Learn about the applications of Marginal Costing:- 1. Cost control 2. Profit Planning 3. Performance evaluation 4. Fixation of selling price 5. Selection of most profitable product mix 6. Make or Buy decision
7. Shut down or continue decision 8. Effect of changes in selling price
9. Level of activity planning 10. Product Diversification 11. Sell or Further Process Decision 12.Pricing Decision
13. Temporary Shut-Down 14. Optimal Level of Activity 15. Alternative Method of Production 16. Key factor Decisions 17. Sales-Mix decisions 18. Operate or Shut Down 19. Special Order-Accept or Reject 20. Addition or Deletion of Product and Services
Application of Marginal Costing
Top 9 Application of Marginal Costing
Marginal costing is a very useful technique for tackling many managerial problems. It is the best tool to deal with many situations which need managerial attention. Marginal costing helps the management in decision making in respect of the following important areas.
1. Cost control
There are situations where profit of the concern may decrease in-spite increase in the sales. If the data are presented on the basis of absorption costing management may not be able to comprehend the results.
Marginal costing analysis will correctly bring out the results indicating why there is a decrease in profit in-spite of increase in sales. Under marginal costing total costs are divided into fixed and variable. Normally, variable costs are controlled by lower level management and fixed costs are controlled by top management that too a limited extent.
The division helps the management to concentrate more on variable costs and take corrective actions wherever essential. At the same time under marginal costing fixed costs are not eliminated at all.
These are charged separately against contribution instead of merging with cost of sales and inventories. It helps the management to have control on fixed costs in the long run as these are decided well in advance.
2. Profit Planning
Absorption costing fails to highlight the effect on profit if there is a change in selling price, variable cost, product mix etc. due to combination of all costs. Under marginal costing effect on profit due to change in selling price, variable cost, product mix etc. can be easily identified.
It gives different formulas to know the effect instantly. The management can easily be in a position to plan the desired profit at a particular level of activity.
3. Performance evaluation
The concern may have different departments, divisions, segments, products. They all do have different earning capacities. Marginal costing helps the management to evaluate the performance of each division, department, segment separately or the basis of contribution of each such unit without giving much importance to fixed costs.
Fixed costs remain the same during a particular period or level of activity. Hence, decision should be taken only on the basis of contribution, not on profits.
4. Fixation of selling price
Fixation of selling price depends upon a number of factors. Taking into account the various factors, selling price is fixed.
Normally it depends upon the following factors:
a) Under normal conditions
b) Under stiff competition
c) In times of trade depression
d) In accepting additional orders
In all these circumstances, marginal cost will guide in fixation of selling price.
5. Selection of most profitable product mix
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.
The marginal costing technique helps the management to a great extent while determining the most profitable product or sales mix. Contribution under various product mix will be determined first.
Then the product which gives the highest contribution must be given the highest priority. Similarly, any product which gives negative contribution should be discontinued.
6. Make or Buy decision
Many times management face the problem of choice between manufacturing the product or to buy it from the market. In such cases the marginal costing will come to the rescue of management.
For taking the above decision the points to be considered are the marginal cost of the product and available capacity.
In case of availability of surplus capacity decision is taken by comparing marginal cost and purchase price. If the marginal costs are lower than the purchase price, then it is suggested to produce the article in the factory, otherwise buy it from the open market.
If the surplus capacity is not available marginal cost should also include loss of contribution for setting aside the present work and additional fixed cost if any.
In short ,if the purchase price quoted by the seller is higher than the marginal cost including loss of contribution and increased portion of fixed cost, the product should be manufactured in the factory itself.
7. Shut down or continue decision
In some cases it becomes necessary for a firm to close or suspend the activities of a particular department or product due to various reasons. The decision is taken based on contribution. The product or department which contributes less amount towards fixed expenses will be closed or suspended.
8. Effect of changes in selling price
Under marginal costing effect of change in selling price on profit will be determined very easily. Change in selling price leads to change in p/v ratio. The changed p/v ratio will give the effect on profit.
9. Level of activity planning
The marginal costing technique is great help to the management in planning a level of activity at which business can operate. Under this method a level of activity which gives maximum contribution will be planned.
7 Important Application of Marginal Costing – Product Diversification, Make or Buy Decision, Sell or Further Process Decision, Pricing Decisions and More…
The important applications of marginal costing are:
1. Product Diversification
2. Make or Buy Decision
3. Sell or Further Process Decision
4. Pricing Decision
5. Temporary Shut-Down
6. Optimal Level of Activity
7. Alternative Method of Production
Application # 1. Product Diversification:
Companies are diversifying their lines of product either for the purpose of survival in the market or for the purpose of accomplishing higher results or for both. Further, limited product life, availability of idle capacity, possibility of utilizing the wastes, by products, favourable market result for the new product, etc., encourage the companies to introduce a new product either in addition to the existing product or in place of an existing product.
It is, therefore, necessary to find out whether it is economical and profitable to introduce a new product or not. In order to answer this question, it is necessary to estimate the costs that would associate with the new product and the anticipated revenue from the same. As far as the revenue side is concerned, it makes no difference whether a company uses Full Costing or Marginal Costing.
But, costs attributable to the new product differ from Marginal Costing method to Full Costing method. If the costs are analyzed under Full Costing, there is every possibility of management taking the wrong decision.
Because, Full Costing assigns both relevant and irrelevant costs (i.e., common and inescapable costs) to the new product and this makes the new product a less profitable or not at all a profitable one. Hence, the problem is to be analysed based on the principles of Marginal Costing.
Costs attributable to a new product usually include the variable costs. If the introduction of a new product causes the increase in the fixed costs, it should also be considered as the same is identifiable with the new product. The extent of increase in the fixed costs caused by the new product may be called direct fixed costs.
Hence, the aggregate of variable costs and specific (or direct) fixed costs is compared with the revenue from the new product. If the revenue exceeds costs, it is profitable to introduce the new product. Otherwise, it is not profitable. If both are same, it makes no impact on the company’s profit and therefore, management may or may not introduce the product.
To put it alternatively, if the new product is capable of earning some contribution towards common fixed costs and profit (after the recovery of its variable costs and specific fixed costs), it is profitable.
Otherwise, it is not profitable. Of course, the companies also consider, in addition to the above financial variables, a number of other variables such as the possibility of new product improving the sale of one or more of their existing product/s, potentiality of the new product to earn higher contribution in future, etc.
Application # 2. Make or Buy Decision:
In the case of a number of industrial undertakings, many a number of spare parts, component parts, etc., are used in the final assembly of their final or finished products. These parts can either be manufactured internally or can be purchased from outside sources.
It is, therefore, necessary to decide whether all the parts are to be manufactured in its own plant or to be purchased from outside sources. If all the parts, semi-finished products, etc., are to be manufactured internally or if all the parts are to be purchased from outside sources, there is no scope for managerial decision as there is only one course of action.
But the reality lies somewhere between the two extremes of manufacture all and purchase all. Therefore, the management has to decide which parts are to be manufactured in its own plant and which are to be purchased from outsiders. Once this is decided and implemented, management has to review this decision periodically.
Because, it is necessary to decide whether an item which is hitherto a bought-out item can be manufactured internally and vice versa. However, to take a proper decision, it is necessary to analyse each situation systematically.
Important items of costs that are to be considered while taking a decision about making or purchasing a part are enumerated below:
i. Purchase price of the component part, spare part, intermittent product, etc., is a relevant cost as it is an item of future cost that differs between the alternatives of ‘making’ and ‘buying’. For instance, purchase price of say, Rs.1.5 lakh is to be paid only when a company purchases the part. Otherwise (i.e., if it is made internally), payment of the same does not arise. Hence, it is an item of relevant costs,
ii. All the items of variable manufacturing costs of the component parts, spare parts, etc., are the items of relevant costs as they differ between the alternatives of buying and manufacturing the parts, and
iii. As far as the fixed costs are concerned, it is necessary to study their response to the decision of manufacturing a hitherto bought-out part internally or to the decision of purchasing an item which has hitherto been manufactured internally.
If there is no change in the fixed cost, fixed cost is irrelevant as it does not differ between the alternatives. On the other hand, if the decision necessitates the incurrence of higher amount of fixed cost, the fixed cost becomes relevant as the amount differs between the alternatives.
However, the analysis of this problem depends upon the circumstances – whether idle capacity is available or not, etc.
Hence, this problem is analyzed under three heads as presented below:
i. When a company has adequate idle capacity:
In this case, there is no much difficulty for the company to undertake the production of a hitherto ‘bought-out item’ internally. That means, a firm is, at present, purchasing a particular item from outsiders. Now the firm wants to evaluate whether it is economical and/or profitable to manufacture this item internally on its own.
Since adequate idle capacity exists to undertake the production of this item internally, there is no much difficulty for the firm to stop purchasing the item from outsiders and start manufacturing the same internally. Because, the company has adequate production capacity which can be utilized conveniently for the production of the item under consideration.
Utilization of the idle capacity for the production of the component part may or may not cause the increase in the fixed costs. If there is an increase in the fixed costs, it should also be considered for the purpose of taking the decision. It is implied that all the variable manufacturing costs (of manufacturing the item internally) are relevant.
Further, the cost of manufacturing the part or item is to be compared with the outside price for the purpose of taking the decision. If the cost of manufacturing the item internally is lower than the purchase price, the part or item is to be manufactured internally as the company is able to save in its cost.
Otherwise, it is economical to continue to buy the part from outsiders. The same principle can be applied even when the company is manufacturing, at a present, a particular part, and now it is thinking of purchasing the same from the outsiders.
ii. When the company has no idle capacity:
A company working at its full capacity producing idle capacity, only some of the parts (required for the final assembly of its product) and purchasing the opportunity cost remaining component parts (from external sources) may think of producing internally a considered as component part which is hitherto a bought-out item.
In this type of situation, two alternatives an item of are available to the management – one, acquisition of additional facilities and two, keeping relevant cost aside the production of some items which are now being manufactured in the company.
iii. Scarce resources and two or more components, spare parts, etc.:
When the production facilities in a company are not available in adequate quantity to manufacture all the parts, products, etc., it is necessary to buy some of them from outside suppliers. It is therefore necessary to decide about the parts to be manufactured internally and the parts to be procured from outside sources.
In order to make a proper decision, once again, the emphasis is on the relevant costs. Further, the decision shall be taken on the basis of cost savings per unit of limiting factor.
The parts, products, etc., which ensure higher savings per unit of limiting factor are to be manufactured internally and the remaining are to be purchased from outside sources depending upon the availability of scarce resources, and the difference between the bought-out price and relevant manufacturing costs.
Because, if the bought-out price is lower than the relevant manufacturing cost, the company prefers to buy that item even if the resources are available.
Application # 3. Sell or Further Process Decision:
In the case of processing industries, industrial undertakings aiming at producing a product obtain two or more products simultaneously from the same set of input factors. These products are identified by their name at a particular stage of production called split-off point.
The products so obtained are termed as joint products and by-products depending upon their market value. The products having relatively higher market (realizable) value are called joint products and the products having comparatively lower market value are called by-products. The costs incurred up to the split-off point (also called, point of separation) are called joint costs.
Application # 4. Pricing Decisions:
One of the important decisions that the management has to make is about the price for its company’s product/s. In case of a new product, it is necessary to determine the price at which the product is to be sold.
And in the case of existing product/s, it is necessary to determine the extent to which the price is to be revised in the light of cost hikes. However, pricing is considered as both an important and difficult one.
This is considered as an important one as this is one of the determinants of profitability of the company. Pricing is also a difficult task due to two important reasons – one, there are a large number of factors (both internal and external) which are to be taken into consideration before deciding the price of a product, and two, there is no ready formula which can be used to determine, and/or revise, the price of a product.
A survey of literature on pricing reveals the availability of voluminous literature on pricing aspect. Survey also reveals that the price is determined by the market forces, viz., demand, supply, etc. At the same time, the experience states that these two market forces are influenced even by the price.
Further, it is very well known that the majority of the companies aim at earning reasonable to maximum rate of profit. If at all a company wants to earn profit, its price should be higher than its costs. This implies that the companies should base their prices on costs. This section therefore makes an attempt to study the role of costs in pricing.
It is discussed under three heads viz.:
(a) Pricing under normal and favourable conditions,
(b) Pricing under abnormal conditions, and
(c) Pricing additional sales and export pricing.
(a) Pricing under Normal and Favourable Conditions:
When the conditions prevailed both internally and externally are favourable to the companies, they usually plan to earn some planned profit. Consequently, the companies wish to price their products on the basis of cost plus profit.
The desired profit which companies plan to earn may be expressed either as a percentage of sales revenue or as percentage on their investments. If the profit is related to sales, the following relationship exists between costs and price.
(b) Pricing under Abnormal Conditions:
A large number of factors influence the pricing aspect and changes take place in these influencing factors on a continuous basis. Consequently, the conditions which were favourable to the companies start changing.
The companies should have a vigilant eye on the market conditions. Hence, whenever the conditions start changing, the companies make appropriate changes in their policies, programmes, etc.
One of the variables wherein the companies make adjustments is the price. The extent to which the price is lowered depends upon the gravity of the problem and also the composition of price. In some cases, a 10% reduction in the price may be adequate and in some other cases, a 40% reduction in the price may be necessary.
Further, a company may be willing to forego the entire profit in case the market demands such a drastic move. Another or the same company may be forced to sell its product even below its cost price.
If the firm is not willing to forego a part of its profit, it has to suspend its activities relating to production and sale. It is therefore necessary to decide whether to sell the product at reduced price or to suspend the activities temporarily.
In this type of cases, two alternatives are available to the companies. One is to continue to produce and sell the goods and services at the reduced prices. Depending upon the quantum of reduction in the Selling Price, the company earns either reduced amount of profit or incurs loss.
If the company is not ready to incur the loss or if it is not satisfied with the reduced profit or if it is not willing to operate just at break-even level, the company has to take the second alternative of suspending its sales activities till the conditions improve for the company. Here also, the company has to incur some loss equivalent to inescapable fixed cost.
Hence, it is necessary to determine the loss under both the alternatives and whichever involves the minimum loss is to be preferred if the company takes the decision purely on the basis of financial aspects.
(c) Pricing Additional or Special Sales:
In the case of the companies operating below their capacity, one can find the existence of some idle capacity. It may be due to the fact that the normal demand from their regular customers is for lower volume than what the companies are capable of producing and selling.
For example, a company with an annual capacity of 10,000 units of a product may be producing and selling only 6,000 units due to the lack of demand.
This type of companies also receive additional business offer either from new customers or from their regular customers. Therefore, the companies have to take decision about accepting or rejecting the offer. For the purpose of taking proper decision in this regard, it is necessary to consider the impact of acceptance of the special offer on costs, revenue and profit.
All the costs which are going to change due to the acceptance of the offer are relevant for the purpose of deciding whether to accept the offer or not. Usually, the acceptance of the offer increases the items of variable costs. The items of fixed costs may or may not register an increase.
If these costs change, they shall be reckoned as relevant. Otherwise, they are irrelevant. So the aggregate of change in the items of costs is the incremental cost which is attributable to the additional sales or special offer.
As far as revenue is concerned, two types of special business can be found. One is in the form of asking for the price which the company wishes to quote for a certain number of units of its product. In this case, the company has to consider the above-mentioned incremental cost. The price to be quoted should be at least equal to the incremental cost.
Any price in excess of this incremental cost is a profitable price. The price should not be quoted on the basis of total cost which includes even a share in the common and inescapable or unavoidable fixed costs. Because, if the price is quoted on the basis of total costs, the quoted price may be at a higher level resulting in the rejection of the company’s quotation by the customer.
The second type of special business is in the form of (the company) receiving an offer wherein the offer states that the prospective buyer is willing to buy a certain quantity of the company’s product at a specific price. In this case, the company has to decide about the acceptance of the offer.
In order to take decision, the price offered by the buyer is to be compared with the incremental cost. If the offered price exceeds the incremental cost, it is better to accept the offer. Otherwise, it is not a profitable proposition.
Yet, there may be a third type of offer. This relates to the pricing of export business. In this case, some additional costs and benefits are associated with the exports. Special care is to be given to the packing, insurance, transportation, quality of the product, etc. These are some of the aspects which cause an increase in the costs.
Therefore, they fall into the category of relevant costs. Some additional benefits also accrue to export sales such as cash subsidy, duty draw-back, etc. Hence, these are relevant items. The amount of these benefits may be used to reduce the total of incremental costs.
The net incremental cost should be used to quote the price for international market or the net incremental cost may be compared with the price offered and on the basis of this comparison, the decision is to be taken.
Application # 5. Temporary Shutdown, Dropping, etc.:
It is very well known that the future is full of uncertainty. Because, a large number of both the internal and the external factors influence the future. Further, a very large number of external factors are normally not controllable by the management of industrial undertakings.
Consequently, a company which has been functioning well to-date may be forced, by external factors, to experience a very tough/rough weather in the very next moment. Even the internal factors may contribute their might if they are not properly controlled/managed by the management. The entire industry may also experience the trade depression or recession.
The situations like the above may force the management to think of suspending its activities temporarily for a short period. The suspension may take the form of either dropping a product line which is not profitable or suspending the activities of a sales territory or shutting down the entire factory temporarily till the creation of a favourable condition to the company under consideration.
In this type of situation, companies find two alternatives – one is to continue to operate by incurring loss and the second one is, if the companies are unable and/or unwilling to bear the loss, they have to discontinue their activities temporarily. Even by dropping a product, the companies cannot avoid all the losses.
Because, even after suspension, some costs are to be incurred and since there is no revenue, the entire cost will be left unrecovered. This results in loss. Therefore, the companies have two hard options and the one which is less hard or harmful (i.e., the one which minimizes the loss) is to be selected. In order to select the most favourable or the least-loss alternative, relevant costs and revenue are to be considered.
Since these relevant factors differ from one type of problem to another, the problems are analysed properly and separately as presented in the following paragraphs:
i. Dropping a Product Line:
In the case of multi-product concerns, profitability differs from one product to another. A product may be more profitable and another may be less profitable. The third product may be incurring losses. When this is the case, the management may think of discontinuing the production and sale of the product which is incurring loss for quite a long time.
Because, the management feels that the high profit earned by other products is reduced by the loss of a product resulting in the low profit of the company. Therefore, the management may think of discontinuing the product (which is incurring loss) till the conditions improve for that product. But this is not correct. Because, this conclusion is not based on relevant factors. It is therefore necessary to consider the relevant factors.
Some of the important factors which are relevant to decide whether to drop a product or not are listed below:
a. Revenue from the sale of a product under consideration is relevant as it differs between the alternatives,
b. All variable costs of sales of the product are relevant as they differ between the alternatives,
c. Alternatively, instead of considering the above variable costs and revenue, only the contribution may be considered. Hence, the contribution is also a relevant factor, and
d. As far as the fixed costs are concerned, they may be relevant or irrelevant depending upon whether they are avoidable by dropping the product under consideration.
Normally, two types of Fixed Costs are found – direct or specific fixed costs and common fixed costs. The Fixed Costs which are specific to the product under consideration are usually avoidable.
Therefore, they are relevant. Out of common fixed costs, some costs may be avoided. If this is possible, the common but avoidable or escapable fixed costs become relevant. And the remaining common fixed costs which are inescapable are irrelevant as they do not differ between the alternatives.
Considering all the above factors, one has to decide about dropping a product. It depends upon whether the product earns any contribution towards the inescapable common fixed costs after the recovery of its variable costs, specific fixed costs and non-traceable (i.e., common) but escapable fixed costs from its revenue.
In other words, if the contribution exceeds the aggregate of direct fixed costs and non- traceable but escapable fixed costs, the product should not be discontinued. Otherwise, it is to be discontinued.
ii. Suspension of Activities of a Sales Territory:
As in the case of multi-product concerns, even in the case of companies and trading concerns selling their products in different sales territories, profitability differs from one territory to another. That means, out of a number of sales territories or branches, a branch or a few branches may be working under loss.
Therefore, it is necessary to decide whether sales activities are to be continued in that branch or not. Even for this purpose, the relevant factors (both costs and revenue) are to be considered. As in the case of dropping a product, here also the variable costs and revenue are relevant.
The fixed costs which are common to all sales branches and which are inescapable are irrelevant as they do not differ between the alternatives. Out of the items of direct fixed costs, some are avoidable and the rest are not avoidable. Those specific fixed costs which can be avoided if a branch is shut down temporarily are relevant to the decision.
Other specific fixed costs which are not avoidable are irrelevant as they do not differ between the alternatives. Like this, all the relevant factors are to be considered for the purpose of deciding whether the activities of a sales branch are to be suspended temporarily or not.
Considering all these, the management ascertains whether the branch under consideration is contributing anything towards the recovery of inescapable fixed costs. If it is contributing, its activities should not be suspended. Otherwise, its activities are to be suspended.
iii. Shut-Down of a Plant Temporarily:
In some cases, due to trade recession, the companies may be operating at (a far) below the satisfactory level. There may be overall reduction in the demand for the industry’s product and therefore, for the products of the companies in the industry. This will be followed by a reduction in the prices of the products.
Both changes are undesirable but still the companies have to bear. Consequently, the companies will be forced to incur losses. This is because of two important reasons. They are, uneconomical level of operation and sale of these units at unprofitable prices.
Consequently, some companies (including the companies which are not able to bear the losses) may plan to shut-down their plants or factories for a short-period till the demand rises for their products and till the market conditions become favourable to them. In order to take a wise decision in this regard, one has to rely, once again, on relevant factors – both costs and revenue.
The relevant factors are classified into two groups. One, the loss that the company has to incur if it continues to produce and sell its product/s. This is due to the sale of inadequate quantities at unprofitable prices. Two, the costs that the company has to incur during the shut-down period.
As the company earns no revenue during the shut-down period, the entire costs incurred during this period will be left unrecovered representing loss. These two are to be compared to find out the alternative which is less harmful (i.e., the alternative which minimizes the loss).
In order to take an appropriate decision, it is necessary to consider the following aspects:
1. Since the variable costs (of sales) differ between the alternatives, they become relevant.
2. In the same analogy, the revenue from the sale of product is also relevant.
3. As far as the fixed costs are concerned, some are relevant and others are irrelevant depending upon whether they are avoidable or not. The fixed costs which are to be incurred irrespective of the alternative (that the company is going to select) become irrelevant as they do not differ between the alternatives.
And other fixed costs which can be avoided by opting to shut-down the plant temporarily become relevant.
4. If the plant is to be shut-down, some additional costs, in addition to the above fixed costs, are also to be incurred.
They include, amongst others, the following:
i. Costs relating to the closing down of the plant,
ii. Additional costs for the management of input factors during the shut-down period,
iii. Costs pertaining to the settlement of the employees who are not required, and
iv. Costs that are to be incurred for re-opening the plant when the demand rises, etc.
The above are some of the important items which are to be considered for the purpose of deciding whether the plant is to be shut-down or not. After a careful analysis of all these, the emphasis should be laid on the following net effects – one, the cost of shut-down and two, loss from continued operation. These two are to be compared and whichever is lower is to be preferred. Because, the amount of loss can be minimized.
Application # 6. Optimum Level of Activity:
It is very well known that every business organization wishes to earn the maximum possible amount of profit. A number of avenues are available to the companies to achieve this objective. Setting the plant at the optimum level is one of the important avenues. This deals with the economies of large-scale production and sales, and also the resultant effect on the selling price.
Because, whenever there is an increase in the volume of output, some economies accrue in the production costs. In the same way, some diseconomies may also be incurred. It all depends upon how the changes in the volume of output or the levels of activity influence the cost items.
In other words, it all depends upon how the cost items respond to the changes in the volume of output and sales. However, one can find the reduction in the average cost whenever there is an increase in the output. Of course, this is only up to a particular level of activity – the average or the unit cost goes on decreasing as the output increases.
It is due to the distribution of fixed costs over a larger number of units. If the volume of output exceeds a particular level, diseconomies may take place resulting in the increase in the average cost. The increase in the unit or average cost may also be due to the increase in the fixed costs. This is one aspect influencing profit.
There is an inverse relationship between the sales volume and the selling price. Increased volume can be sold usually by lowering selling price and vice versa. This is another aspect to be considered while finding out the optimum level of activity. Considering these cost and price behaviours, it is necessary to decide the level of activity which ensures the optimum amount of profit.
Therefore, it is necessary to find out the incremental revenue and the differential cost by comparing the costs and revenue at two different levels of activity. If the incremental revenue exceeds the incremental or differential costs, the result is incremental profit.
Consequently, the company’s profit increases to the extent of incremental profit. That means, profit at the higher level of activity will be more to the extent of incremental profit than the profit at lower level of activity.
Application # 7. Alternative Methods of Production:
Labour force is necessary for the purpose of converting the raw-materials into finished goods. The companies use both the manual labour force and the mechanical labour force for this purpose. Both are, to some extent, good substitutes. That means, manual labour force may be replaced, to some extent, by the mechanical labour force and vice versa.
That means, some work can be carried out either by the manual labour force or by the mechanical labour force. Further, a work may be carried out with the help of one machine or the other. In this type of situation, the question arises as to which is the most economical method of production?
In order to answer this question and to select the most economical method of production, the costs which differ between the alternatives are to be considered as relevant costs. The alternative which involves the minimum cost is to be selected as the most economical alternative.
Alternatively, the amount of contribution from each alternative is considered and the alternative which ensures a higher amount of contribution is preferred.
Selection of Profitable Mix, Allocation of Scarce Resources, etc.:
A large number of business undertakings are engaged in the production and sale of two or more products. In this type of situation, the companies have to decide the proportion in which their products are to be produced and sold. Because, the input factors and other resources and facilities are not available in adequate quantity at the right time and for the right prices.
Since the resources, at least few, are available only in limited quantities, the companies have to plan properly for the utilization of these scarce resources to generate maximum possible profits. Hence, this aspect requires a systematic analysis.
In the Absence of Limiting Factors:
If all the input factors are available in adequate quantity, the companies find no difficulty in producing their products in required quantity. Of course, the demand for any product acts as a limiting factor. Because, in majority of the cases, the demand is for limited quantity. Therefore, product is to be produced considering the demand constraint.
This is implied. When this is the case, it is necessary to concentrate on the relevant factors for the purpose of selecting a profitable mix. Mix used here represents the proportion in which the products are to be produced and sold. If the fixed costs do not change from one mix to another, it should be considered as irrelevant.
Therefore, emphasis should be on the revenue from each mix and associated variable costs of sales. Hence, the decision is to be taken on the basis of the contribution from each mix. The mix which ensures higher contribution is the most profitable mix and that should be selected.
In the Presence of Limiting Factors:
The companies face a number of problems and one such problem is the non-availability of input factors in adequate quantity. Hence, they are called scarce resources. The activities of industrial undertakings are regulated (or governed or limited) by these scarce resources. Therefore, they are also called limiting factors.
Limiting factor is defined as the factor in the activities of an undertaking which at a particular point in time or over a period will limit the volume of output. Limiting factor may be in the form of inadequate raw-material, labour hours, machine hours, floor space, finance, and so on.
When there is only one input factor which is available in limited quantity and all others are available abundantly, the problem is comparatively easier one. Because, the management can plan properly concentrating more on the sole limiting factor.
It has to allocate this scarce input factor to the most profitable product line on priority basis, and next to the second most profitable product and so on. In order to decide the profitability of products, contribution from the products per unit of limiting factor is to be computed.
The product which earns higher contribution per unit of limiting factor is regarded as the most profitable product. Products may be arranged in descending order on the basis of contribution per unit of limiting factor. Based on this, scarce resource is to be allocated.
Application of Marginal Costing Technique for Solving Problems Related to Decision Making, Profit Planning and Cost Control
Marginal costing technique plays an important role in managerial decision making. Taking the help of marginal costing technique, management is able to solve its various problems relating to decision making, profit planning and cost control.
The important managerial problems, where marginal costing technique can be applied as given below:
1. Make or Buy Decisions
2. Key factor Decisions
3. Pricing Decisions
4. Sales-Mix decisions
5. Profit Planning
6. Operate or Shut Down
7. Special Order-Accept or Reject
8. Addition or Deletion of Product and Services
Application # I. Make or Buy Decisions:
Instead of purchasing components and spare parts from the market they can be prepared in factory. The marginal cost of manufacturing the components or spare parts should be compared with market price while taking decision “to make or buy” in such situation.
In case the marginal cost in making is lower than the market price, it is more profitable to make the components than purchase from market. Additional or specific fixed cost may be a relevant cost.
Although, the decision shall depend on capacity utilization. In case unused capacity is available, in that position comparing only variable cost with market price will hold good. But in case, the factory operates on full capacity, then such decision has to be taken after adding opportunity cost of the products which is replaced by the manufacture of the component.
Some factors that influence ‘make or buy’ decisions are as under:
Certain types of works are such as may best be undertaken by outside specialist organizations. Components involving specialization work may be bought from outside market.
2. Plant Capacity
For an expanding one, subcontracting may be the only way of keeping up the required sales volume. This may apply in the case when sales are of a seasonal nature.
In case the company wants to maintain the trade secret of a component, then it is better to manufacture it.
4. Nature of Product
For other departments depending upon receiving regular supplies then it is better to manufacture the product.
5. Profit Maximization
In order to get long runs of the most profitable products it may be required to subcontract the less profitable products.
Application # II. Key Factor Decisions:
The factor that puts a limit on production and profit of a business is a key factor. In normal course this limiting factor is sales. A company may not be able to sell as much as it can produce.
At times, a company sells all its products but the production stays limited. The limitation is due to the shortage of materials, labour plant capacity or capital. A decision has to be taken regarding the choice of the product whose production is to be increased, reduced or stopped.
In case, there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio. In case, resources are scarce or limited, selection of the product will be on the basis of contribution per unit of scarce factor of production.
When the output is restricted by a limiting factor, a contribution analysis based on the limiting factor can help maximizing profit. To illustrate, in case machine availability is the limiting factor, then machine hour utilization by each product shall be ascertained and contribution shall be expressed as so many rupees per machine hour utilized.
Then, emphasis of one product in relation to the other one changes and subject to other conditions remaining same, it is possible to influence total contribution and thereby maximize profit.
It is evident from the above analysis, that total profit can be improved by diverting more machine hours from Product Y to Products X and Z. Likewise, in case availability of particular material or skilled labour is the limiting factor, then contribution analysis in terms of that limiting factor should be worked out and appropriate action be taken to maximize profit.
Incidentally, limiting factor is defined as the factor in the activities of an undertaking, which at a particular point of time or over a particular period will limit the volume of output. However, in case more than one limiting factor operates at a particular point of time, the factor that keeps the activity level at the minimum should be considered as the key factor.
It should be kept in view that one can achieve a maximum contribution fund by manufacturing and selling the product that best utilizes the limiting factor. Profitability index is, then, contribution per unit of limiting factor.
Application # III. Pricing Decisions:
Fixing of selling prices is one of the vital functions of management. However, prices are generally determined by market conditions and other economic factors yet variable costing technique gives assistance to the management in the fixation of selling prices.
It is done under various circumstances as:
i. Normal Condition – Pricing under normal conditions.
ii.Competition – During stiff competition.
iii.Depression – During trade depression.
iv.Orders, Acceptance – For accepting special bulk orders.
v.Additional – For accepting additional orders utilizing idle capacity.
vi.New Markets – For accepting export orders and exploring new markets.
Pricing is one of the major decisions that managers take. Pricing is complicated because it can take many forms.
Besides pricing, special orders, managers make the following pricing decisions:
1. Responding to a new price of a competitor.
2. Pricing bids in both sealed and open bidding situations.
3. Setting the price of a new or refined product.
4. Setting the price of products sold under private labels