reduction
Per Unit
Amount
Per Unit
Amount
Selling price
12.00
2,40,000
10.80
2,16,000
Materials
4.50
90,000
4.50
90,000
Labor
3.25
65,000
3.25
65,000
Variable expenses
1.25
25,000
1.25
25,000
Marginal cost
9.00
1,80,000
9.00
1,80,000
Contribution
3.00
60,000
1.80
36,000
Fixed costs
6,600
6,600
-
-
Profit
53,400
29,800

As a result of the decrease in selling price by 10%, the profits of the firm will be reduced to Rs. 29,400 if no effort for additional sales is made. Since the firm has decided to maintain the present level of profit, i.e. Rs. 53,400, it will need additional sales to counter balance the loss due to price reduction. The number of units required to be sold to maintain the existing levels of profit is calculated as under:

Number of units to be sold =
Total contribution required
Contribution per unit
=
60,000
= 33,333 units
1.80
Therefore, extra sales required = 33,333 - 20,000 = 13,333 units.
Note-- The present level of profit can be maintained only if the present contribution could be
attained by the price change.
Pricing in Foreign Markets

A foreign market can be kept separate from the domestic market due to many legal and other restrictions imposed on imports and exports. As such a different price can be charged from foreign buyers. Any company which enjoys surplus production capacity can increase its production to sell in the foreign market at lower prices if its full fixed cost already stands recovered from the sales in the home market. Any price in excess of the marginal cost will lead to more revenue. This aspect is explained in the following example:

Illustration

Light Lamp Ltd. is operating at 60% of its installed capacity and producing 27,000 units. These are sold in the domestic market at a price of Rs. 15 per unit. The marginal cost of production is Rs. 12 per unit and the fixed cost amounts to Rs. 15,000.

The company has received a foreign offer to purchase 9,000 units of its product at a price of Rs. 13.50 per unit. The company will have to incur nothing on additional fixed cost. However, it will have to bear Rs. 0.75 per unit as distribution cost in respect of foreign buyer.

(a) Suggest to the management whether or not the order should be accepted and (b) what will be
your recommendations if the buyer is a local one?
Solution
Production and Sales
Production and Sales
at 60% capacity
at 80% capacity
(27,000 units)
(36,000 units)
4,05,000
5,26,500
3,24,000
4,32,000
81,000
94,500
15,000
15,000
66,000
79,500
Particulars

Sales
Marginal cost
Contribution
Fixed cost
Profit

Less: Distribution cost of
export of 9,000 units
@ Rs. 0.75 per unit

6,750
Net profit
66,000
72,750
Excess profit from exports = 72,750 - 66,000 = 6,750

The above cost statement clearly shows that the company should accept the foreign offer as it will generate an extra profit of Rs. 6,750. If the buyer is a local one, the company will have to keep this buyer separate from other buyers for additional supply of 9000 units @ Rs. 13.50. Otherwise, other customers will also ask for price reduction and the company will be put to difficulties.

Price under Recession/Depression

Recession is an economic condition under which demand declines. During depression, the demand is at its lowest ebb and the firms are confronted with the problem of price reduction and closure of production.

Under such conditions, the marginal costing technique suggests that prices can be reduced to a level of marginal cost. In that case, the firm will loose profits and also suffer loss to the extent of fixed costs. This loss will also be borne even if the production is suspended altogether. Selling below marginal cost is advisable only under very special circumstances.

Illustration
Solar Ltd. is experiencing conditions of depression. The demand is declining and the company is

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