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Applications of Marginal Costing - Cost control, profit planning, evaluation of performance and decision making
This article will help you recognize and understand the areas of applications of Marginal Costing. In this article, we will discuss about where Marginal costing tool can be applied in the financial world focussing in detail about Decision making processes.
Table of Contents [hide]
- Applications of Marginal Costing
- Fixation of Selling Prices
- In house make or buy decisions
- Selecting production with Key Factor or Limiting Factor
- Effect of Change in Sales Price
- Selection of Suitable Product Mix
- Alternative Methods of Production
- Diversification of Products
- Closing down or suspending activities
- Alternative Course of Action
- Level of activity planning
Applications of Marginal Costing
Marginal Costing is an accounting system technique for decision making in management. To go further with this article, you should be well aware of the basics of Marginal costing and other related definitions. See Marginal Costing - Basics chapter
Listed below are the various areas of applications of Marginal Costing.
- Cost Control
- Profit Planning
- Evaluation of Performance
- Decision Making
- Fixation of selling prices
- In house make or buy decisions
- Selecting production with Key or limiting factor
- Effect of change in sales price
- Maintaining a desired level of profits
- Selection of a suitable product mix
- Alternative methods of production
- Diversification of products
- Accepting an additional order
- Dropping a product
- Closing down or suspending activities
- Alternative course of action
- Level of activity planning
As mentioned in the introduction section, this article will mainly focus on the Decision making processes. Marginal Costing tool is considered as an important technique used for Decision making in management. The following sections will describe the key areas in which decision making has been proven to be required and excercised.
Fixation of Selling Prices
- Under normal circumstances
- In times of competition
- In times of trade depression
- In accepting additional orders for utilizing idle capacity
- In exporting and exploring new markets
- Selling Price below the Marginal Cost
- When a new product is introduced in the market
- When foreign market is to be explored to earn foreign exchange
- When the concern has already purchased large quantities of materials
- At the time of closure of business
- When the sales of one product at a price below the marginal cost will push up the sales of other profitable products
- When employees cannot be retrenched
- When the goods are perishable nature
In house make or buy decisions
In some cases, in spite of lower variable cost of production, there may be an increase in the fixed costs. It becomes essential to find out the minimum requirements of volume in order to justify the making instead of buying.
The formula is
Increase in Fixed Costs
Contribution per Unit (i.e. Purchase Price – Variable Cost of Production)
Selecting production with Key Factor or Limiting Factor
A key factor is that factor which puts a limit on production and profit of a business.
Usually this limiting factor is sales. A company may not be able to sell as much as it can produce.
Sometimes a company can sell all it produces but production is limited due to the shortage of materials, labor 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.
When there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio.
When there are scarce or limited resources, selection of the product will be on the basis of contribution per unit of scarce factor of production.
Effect of Change in Sales Price
Management is confronted with the problem of cut in price of products from time to time on account of competition, expansion programs or government regulations.
The effect of a cut in selling price per unit will be that contribution per unit will be reduced.
Selection of Suitable Product Mix
When a company manufactures more than one product, a question may arise as to which product mix will give the maximum profits.
- The best product mix is that which yields the maximum contribution.
- The products which give the maximum contribution are to be retained and their production should be increased.
- The products which give comparatively less contribution should be reduced or closed down altogether.
The effect of sales mix can also be seen by comparing the P/V ratio and breakeven point.
- The new sales mix will be favorable if it increases the P/V ratio and reduces the breakeven point.
Alternative Methods of Production
The method which gives the greatest contribution is to be adopted keeping the limiting factor in view.
Diversification of Products
- In order to decide about the profitability of the new product, it is assumed that the manufacture of the new product will not increase fixed costs of the concern.
- If the price realized from the sale of such product is more than its variable cost of production it is worth trying.
- If the data is presented under absorption costing method, the decision will be wrong.
- If with the introduction of new product, there is an increase in the fixed costs, then such specific increase in fixed costs must be deducted from the contribution for making any decision.
- General fixed costs will be charged to the old product/products.
Closing down or suspending activities
The decision to close down or suspend its activities will depend whether products are making contribution towards fixed costs or not.
ie. Whether the contribution is more than the difference in fixed costs (by working at normal operations and when the plant or product is closed down or suspended)
If the business is closed down:
- There may be certain fixed costs which could be avoided.
- There will be certain expenses which will have to be incurred at the time of closing the operations like redundancy payments, necessary maintenance of the plant or overhauling of plant on reopening training of personal etc.
- Such costs are associated with closing down of business and must be taken into consideration before taking any decision.
Fixed costs may be general or specific
- General fixed costs may nor may not remain constant while specific costs will be directly affected by closing down of the operations.
- Besides, obsolescence if any, retaining the customers, relationship with the suppliers, non-collection of dues from customers or interest on overdraft for closing down the operations must be taken into consideration.
Alternative Course of Action
Whatever course of action is adopted, certain fixed expenses will remain unaffected.
The criterion is the effect of alternative course of action upon the marginal (variable) costs in relation to the revenue obtained.
The course of action which yields the greatest contribution is the most profitable to be followed by the management.
Level of activity planning
Maximum contribution at a particular level of activity will show the position of maximum profitability.
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