The following points highlight the top seven applications of marginal costing.
Fixation of selling price of a product is, no doubt, one of the most significant factors in modern management.
It becomes necessary for various purposes, like, under normal circumstances of the interest; at trade depression, accepting additional order etc.
Under normal conditions, according to Financial Accounting technique, the selling price of the product must cover the total cost plus a certain margin of profit. But, under Marginal Costing technique, the price must equal the marginal cost plus a certain amount which depends on the nature, variety, demand and supply, policy pricing and other related factors.
Needless to mention that, if the selling price of the product is fixed at Marginal Cost, the amount of loss will be the amount of fixed overheads and the amount of loss will be same or lower if the production is suspended or closed down.
That is why selling in all the periods/loss must be higher than Marginal Cost. In this regard we should remember that it would be easier for us if profitability of a product is known while fixation of selling price.
X Ltd. has an average P/V ratio of 50%. The Marginal Cost of a product is estimated at Rs. 30. What will be the amount of selling price?
If selling price is Rs. 100, Variable Cost will be Rs. 50 i.e., contribution will be Rs. 50.
Thus, P/V Ratio = C/S = Rs. 50/Rs.100 = ½ or 50%
So, the selling price which have a marginal cost of Rs. 60 should be:
100 /50 x Rs. 30 = Rs. 60
P/V Ratio = S – V/S
Variable Cost/Sales = 50/100
...Selling Price will be = Variable Cost/sales = Rs. 30/50%= Rs. 60
The directors of X Ltd. have been approached with an enquiry for a special job since the company has been working well below normal capacity for recession.
For this purpose, the costing department of the company estimated the following relating to the job:
You are requested by the directors of the company to advice-them about the minimum price which may be charged assuming that no production difficulty will arise for the purpose.
From the above it becomes clear that the minimum price is Rs. 22,500 i.e., the Marginal Cost. But by quoting so, the company has to sacrifice the recovery of fixed cost and profit. As the fixed costs are to be increased even if the company does not accept the offer, so any price over and above Rs. 22,500 may be accepted.
A factory produces 1,000 articles for home consumption at the following costs:
The home market can consume only 1,000 articles at a selling price of Rs. 155 per article; it can consume no more articles. The foreign market for this product can, however, consume additional 4,000 articles if the price is reduced to Rs. 125. Is the foreign market worth trying?
Statement showing the contribution per unit and 4,000 units:
From the above statement, it is quite clear that if the foreign market’s order is accepted, the company will earn an additional contribution on 4,000 units @ Rs. 13, i.e., 52,000. At the same time, as the production is operating above BEP, additional contribution will earn additional profit. As such, foreign market is worth trying.
In order to capture a new market or to utilise idle facilities etc., it may so happen that a new product may be introduced in the market together with the existing one. Naturally, the question arises before us whether the same will be a profitable product one.
In this regard it may be mentioned that the new product may be introduced only when the same is capable of contributing something against fixed cost and profit. Fixed cost will not be considered here on the assumption that the same will not increase, i.e., the new product will be produced out of existing resources.
If any firm produces more than one product it may have to decide in what ratio should the products be produced or sold in order to earn maximum profit. However, the marginal costing techniques help us to a great extent while determining the most profitable product or sales mix.
Contribution under various mix will be determined first. Then the product which gives the highest contribution must be given the highest priority, and vice versa. Similarly, any product which gives negative contribution should be discontinued.
The following illustration will, however, make the principle clear:
The directors of a company are considering sales budget for the next budget period. From the following information you are required to show clearly to management:
(i) The marginal product cost and the contribution per unit;
(ii) The total contribution resulting from each of following sale mixtures;
(a) 100 units of product A and 200 of B
(b) 150 units of product A and 150 of B
(c) 200 units of product A and 100 of B
Recommend which of the sale-mixtures should be adopted.
(ii) From the above Comparative Contribution statement, it becomes clear that as P/V Ratio of Product A is higher in comparison with the Product B, Product A is more profitable one. And, as such, the mixtures which consider the maximum number of Product A would be the most profitable one which is proved from the following table:
Sales Mixture (C) i.e., 200 units of Product A and 100 units of Product B will yield highest contribution.
Sometimes a firm may have to face a problem as to whether a part should be produced or the same should be purchased from the outside open market.
In this case, the following two points should carefully be considered:
(a) The Marginal Cost of the product; and
(b) Whether surplus capacity is available.
Needless to mention here that the decision in such a case is taken after comparing the price which has to be paid and the savings which can also be effected in terms of Marginal
Cost, as question of savings usually does not arise in case of fixed cost.
In other words, if the marginal costs are lower than the purchase price it may be suggested to produce that article in the factory itself.
Moreover, if the surplus capacity is not available and, at the same time, making the parts in the factory involves putting aside other work, the loss on contribution so made must also be considered together with marginal cost. In short, if the purchase price—which are quoted by the outside sellers—is higher than the marginal cost plus a portion of fixed cost plus loss of contribution, the same may be produced by the factory.
A radio manufacturing company wants to make component X 273 Q, the same is available in the market at Rs. 5.75 each, with an assurance of continued supply.
The break-down of cost is:
(a) Since the Marginal Cost of each component is Rs. 5, which is less than the purchase price of the open market of Rs. 5.75 each, it is recommended that the component should be manufactured by the company (if, however, the company is having spare capacity that cannot be filled with more remunerative jobs).
(b) If the purchase price in the open market is Rs. 4.85, which is less than the marginal cost Rs. 5.00, leaving a saving of Re. 0.15 per unit, it is recommended that the component should be purchased from the outside market as there is continued supply also. The spare capacity may be utilised for other purposes.
Part X 293 used in the assembly of a product manufactured by your company has, during the past three years, been a bought-out item. The current price of this part is Rs. 120. Transportation and other delivery costs accounts for Rs. 15 per piece. Sales Tax @ 10% is added to the invoice price.
Your company had been manufacturing this part earlier but decided subsequently to discontinue its own manufacture. There is sufficient un-utilised capacity which can be used, if it is decided to manufacture this part again in its own plant. Annual requirements of this part are 6,000 units.
Prepare a study to enable the management to come to a decision on a proposal to manufacture the part within its own plant.
The following requirements are available:
In addition, special tools, jigs and fixture required to manufacture this part are needed to be acquired at a cost of Rs. 1,50,000. These are to be amortised over 5 years.
The overhead rate is the budgeted recovery rate for products manufactured by the company. The variable portion of this amounts to 100% of direct wages.
Make your recommendations.
From the above statements, it becomes quite clear that manufacturing cost per unit is Rs. 121.50 whereas the buying cost is Rs. 147 per unit.
Thus, the total savings is Rs. 1,53,000 (i.e. Rs. 8,82,000 – Rs. 7,29,000). So, Part X 293 should be manufactured in the factory instead of being bought from outside, i.e., open market.
It is interesting to note that the techniques of marginal costing are frequently applied while comparing the alternative methods of production, viz., whether one machine is to be employed instead of another, machine-work or hand-work etc.
It should be remembered that the basis of selection would, however, be the relative contribution available from various methods when fixed costs are constant. That is, the method of production which will give the greatest contribution should be selected. Time factor or limiting factor, if any, should carefully be considered.
Effect of change in selling prices is another significant factor which creates problem, particularly when a firm needs expansion. For its wider market the selling price of the product may be reduced. Needless to mention that the effect of such a change in selling price should carefully be considered.
The Income Statement of X Ltd. for the year ended 31st Dec. 1993 is given below from which the directors are analysing the results of trading:
The budgeted capacity of sales is Rs. 5,00,000 and sales demand is the limiting factor. Now, the sales manager of the company proposes, utilising the existing capacity, the selling price should be reduced by 5%. After considering the following additional information you are asked to prepare a forecast statement which will show the effect of the proposed reduction in selling price and also to state any changes in costs expected in the coming year.
Sales Forecast Rs. 4,75,000; Prices of Direct Materials are expected to increase by 2%; . Prices of Direct Wages are expected to increase by 5% per unit; Variable Overheads are expected to increase by 5% per unit; Fixed Overhead will increase by Rs. 5,000.
Due to trade recession, unprofitable operation etc. it often becomes necessary for the management to suspend or close-down temporarily or permanently a part of activity which should be taken after careful relevant consideration. In the circumstances, absorption costing techniques will distort the position due to fixed cost while marginal costing technique helps us to take proper decision in this case.
That is, if the products make a contribution towards fixed costs, it is advisable to continue the same because losses are minimised. Similarly, if the operation is suspended, certain fixed costs may be avoided but certain fixed costs may yet have to be incurred (i.e., maintenance of plant).
Thus, the decision depends on whether the contribution so made is more than the difference between the fixed costs in the normal courses of operation and the fixed costs incurred in the plant is shut-down.
A company has three branches and their summarised accounting particulars for a period are: