Meaning of Marginal Cost

It is the amount by which total cost increases when one extra unit is produced, or the amount of cost which can be avoided by producing one unit less. Accordingly, marginal cost may also be defined as the variable cost incurred due to a specific activity. It is concerned with variable costs, because fixed costs by definition do not change with the volume produced.

Definition of Marginal Costing

The Official C.I.M.A Costs of the Terminology defines marginal costing as, The accounting system in which variable costs are changed to costs units and fixed period are written off in full against the aggregate contribution. Its special value is in decision-making Accordingly, Marginal cost = Variable cost = Direct material + Direct labour + Direct expenses + Variable overheads.

Typical decision-making situations

Marginal costing can provide useful information for decision-making in a number of typical situations such as the following:

1) Suspension of activities:
Sometimes, management may be confronted with the problem of closing down an unprofitable department, branch or a line of activity. In such a situation, the guiding principle to be followed is the contribution by the product, branch or department to the pool or fund. The object of the analysis is to increase profits by dropping an unprofitable line of activity and replace the same with a profitable one. Products or departments which show a negative contribution should be closed if there is no possibility of an improvement. Negative contribution means that the variable cost per unit exceeds the price and the business would be better off without this line of activity. If there is positive contribution, the decision should be

in the favour of its continuation. As otherwise it would mean loss of contribution and the consequent reduction in profits. Sometimes, it becomes worthwhile to suspend the activities even if there is positive contribution or continue the line regardless of the negative contribution. Accordingly, the application of the rule of positive contribution is not absolute. For instance, the negative contribution may be temporary ant there is the possibility of its becoming positive. Similarly, positive contribution may be considered to be insufficient and the resources tied up in the activity could be got released by suspension and invested elsewhere to earn a higher return. Thus, it is difficult to lay down strict rules of decision-making with regard to a situation such as this. Much depends upon not merely the quantitative factors but qualitative also such as the effects of suspension or closure on the other parts or activities of the concern.

Illustration:
MOM Ltd., is engaged in three distinct lines of production. Their production cost per unit and selling prices are as under:

A Production (units) Material Cost Wages Variable Overheads Fixed Overheads Selling Price 3,000 Rs. 18 7 2 5 32 40 8 26 9 3 8 46 60 14 2,000

B 5,000 Rs. 30 10 3 9 52 61 9

C Rs.

The management wants to discontinue 1 line & gives you assurance that production in 2 other lines shall rise by 50%. They intended to discontinue the line which produces article A as it is less profitable.

a) Do you agree to the scheme in principle? Do you think that line A should be discontinued? b) Offer your comments with supporting calculations. (B.Com, Mahatma Gandhi, April 1988)

Solution:
Marginal Cost Statement (Present Position) Material Cost Wages Variable Overhead Marginal Cost Contribution Selling Price No. of units produced & sold Contribution per unit Total Contribution Less: Fixed Cost Profit If A is discontinued No. of units Contribution per unit Total Contribution Less: Fixed Cost Profit A (Rs) 18 7 2 27 13 40 3000 13 39,000 15,000 24,000 B (Rs) 26 9 3 38 22 60 2,000 22 44,000 16,000 28,000 3,000 22 66,000 C (Rs) 30 10 3 43 18 61 5,000 18 90,000 45,000 45,000 7,500 18 1,35,000 Total (Rs)

1,73,000 76,000 97,000

2,01,000 76,000 1,25,000

a) The scheme cannot be agreed with in principle. A should not be discontinued since it contributes Rs.39,000 for meeting fixed cost allocated to of and shows a profit of Rs.24,000. b) If A is discontinued & production of B & C is increased by 50% total contribution would be more by Rs.28, 000 & profit by the same figure. Since maximization of revenue is the guiding factor in tactical decisions & not merely negative or positive contribution, the proposal to drop line A may be considered.

However, it is clear from the problem that the selling price of A is the lowest. As such, before taking a decision, it is necessary to see whether the selling price could be increased with a view to increasing the contribution of A. It is not possible owing to market conditions, then line A may be closed down.

2) Pricing Decisions:
One of the purposes of cost accounting is the ascertainment of cost for fixation of selling price. Although market price is the result of market forces, the absence of perfect competition has the effect of empowering every firm to fix its own price. However, price fixation is one of the fundamental problems that management has to face. Whether the cost plus formula of pricing, differential pricing or productline pricing, depends upon the cost which sets the lowest limit to pricing. During normal circumstances, price is based on full cost. This is in fact, the principle underlying absorption costing. However, during business recession, this principle of full cost pricing cannot be followed. Further, when spare capacity exists, and it is necessary to make use of the same to execute a bulk order at a lower price, the question arises as to what extent the price could be reduced. The same would be the case when a buyer in a foreign country desires to buy the product at a lower price. In these cases, it is the techniques of marginal costing that aids pricing decisions. The principle that should govern the fixation of price in these special cases is that the price should cover the marginal cost. Sometimes, it may become necessary to reduce the price even below the marginal cost. The circumstances necessitating the fixation of price at or below cost are the following: i) When it is desired to make a new product popular in the market. ii) When a foreign market is explored. iii) When the surplus stock of a product which is liable to deteriorate is to be disposed off. iv) To assist the sale of a joint product.

v) When there is keen competition in the market and lowering the price is business strategy adopted to drive the competitor out of the market. vi) When it is felt that lowering the price is much better to keep the business going rather than close it temporarily, and meet the costs of closing and subsequent reopening. vii) When employees, especially skilled workers, cannot be retrenched. vii) To retain the old customers who may be lost to competitors in the activities are suspended. ix) To keep plant and machinery quite fit for production which could not otherwise be possible if business is stopped. x) When it is desired to make use of the existing stock of materials likely to deteriorate.

Illustration:
The following details were extracted from the budget for the forthcoming year: Rs. Sales (40,000 units) Direct Materials Direct Labour Variable Overheads Fixed Overheads 1,20,000 80,000 40,000 1,00,000 Net Profit 3,40,000 20,000 Rs. 3,60,000

In order to improve the amount of net profit budgeted; it is proposed to reduce the selling price from Rs.9 to Rs.8 per unit. It is anticipated that if this reduction is made, the volume of sale would increase by 30,000 units. Assuming that if the selling price were reduced as suggested, calculate the net profit that will be achieved.

Solution:
Marginal Cost Statement Sales: (@Rs.9) Less: Marginal cost Contribution Less: Fixed cost Net Profit At 40,000 units Rs. 3,60,000 (@Rs.8) 2,40,000 1,20,000 1,00,000 20,000 At 70,000 units 5,60,000 4,20,000 1,40,000 1,00,000 40,000

Thus, a price reduction by Re.1 would increase the contribution by Rs.20, 000 and the net profit also by the same amount. The reduction is desirable provided the market is capable of absorbing the additional output and there is no increase in fixed costs.

3) Selection of suitable product mix: In the case of a multi-product concern, the question often arises as to the product mix or sales mix which will yield maximum profit. Such a question cannot be easily answered because when a concern is engaged in different lines of activity, it is quite unlikely that each line of activity is as profitable as the other in view of different cost structures and different sales prices. Under such circumstances, management may alter the existing product mix by pushing up the production or sale of the less profitable ones. In other words, it is necessary to select, from amongst the available alternative combinations of products which gives maximum contribution. Such a combination is known as the optimum product mix. If there is a key factor, the contribution per unit of that factor has to be compared in order to know the profitability of the products.

Illustration:
The following 3 alternative plans are being considered for the next accounting year: Plan A: Sell 1,000 units of product X and 500 units of product Y. Plan B: Sell 800 units of product X and 700 units of product Y. Plan C: Sell 760 units of each product. X Rs. 8 3 2 0.50 Y Rs. 7 3 2 0.25

Selling Price Direct Material Cost Direct Wages cost Variable overhead

Calculate the budgeted profit that would result from each of the 3 alternatives and suggest the most profitable alternative. The budgeted fixed cost are Rs.1, 500.

Solution:
Selling Price Marginal Cost Contribution per unit X 8 5.50 2.50 Y 7 5.25 1.75

Plan A: Sell 1,000 units of product X and 500 units of product Y. Contribution: X 1,000 x Rs.2.50 Y 500 x Rs.1.75 Total Contribution Less: Fixed cost Net Profit Rs.2,500 875 3,375 1,500 1,875

Plan B: Sell 800 units of product X and 700 units of product Y. Contribution: X 800 x Rs.2.50 Y 700 x Rs.1.75 Total Contribution Less: Fixed cost Net Profit Plan C: Sell 760 units of each product. Contribution: X 760 x Rs.2.50 Y 760 x Rs.1.75 Total Contribution Less: Fixed cost Net Profit 1,900 1,330 3,230 1,500 1,730 Rs.2,000 1,225 3,225 1,500 1,725

Plan A, with 1,000 units of product X and 500 units of product Y is the best mix since the contribution and the profit are the highest. However, before the decision, consideration should be given to the limiting factors if any.