MANAGERIAL APPLICATIONS OF MARGINAL COSTING —~| (DECISIONS INVOLVING ALTERNATIVE CHOICES) . Marginal costing technique is a valuable aid to management in taking many managerial decision It is a useful tool for making policy decisions. profit planning and cost control. The information supa:ic OLLI CON Chan Prot Ang, . nab sajcost method 18 Utaly not y ea anager probles 1 pecing Decisions, 2, Poi Planing and Maintaining 4 3, Make oF Buy Decisions Pes Level of Pot 4. roblems of Key oF Limiting Paeoe 5 6 1 8 8 selection of a Suitable or Profitable Effect of Changes in Sates Price, ‘Altemative Methods of Produetion, Determination of Optimum Level of Activity Evaluation of Performance, " 10, Capital Investment Decisions, Sales Mix, important functions of management. Although prices ‘other economic factors yet marginal costing technique sits the management in the fixation of selling prices under various circumstances as (a) Pricing under normal conditions (6) During stiff competition (c) During trade depression (@ For accepting special bulk orders (¢) For accepting additional orders utilising idle capacity () For accepting export orders and exploring new markets. (@) Pricing Under Normal Conditions Under normal circumstances, the prices are based upon total cost of sales so as to cover both fed 5 well as variable cost and in addition to provide for certain desired margin of profit. But prices cnabo be fixed on the basis of marginal cost by adding sufcienty high margin to marginal (variable) «as 50 a5 to cover the fixed cost and profits. However, under other circumstances, products may have ‘be sold ata price below the total cost. For example, inthe days of stiff competition or to meet the siution arising due to trade depression, for accepting special bulk or additional orders for utilising ide cagucity ; for exporting and exploring new markets. et. The products may have to be sold at a price teow the total cost based upon absorption costing. In such circumstances, the prices should be fixed «athe basis of marginal cost (and total cost) in such a manner so as to cover the marginal cost and cetbute something towards the fixed expenses. Sometimes it may become necessary to reduce the ‘ling prices to the level of marginal cost or even below the marginal cst (0) Selling Price Below the Marginal Cost The selling prices of products may be fixed even below the mary Girunsances () To introduce a new product in the market (ii) To popularise a particulat product. L cost in the followingreak-Even Analysis (Cost-Voly Marginal Costing ond Break-Even Anal lume Prop, ng (iii) To explore foreign markets. (iv) To eliminate the competitor from the market (») To help the sale of joint products (vi) To avoid the retrenchment of workers (vil) To dispose off the product of perishable nature. (iti) To utilise idle capaci (ix) To Keep plant and machinery in the running conditions, (x) To retain old customers and prevent loss of future orders. (i) To avoid extra losses by closing down the business (aii) To dispose off surplus stocks. (c) Pricing During Stiff Competition and Trade Depression Daring stiff competition, produces may have to_be sold at a price below the total costn circumstances, the price should be fixed on the basis of marginal cost in such @ manner 50 a8 to cing the marginal (variable) cost and contribute something towards the fixed expenses. Sometines climinate the weaker competitors from the market, the price may be fixed even below the marginal cg During depression also produets may be sold at a price below the total cost. There isa fig the price as a result of depression. The prices can be safely reduced to an extent which covey ty variable cost and contributes something towards the fixed cost. This is so because fixed expenses wi be incurred even ifthe product is discuntinued during depression for @ short period, In ease the prin can be sold at something above the marginal cost, the total loss on account of fixed expenses sal reduce as sales will recover some of the fixed expenses. If there is a serious but temporary fall inte demand of the product, the minimum price that ean be fixed is the marginal cost because selling bei the marginal cost would mean more losses than the losses on closing down the business. Henee, if product can be sold ata price equal to or more than the marginal cos, the business should be continue Under such circumstances. This has been made clear with the help of the following example: cost of a product is € S/- per unit and fixed expenses amount to 81,0000 Suppose, margi Selling price per unit is © 6!- and $0,000 units can be sold at this price. 7 Marginal cost of $0,000 units @ Sper unit 250000 FinedEapenscs ‘oon Toul Cos Zao Selling price of & 6I- per unit is below the total cost of € 7/- per unit, yet itis advantagenss to sell the produets at © 6/- per unit as it is more than the marginal costs. Seeee see feos ese 3m ‘Loss. ae ‘Loss due to fixed expenses, if product is discontinued TT __ neal pc etn LSS 00) ~sa ninedi Oem seaSomy Accepting Special orders, Bulk or me — Nord % ‘Bulk orders, additional orders, export orders and exploring new markets ulk orders, additional orders and orders from foreign or-new markets, may be accepted atyo) Ct EO COHN Chae Profit Analy ) market pri 637 pelo the nora Price 60-06. ifr ie below th mace pce and he ge i oe yaer may be accepted at any price reese 8 ison st ee rice above the ed even otherwise. Any contibuton ® sos) profit, But €aF® MUS be taken to see that soca normal selling price adversely, F ‘Ping an order below the market price does not y. For example, an or ve 1. Such orders are received usually = 10 be taken to accept or reject the larginal cost because the fixed costs have ae i) pie bl te om may oe buying at a normal er jar. The company’s normal it ost for 10,000 jars is given below : " ’ Zz ‘Mise. Supplies sr ae ‘The company has received an offer forthe export under a diferent b era different brand name of jars f.svow at 10,000 jars per month at 75 paise ajar. : ee Write a short report on the advisability or otherwise of accepting the offer. sstton: ‘Marginal Cost Statement Fer Unit Present Proposedanother capaci ‘0% 25 paseperunit 10,005 70,000 c Sis aH) sas Vale) 120 100 usr: Marginal Cost: Direct Material 0.1000 4,000 1000 Direct Labour ones 2415 2415 Power 140 40 140 Mise. Supplies 90880 20 30 Jace 0.0600 a0 00 ass Hess Contipsion 0.7845 7855 2855 Fred Cost, 7935, = ProfuLose Tpi00 25 10,000 units, there isa loss of © 100 in spite of the fact At the present level of activity, Le. price of € 1.25 per unit. The reason is thatthe total ‘at variable cost i only Re. 0.4645 against a selling " cust pe anit (including fixed costs) is & 1.26 per uni, But if addtional 10,000 units are sold it converts ‘elas of & 100 into a profit of € 2,755 in spite of the fact that addtional offer for 10,000 unis is Fre ae Pi oo because of eft tht atonal ales gv w cotton ofMarginal Costing and Break: EVEN ARON O8-Yolume Prag, oon tional sales give contribution ang 55 Le (0.78-0.4648 or say 0.2855 pe nil). A aad Ort in ee ea 2455 Te acceped. However, before taking & fing) een ied costs are involved, the of : following further points should be studied 1 i ge hme met 6 ec ee ange nt na mum profits or to maintain a desired level of sca he ap anette ‘Sing te 0 oe en ‘of profit may be ascertained as follows con the home market Marginal costing techniques the planning of future operations to achieve maxi for maintaining or ataining a desired level Fixed Cost Desired Profit Desi Fixed Costs Desired Profit mee PIV Ratio Mustration 26. The price structure of a cycle made by the Cycle Company Ltd. is as fallen, Per er ‘Wares Labour Variable Overheads Fixed Overheads Profit Seling rice This is based on the manufacture of one lakh eycles per annum. “The company expects that due to competition they will have to reduce selling prices, bt ty want to keep the total profits intact. What level of production will have to be reached, ie, how may «cycles will have to be made fo get the same amount of profit if : (o) the seling price is reduced by 10%. (@) the selling price is reduced by 20%, Solution eae Bese: Fined Overheads =€ 50 per eyee Present Profit = €50 pereyete. TToval No.of Cycles = I lakh Fixed Costs 50% 18 50 lakhs ‘oval Present Profit =® 0 lakhs Fixed Cost + Proft__FixedCost + Profit Desired Sales PIV Ratio Contsbutionperunit (a) If the selling price is reduced by 10% NewSelingprice — =200-10%4= 200-20=8 180COT Hence, = 2.00,000 + 59, 639 oye lg pr road ya NaslingPrie " 00-20% = 200-40 «8 169 esired Sales Fraibilty of surplus capacity, ete. may force a concem to make rather than to buy. Illustration 27. A manufacturing company finds that 4 : le te cnt of malig com yo.051 in is own worshpis® 800 ea te sau raaeia uaa 650 wth euce Ma ae ciel Give ow mapeios Mabie caine eee ooiees Ce ae oe site af Sine 8 See cme 8 Se lta 2 0 ion Since fixed costs are to be incured whether we manufacture this component or no, the decision depends upon the marginal cost of making the component which i calculated as follows Marginal Cost of Component 0.51 (peru) Materials Direct Labour Other Variable Expenses itself ifthe marginal cost of making the component is is advis coenponert it Its advisable to make the componet produced will give some contribution to the lower than the purchase price because every ‘component4 “| beter 6 ty sk Even Analyt (Con-Voume 40 arent Coning od Bree Eer AoC ry company. But incase the marginal cost i higher than the purchase PSs component from outside than to make Inthe above example, rchase price is © 6.50, it 8 not advisable f0 BUY the compen, inmate ei ron ym wil ge a contbuion of $0 pis. But the company should not manufseit the compone Avail at 880 ffom outside, tht cse i eter to Bay than 0 ma * 20,000 bells per annum from an outside supplier cnc ON Pee mance nd nt pra A machin cong yg Will be required to manufacture the item within the factory. The machine has an annual eapaiy 530.00 uns and ie of 5 years. The following addtional information is avaliable = Maal soap aT ' Veabicorhent 100% otto ‘e) The company should contiave To purchase the bells fom outside supplier or shoud wa, them in the factory, and (8) The company should accept an of € 4.50. per unit ? — ‘aerial Labour Variable Overheads (100% of Direct Labou) ty onder to supply $000 bells tothe market ata sein ig Additional Fixed cost of manufacture p.a. Depreciation (50,000 x 1/5) = & 10,000 Since the marginal cost of manufacturing the bel is less than the supplier's price of 85, hee shall be a saving of & (@ 5-4) or Re. 1 per bel if the bell is manufactured within the fact Manufacturing will however result in an additional fixed cost of € 10,000 p.a. Hence the total savig will have 10 be compared with this addtional cost (@) Total savings (contribution) for 20,000 bells = © 20,000 x 1.00 = & 20,000 , Less : Additional fixed cost = 10,000 Profit (Net Savings) % 10,000 Thus, it is advisable to manufacture these bells within the factory (8) I the company accepts the order to supply 5000 bells at € 4.50 per unit, it will result ino ‘an additional contribution (profit) of & 2,500 as calculated below : . Selling price perunit £4.50 ‘Marginal cost per unit ti00 Contribution per unit 050 ‘otal contribution on $000 bells €5,000 » 0,50 =82,500 Total Net savings (a + 6) % 10,000 + 2,500 = © 12,500 Hence, the company should manufacture the bells within the factory and accept the orde supply $000 bells at % 4.50 each. yinl 7 ym of Key oF Limiting Factor eat ming 91" i 8 For wich tiny acon omnkng ‘olin Sats Lining fore PU OF Ses ad ths prevents 12 arse 881 which prodit syne PS ney and te erty ad 8 2 Prod! shoud pei ad teri ey a i si posible manner and to maximise the roi: nes pny ls the i 26S of iin FEOF SHOU be the eterno hes highest contbution per unit of limiting ace oy tre cotton re ult of iting ctr. When eee , laa 1 tak all of them int conden, we ls Ta paris ustration 29. In a factory producin, '8 to different kinds of artic sity of ibis. Eroi the fiers the limiting factor is spe avait 0 m the ellowing information, show which producti more profiabe Pec Cetera Prd Ciera sesh sma ee TEE cous @Re 050 a a0 3 House @ Re. 0.50, - ovshets: Fined S0¥ot labour 1s 19 Varable La a Total cost i100 $75, Setingprie 14.00 aso oft. a Tol Production forthe moth ae oo ‘Maximum capacity per month is 4800 hours. Give proof in support of your answer. sation: i To gpa able Cost A 2 ies Narale 4 2 $00 sob ther 3.00 iso ese vereads Lo 1 = r pc Contin pe nit a sae {hur Hows eed per ui oa a er hour 6 3 Ceibtion pers a ae on eos sce, proctor prfbl (nase ofr conto Ft aa Frat Fea L 00ers Wear ‘numa Copan per woth how Labor hous equted pera oy sy, : Maximum Capa in wis6a rz ConngandBreseEen dna Cte Poy Materials Labour @ 8.0.80 per hour for 4800 hours Overheads Fixed-—S0% of hour Variable @€ 1.80 per unit Toul Cost Stes Profit Selection of a Suitable Production/Sales Mix ena conc snufuctures ‘one produc, 8 P ern ee ma a emg He win the peed ee give the maximum contbusion are oe reais and their. production be increased, The production of products which give comparatively lesser contribution shou jy reduced or dropped altogether. Finally, the optimum les mix is that_which_gives the hig reduced oF roe a ony cor, the cotton pet wit of limiting Teor shou, considered while judging the profitability of a product. Tstration 30. Present the following information to show clearly 1o management (a) the marginal produet cost and the contribution per unt. (0) the tal contribution and profits resulting from each of the folowing mixtures, oblem often arses a8 tothe py , Direct Maverial Direct Material Direct Wages Dirt Wages Fixed Expense 8 800 ‘Variable expenses are alloted tothe products as 100% of direct wages. Product Pega a ee x w 5 SaiePrce SulePrice 3 Sales Mixtures: (a) 100 units of product A and 200 of B. (6) 150 units of product A and 150 0fB. () 200 units of product A 100 of B =e Solution : ‘Marginal ostStatement rodcta Preaa c c Seling Price (peu) 20 is Less: MarginalVarable Cos: Direct Materia! 10 ° Direc Wages 3 2 ‘Variable Expenses (100% of wages) 3 6 i Contribution (per unit), 4 ‘Sales Metressting and OTe a ONES (Cost-Volume.} Cost ‘ohume-Proft Anaya) 100 units of produet A and 200 to B ci) 1 Serban mee Suan a omttn Ja Exp fet of Product Aan 10 1 bat me aisond Arltpaa eal Cenibtion Te Ged pee Pett rt of Product Aand 10 of 8 meen mnoond Acfosa rl cattoton Tae Mae apes Prt beaks, Eeske, esse. 78 i 5 aa mixture (¢), i.e., 200 units of A and 100 units of B gives the maximum profit, itis mat of Changes in Sales Price Management is generally confront i sen be poly fhe smerny fe ted mr on mo tanpeition, depression, expansion programme or government regulations. The effect of changes in sales pices can be easily analysed with the help of contribution technique. 7 us ‘haecon So dor ‘Sie Resco 00 You are required to : (@ Calculate the P/V Ratio, Break-Even Point and Margin of Safety at this level. () Calculate the effect of 10% increase in sale price. (o) Calculate the effect of 10% decrease in sale price. Solution + or Sab 09 (oP Ratio ‘Sales Contribution =Sales-VeriableCost '=£60,000-30,000 =€ 30,000 30,000 fo. = 22:00 , 190 = 50% PIV Ratio =F fences Break~Even Point “Err Rato 15000100, 00 8costing and Break-Even Analysis (Cost-Voly oa Marginal Contin merit, p. ot Satay = Preset Seles Slat EP- i ‘= 60,000-30,000 = © 30,000 (yep nce nS et aaa Sales = Mor £60,000 + 10%" 66,000 Connon. prveatio = Sis : 66,000 = 20,000 9 36:00? 100 = 34.59% G0 6.0 edt, FHedCo rss ‘Break-Even Point ="pry Reig Total Contribution 38. 27.500 15.000 10 5 66,000 36,000 Margin of Safety = Actual Sales Sales at BE.P. = 66,00 27,500 = 38,500 eee 1 ce ns Pe acme ‘les = € 60,000-10% = € 54,000 Conuibtion, fg, = Com 109 PIV Rati me = 54.000 = 30.000 199 24000 109 = 4.44% ‘4,000 sales en FixedCost Break-Gven Point == Conon 235.000 54,0002. 33,750 2,000 Margin of Safety = Actual Sales-SalesetB.E.P. = 54,000-33,750=€ 20,250 7. Alternative Methods of Production Sometimes the management has_to choose from among alternative methods of production «, machine work or hand work. The same product may be produced either by employing machine No 1 or Machine No, 2, and the management may be confronted with the problem of choosing one ancy them, In such circumstances, technique of marginal costing can be applied and the method which ges the highest contibution can be adopted keeping in view, of course, the limiting factor. Ilustration 32. Product ‘A’ can be manufactured either by machine X or machine Y. Mace X can produce 50 units of A’ per hour and machine Y, 100 units per hour. Total machine hours ess are 2000 hours per annum. Taking into account the following cost data, determine the profitable met of manufacture : of manufacmres Per Un of Product? Machine X aT ¥ c foe Drecel “ i" Diet age f % VatableOveteads 2 a FoedOveed a 4 Senge z 3ner Cost et fie ene i o8 bleOve v 4 ptbtion pe unit ert pet Hour Paton per hour Gea chine Hout (per annum) ‘ual Contribution tee, progocton of Machine Ys more profiable ern of Opti Level of Actity ‘he technique of marginal costing also hel spwviy, To make such a decison, contbutonts of jel of activity which gives the highest contribution will be the opt oe se ohm fe pn rt hee pe Iustration 33. A factory engaged in. manufac 4 Wedd coxiy and produces 10,000 buckets per annum, PAsie buckets is working at 40% ‘The present cost break-up for one bucket is as under: _—— janagement in determining the optimum level 8 diferent lees of activity can be found, and the e Materia fat about Cost, 4 Oven 5 (corFixes) The Selling price is € 20 per bucket, If itis decided to work the factory at 50% capacity, the selling price falls by 39. At 90% sat, the selling price falls by 5% accompanied by a similar fll in the prices of material You are required to calculated the profit at 50% and 90% capacities and also calculate break- en prints for the capacity productions. Sion uput at 40% Capacity ‘Output at $0% Capacity ‘And Output at 90% capacity Profitability Statement at 50% And90% Capacities = renin y Pega @ € & 1940 A300 ied T2750 : (2) (ie)srngnt Conger Breck Even Ant CoM line Profit Materiss 725000 70.00 * 37500 Vatnle Ovthend batt i (40% of) ar Total Vvinble Cost am Contribution (2-5) iy Fixed Overheads M (60% of 8) Le, (10,000 3) ra ()_Profive-d) Fixed Expenses ‘Contribution per unit Bresk-Bven Point Ber.asiriciniy «2202 gsitei 9. Evaluation of Performance Evaluation of performance efficiency of various departments, product lines or markets can ay bbe made with the use of the technique of marginal costing. Sometimes, the management may have jp lccde wo discontinue the prodecton of non-profiable products or departments $0 a © WANs Be profits. In such cases, the contribution of different products, departments ‘OF Sales divisions can be compared and the one which gives the lowest contribution in comparison to sales, ie. the one wih lowest P/V ratio should be discontinued. The following illustration explains how the technique of marginal costing can be applied to evaluate the performance of different products or departnens. . “The management of a company considers that product B, one ofits thee main lines, is not as profitable asthe other two withthe result that no particular efforts are being made to push its sales. The selling prices and costs of these products are as follows : Product ‘Selling Price Direct Materal DirectLabour Dep. X Dep. X Deez © © ° ° t See x 3% 0 7 2 7 a 0 6 2 4 2 c 4“ 8 2 2 4 ‘Overhead rates for each department per rupee of direct labour are as follows : Dept X ‘Dept ¥ Dent € ° € "Variable Overbead 13s 030 To Fixed Overhead 125 200 10 250 250 20 ‘What advice would you give to the management about the profitability of Product B ? Givt reasons.end Brak Even Ante CHV ame Prag verve Prot SMe Ti and © wl Be dia ey pada rome, © Ce eee 2400 x 2 4800 units: inal Cost oan Mors 7 Com Production of C 3000 x 2 * 6000 unit Pane val Produ 8 NG F] se ues care es cones eee ocr ches a2 Pd a wh 132 Pn me aed = oi ‘A and B will double : (©) If product C Is discontinued, the production of ‘A= 2000 x 2= 4000 units Production of Production of| ‘B= 2400x 2 = 4800 units Contribution 7 Product A = 4000 12° fae Product B 14800 x¢ I= “Toval Contrbution ar Less: Fixed Cost lean Profit ea (@ If the existing production of three products is continued Contribution 5 Product A = 200% 12= eel Produc B Cao = eo 3000 14 fae Product © Total Contribution or Lex Fixed cos oe Profit From the above analysis, itis clear that profit is maximum when product A is discontinue hence the management is advised to discontinue product A and double the production of B and C. tal Investment Decisions ‘The technique of marginal costing also helps the management in taking capital investment decisions, Such decisions are very crucial for the management and” capital invesment decisions has been separately discussed in this book. However, a simple example is given below i itustrate how marginal costing technique can be used while making such decisions. IMlustration 36. A practising Chartered Accountant now spends Re, 0.90 per kilometre ont {ares for his client's work. He is considering two other alternatives, the purchase of a new small = or an old bigger car. The estimated cost figures are : 10. Capi————___ ee OR BUY DECISIONS A firm may be manufacturing a product by itself. It may receive an offer from an Outsid ler supplier to supply that product. The decision in such a case will be made Hi price that has to be paid and the saving that can be effected on cost. The cease 7 in terms of marginal cost of the product since generally no savings can be effected in a costs, Similarly, a firm may be buying a product from outside, it may be considering to manufacture that product in the firm itself. The decision in such a case will be made by comparing the price being paid to outsiders and all additional costs that will have tobe incurred for manufacturing the product. Such additional costs will comprise not only direct materials and direct labour but also salaries of additional supervisors engaged, rent for premises if required and interest on additional capital employed. Besides that the firm must also take into account the fact that the firm will be losing the opportunity of using surplus capacity for any other purpose in case it decides to manufacture the product by itself.a Decitions 1m decides 024 Product many sont jak nto account the folowing ea oe bn 2 ter beowsie supplier woul ee re Position omni th Fotos the SUPPLE WOUIA bo repsar in hig (2 Weer the supplier is reliable. Tn gay SUPP, ca Mey ound. ‘ds, he Should be financially and piesa 82 aca ne product ‘ wil i H note elisabeth im eb ABC oes aiety of products each having a amber fen onal machine which wagon ORE Pa Pt ssi efter Aono oat a bo of 10 per nit. The SUPP’ price forthe component is 25 pers HSA woo ert company should buy the component X-109 i make suitable assumptions) Basic Calculations of Product B seg (per uit) fa o ic (per unit) of Product. ‘en eons (405 ous) [re Relevant Cost of Production of Component X100 ‘ee Co per uit) pty Cost of Utizing (2 hours of machine time * 8) eC of Provcton ee eel Evaluation of Make or Buy Decision Regarding Component X—100 SS sso a te ppc ios an le co pn Hei eat” 10 fom ouside suppers snr 7- A machine manufacture 10,000 units of part at ot cortof®21 of which®18is variable hepa avaiable in the market at 819 per unit, ' ses som th mkt the the machine can iter be sized omni aconpoot eeemetting 82 per component ort canbe hited uta €21,00 td which of the alterative is profitable?_/ EXPAND OR CONTRACT Expansion of business operations results in economies of scal fixed costs and greater capacity of the firm to meet the Sistine’ eae flexibility, lone also brings with it many organizational and communications ari : monitoring functions becomes more complex and delegation etnies lems. Contro| al becomes more confused. jority and ‘bie Since profit maximization is a firm’s prim oal, 3 operations should also be viewed from that Toes re Of the business means sales volume will have to be increased for meeting such costs oa Costs, it increase in per unit contribution on account of economies of the scale. The ere may be aust, therefore, make sure that market will absorb the additional volume of Seite