Marginal Costing and Decision Making

Marginal Costing is a very useful decision-making technique. It helps management to set prices, compare alternative production methods, set production activity level, close production lines, and choose which of a range of potential products to manufacture.

Following are some techniques which highlight the application of marginal costing in decision making-

PROFIT PLANNING

Profit planning is the planning of future operations to attain maximum profit. Under this technique, the contribution ratio indicates the relative profitability of the different products of the business wherever there is any change in the volume of sales, total fixed costs, selling price, etc.

PRICING OF PRODUCTS

This is one of the most important techniques in marginal costing and decision making. Generally, prices are determined by demand and supply of products or services. But under special market conditions, marginal costing is helpful in deciding the price at which the management should sell.

These special market conditions are following-

  1. Selling in the foreign market i.e. export prices may have to be decided. The export price may be lower than the price at which the product is selling in the domestic market.

  2. In times of cutthroat competition, the market price of products may fall below total cost. The management should be compelled to sell at a price which is below total cost. But the price should not be below the variable cost.

MAKE OR BUY DECISION

Under this technique, the company has to decide whether they should make the product or they should buy the product from outside sources. For making such a make or buy decision, a comparison should be made between the variable cost of manufacture of the product and the supplier’s price for it.

It will be advantageous to make a product than to purchase it if the variable cost is lower than the purchase price provided, as the decision to manufacture does not result in the substantial increase in the fixed costs and that the existing manufacturing facilities can be utilized more profitably. If the decision to manufacture involves an increase in fixed cost, it should also be added to the marginal cost for the purpose of comparison with the purchase price of the product.

So, the decision will be to purchase if the marginal cost of the manufacturer plus fixed costs plus loss of contribution is more than the purchase price.

Example Question

Question – XYZ. Ltd produces a variety of products each having a number of components parts. Product B takes 5 hours to produce on a particular machine, which is working at full capacity. B has a selling price of ₹ 100 and a variable cost of ₹ 60 per unit. A component part Z could be made on the same machine in two hours at a variable cost of ₹ 10 per unit. The suppliers’ price for the component is ₹ 25 per unit. You are required to advise whether the company should buy the component Z. If necessary make a suitable assumption.

Answer

Selling price of B = ₹ 100

Variable cost of B = ₹ 60

Contribution from B = ₹ 100 – ₹ 60 = ₹ 40

Contribution of B per hour = ₹ 40/5 = ₹ 8

Variable cost of Z Component = ₹ 10

Loss of contribution from B if Z is manufactured = ₹ 8 X 2 HRS = ₹ 16

Total cost of Z, if manufactured = ₹ 10 + ₹ 16 = ₹ 26

Supplier price = ₹ 25

As the supplier price is lower than own cost. It is advisable to buy the component from the supplier. It is given that the company is already working 100% capacity.

EXPLORING NEW MARKETS

Companies make a constant effort in exploring new markets to sell more and more so that they can fully utilize their plant capacity. The marginal costing technique helps in deciding the minimum price at which to sell in the foreign markets or home markets and widening their area of operation in various markets.

DETERMINING PRIORITY OF PRODUCTS

In those businesses, which manufacture more than one product, there arises a problem of determining the priority of products to be manufactured. In such a situation the management is faced with the problem of which product should be manufacture in large quantities as compared to other products. This is because the cost-profit relation of various products differs and products should be produced in large quantities which makes a larger contribution per unit. Thus, the data required for determining the priority of products is that which is required for calculating contribution.

In other words analysis of cost into fixed and variable and data regarding selling price is needed to determine the most profitable product mix. From such data, one can compute contribution and thus determine the priority of products. Apart from these cost factors, certain non-cost factors, or qualitative factors like the continuity of supply, the quantity of products, terms of supply, no price change in the near future should also be considered.

#MakeorBuyDecisionExample #MakeorBuyDecisioninMarginalCosting

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