Marginal costing is the most powerful and popular technique in aid of managerial decision making. It reveals the cost, volume profit relationship in all its ramifications which is useful in profit planning, selling price determination, selection of optimum volume of production, etc. Marginal costing, with its focus on variability of costs and avoidance of overhead apportionment, is so versatile that it is applied in varied circumstances and to tackle diverse problems by those in charge of such situations.
The following are some of the more popular areas of application of marginal costing:
1. Key factor (or) Limiting factor
2. Make or buy decision
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3. Fixation of selling prices
4. Export decision
5. Sales mix decision
6. Product elimination decision
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7. Plant merger decision
8. Plant purchase decision
9. Further processing decision, and
10. Shut down decision.
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The above list is not exhaustive. There are numerous situations suitable for applying the principles of marginal costing and situations chosen above are only a few of the popular areas of application of marginal costing.
The following is a brief discussion of each of the areas of application listed above:
Application # 1. Key-Factor (or) Limiting Factor:
Any factor concerned with production or sales which imposes ‘limits’ on the production or sales can be called ‘limiting factor’ or ‘key-factor’.
Key factor can be any of the following:
(a) Sales potential may be limited. It may be due to severe competition or lack of demand or quota restrictions by government or some other trade bodies. The limit on sales can be in terms of quantity or value.
When sales are the key-factor, the production, purchasing, etc. should be adjusted according to the ‘possible sales’. Sales sets the limits for how much to produce or how much material to purchase, etc. The whole organisation operates at a level imposed by the limiting factor i.e., sales.
(b) Production capacity may be limited due to the limited availability of skilled labour time or machine hours. Both of them can be increased in the long run. But in the short term, they limit the production and in turn the purchase of materials and the sales of finished goods, etc.
(c) Raw material may be in short supply. The short supply may be due to heavy demand and low supply or import restrictions or quota system followed by trade bodies, etc. Here the production and sales have to be confined to the available material.
(d) Finance also can impose limitation on the operations. Purchases have to be restricted to the available finance.
Double Key-Factor:
Sometimes there can be more than one key-factor, imposing severe restrictions on operations. For example, when two or more products can be produced with the same material or using the same labour time, the material or labour time may be in short supply. At the same time, there may be limit on the maximum possible sale for each product.
Steps in Key-Factor Decision:
1. Contribution per unit of each of the products produced should be ascertained.
2. The contribution per unit should be divided with the given key-factor to obtain ‘Key-factor contribution’ (K.F.C).
3. The products can be ranked on the basis of the ‘key-factor’ contribution for priority in production and sales. If there is no other restriction, the first ranked product alone may be produced to maximise profit.
4. If a second ‘key-factor is also given, in terms of limits on sales, etc., the maximum sale should be on the basis of ranking of products made as per step 3. Then priority can be given to the product next in rank.
5. Finally, the most profitable mix can be determined as per the decision regarding priorities in step 4. For the mix decided, the sales, variable costs, contribution and profits may be estimated.
Application # 2. Make or Buy Decision:
Many durable products are assembled by using a large number of parts or components. Some of them may be made by the firm which is assembling the product. It may buy some of the parts from outside.
When an assembling firm receives on offer from outside for a component it is already making, the ‘make or buy decision’ must be taken.
The following is the usual procedure to take a ‘make or buy’ decision:
1. Non Cost Factors:
The following non cost considerations should be satisfied before the cost aspect can be examined:
(a) The supplier should be able to supply the required quantity regularly according to schedule. So, reliability of the supplier is to be ensured.
(b) The quality of the components to be supplied should be of the required standard, satisfying the acceptable quality tolerances.
(c) The discontinuation of making the component should not result in strained labour relations in the firm. Trade unions should not be opposed for such a move.
(d) The vendor should not be a potential competitor for the final product. Otherwise buying from such vendor will result in creating competition with own investments.
If non cost considerations are satisfied, cost factors should be analysed.
2. Cost Factors:
(a) If the outside supply price is less than the variable cost of making component, it is advisable to buy it and discontinue making it in the firm.
1. If the price offered is more than variable cost of making it, any contribution from idle facilities should be explored.
(a) If no contribution is possible from idle facilities, the component should be continued to be made in the firm. The supply offer should be rejected.
(b) If contribution from idle facilities is possible, the amount should be estimated. It should be reduced from the outside supply price to find the adjusted supply price. This is logical since the idle facilities contribution is possible only when the component is bought from outside.
If adjusted outside supply price is less than the variable cost of making, the component should be bought.
If adjusted outside supply price is more than the variable cost of making the component should be continued to be made in the firm.
Idle facilities contribution may be in the form of renting out or leasing out the facilities which are at present used to make the component in the firm. It can also be through usage of the facilities to make some other component or part or product and earning contribution from that output.
In big assembling companies using hundreds of components, like T.V. makers, radio companies, etc., make or buy decision is of great significance with enormous financial implications. In such firms systematic procedures should be established for such decisions.
Application # 3. Fixation of Selling Prices:
Marginal costing technique is widely applied in the area of determining selling prices. Prices may have to be fixed in different situations, under specific constraints, etc.
Normally, prices are fixed on the basis of full cost. Total cost must be recovered and profit also to be made by fixing appropriate selling price. Marginal costing is not of significant use in total cost based pricing. However there are different situations where marginal costing approach is of great utility in fixing prices.
(a) Selling Below Cost:
When there is a recession in an industry or depreciation in the economy, demand reduces drastically. Price may have to be reduced below cost. Marginal costing sets the limit for such reduction. The selling price can be less than total cost; but it should be above variable cost.
(b) Competitive Pricing:
When there is cut-throat competition also, selling prices may be reduced drastically to edge out marginal competitors. Usually such a move is only for a short period. Later, prices can be increased when competitors are edged out. Here also, the ultimate limit for price reduction is the variable cost.
(c) Pricing Based on Idle Capacity:
When idle capacity exists, dual pricing policy or even multiple pricing may be used. However, the general price charged in the market should not be affected by such prices. So, supplying for special orders and direct sale to large ultimate consumers come under this category. However, here there are no specific lower side limits for selling price except the variable cost. The prices quoted to utilise idle capacity are usually less than the open market price but above variable cost. They may differ from case to case.
(d) Penetrating Pricing Policy:
Penetrating pricing policy may be followed while exploring new markets. Initially charging low prices and then gradually raising the prices is the accepted strategy. This method is highly successful in case of ‘Habit forming products’, like cigarettes, coffee, etc.
Application # 4. Export Decision:
When idle capacity exists, exporting is usually the most profitable strategy. The great advantage with exports to foreign countries is that the export price will not adversely affect the local price. So companies which have already recovered their fixed costs from local sales can export just above their variable cost and still make good profits. This is generally termed as ‘Dumping’ and is usually controlled by the importing countries through high tariffs.
Export price should be above variable cost. It need not be linked to domestic price.
Any additional cost incurred like special packing and shipping costs must be recovered in the price charged.
Application # 5. Sales Mix (or) Product Mix Decision:
When a firm sells two or more products, the ratio of different products in the total sales is called Sales mix or product mix. The objective should always be to have ‘The most profitable product mix.
It is essential to ascertain the P/V Ratio of each product separately. It is also necessary to compute the composite P/V ratio of all the products. P/V Ratio of each product should be multiplied with its proportion in the total sales. Then the adjusted P/V Ratios of all the products should be added to obtain the composite P/V Ratio.
The long-term or even the short-term objective of sales mix decisions is to maximise the composite P/V ratio so that maximum possible profit can be made from given sales.
When two or more possible sales mixes are to be considered, the total contribution from all the products of each mix should be computed. The mix which results in the maximum overall contribution should be adopted.
Application # 6. Product Elimination Decision:
When two or more products are sold by a firm as a sales mix, situations may arise where it may be felt that a particular product has to be eliminated.
(a) Elimination without Replacement:
Here a product is just eliminated. This is advisable in case of products which provide negative contribution. Just by discontinuing such products overall contribution goes up.
(b) Elimination through Replacement:
Here one or more products with lower P/V ratio may be discontinued in favour of one or more existing or new products which possess a higher P/V Ratio. Such a move can boost the composite P/V Ratio, overall contribution and profits.
Application # 7. Plant Merger Decision:
Two or more plants may be operating under the same management producing similar products. It may also be possible for one firm to acquire another competing firm.
It is possible that:
(a) Each plant may be operating at a particular capacity level either at 100% capacity or less.
(b) The selling prices, variable costs and fixed costs may be different.
The following are the usual steps in such situations:
1. A merger statement is prepared showing each of the merging factories and the merged factory as to their sales, variable costs, contribution, fixed assets and profit.
2. It is necessary to show all the merging plants at a common capacity level, preferably at 100% capacity level.
3. Break-even point and break even capacity of the merged plant may be ascertained for purpose of break-even analysis.
4. The current operating capacity of the merged plant and the expected profit may be found.
5. Based on the above data profit planning, planning for future capacity of operation, etc. may be decided.
The success or failure of a merged factory depends on the ‘synergy’ and smooth fusion of operations. Proper profit planning and capacity planning are vital for its success.
Application # 8. Plant Purchase Decision:
Purchasing plant is a long-term capital expenditure decision-involving investment and the required return on investment.
However, the following is a brief explanation of plant purchase situations:
(a) When a single model of plant is available and the decision is whether to buy it or not, the effective contribution from the plant and the contribution as a percentage on investment are the deciding factors.
(b) When one of the two models of a plant or equipment has to be chosen, the least cost option should be made.
Variable cost per unit of output and fixed cost relating to each of the machines should be estimated.
The break-even level for the cost = Difference in fixed cost/Difference in variable cost per unit
If a particular machine is cheaper in terms of both valuable cost and fixed cost, it must be automatically chosen. However, usually, one of them may be cheaper in fixed cost and the other in variable cost. In such cases, the above formula can give the level of output at which both are equally costly. The machine with higher fixed cost will be cheaper if output is more than that level. The machine with lower fixed cost is cheaper at lower production levels.
Application # 9. Further Processing Decision:
Two or more products may be produced in a joint process. They may have market at the split off point itself. It may be possible to further process one or more of the products to enhance their market value.
The decision to further process or not depends on the overall contribution received. If further processing can result in additional contribution from the product, it is desirable. However, the return on investment for further processing may also be computed to ensure that the additional contribution justifies any extra investment in the form of working capital for the further processing.
Application # 10. Shut Down Decision:
When a firm is operating at loss for some time, the management may have to decide upon its shut down.
(a) Complete Shut Down:
The firm may be permanently closed without any intention to revive it. Such a decision is warranted.
1. When the selling price does not even cover the variable costs; or
2. The demand for the output is very low and future prospects are bleak.
Complete shut-down saves the management from the fixed cost of running the factory or division or firm.
(b) Partial or Temporary Shut Down:
Here the intention is to close down for some time and reopen the firm when circumstances favour it.
Here, some fixed costs will continue in the form of irreducible minimum, ‘like skeleton staff to maintain the factory, some managerial remuneration, salaries, irreplaceable technical experts, etc.
The savings from the partial shut-down should be compared with the position if the firm continues. If there is substantial saving, shut down may be preferable.
Minor saving in expenditure does not warrant shut down because reviving a firm is a cumbersome process.
Differential Costing or Incremental Analysis:
Marginal costing technique is useful to management in decision making. Marginal costing and differential costing are akin to each other but conceptually they are different.
Differential Cost:
I.C.M. A. defines differential cost as “the increases or decreases in total costs or the changes in a specific element of cost that result from any variations in operations.” With reference to level of output, differential cost is the difference in total costs for two levels of output. In the words of J.M. Clerk, “when a decision has to be made involving increase or decrease of ‘n’ units of output, the difference in cost between two policies may be considered to be the costs really incurred on account of these units of business.”
This may be called the differential cost of a given amount of business. It represents the cost that must be incurred, if that business is taken up and which need not be incurred, if that business is not taken up”. In this sense differential cost is also known as ‘Relevant cost’ also particularly when a decision is under consideration. Every decision to be taken involves two or more alternative courses of action.
The decision is based on the difference in effect of cost of the alternatives on future performance. Only those future cost data are relevant which will differ between two alternatives. Historical costs have no direct bearing on the decision. Differential cost meets these two criteria: Thus, differential cost is the difference in total costs of two or more alternatives or courses of action and relevant for decisions.