Download Uses of Marginal Costing

CVP ANALYSIS
According to absorption cost system all costs should be absorbed into the products, activities or
cost centers identified within the costing system. Absorption costing is a concept of costing on the
basis of total cost and it is an important aid to management in the control of costs.
However, the accountant’s task of providing information costs for decision-making purposes may
require a different approach. When planning volume of output in the short term, the management
accountant has to provide information about the behaviour of fixed and variable costs over the
planned rate of output (relevant range). For the purposes of a number of special decisions relating
to alternative courses of-action, such as making or buying a component, the accountant has to
provide cost information which help management to choose the most profitable course of action.
The total absorption of all costs in products and services can lead to bad decisions being made
and that explains why marginal costing approach is used in many decision-making situations.
Fixed, Variable and Semi-variable Costs
A fixed cost is one, which tends to remain unchanged (fixed) regardless of the level of production.
Examples are rent, rates, and the salary of production manager. Any expense classified as ‘fixed’
is only fixed for a certain period of time, and only within certain levels of production. For example,
under normal circumstances local authorities are likely to increase rates once a year or once every
few years, so rates are not fixed forever. However, within the year, rates are fixed regardless of the
level of production at the factory.
Variable costs are costs, which vary with the level of activity. Selling expenses such as travelers’
commission are an example of variable costs. If the firm makes no sales, no payment or expense
arise, but as sales rise the cost of commission increases according to the level of sales achieved.
Semi-variable costs (or semi-fixed costs) are partly fixed and partly variable. A good example is the
charge of electricity, which consists of a standing charge per quarter (the fixed element) and a
charge per unit of usage (the variable element). Any semi-variable cost can be separated into fixed
and variable components.
Marginal Costing and decision-making
Marginal cost is the variable cost of one unit of a product or a service; i.e. a cost which would be
avoided if the unit was not produced or provided.
Given the description of fixed, variable and semi-variable cost it is clear that producing on item less
does not avoid any fixed cost or any of the fixed element of semi-variable cost.
A statement of cost on a marginal basis therefore contains only the variable cost, built up as
follows:
$
Direct material
Direct labour
Direct expenses
Prime cost
Add: variable overheads:
Factory
Selling
Marginal cost
Cost per unit
$
x
x
x
x
x
x
x
x
When the total variable (or marginal) cost of a number of products is deducted from the total sales
revenue, the amount that is left over is called contribution. Since fixed costs have not yet been
taken into account, this contribution has to cover fixed costs; any amount remaining is profit. (This
explains why it is called contribution – it contributes to fixed costs and then to profit). Symbolically
this can be expressed as S – V = F + P. This is the basic equation of marginal costing (sales
revenue - variable cost = fixed cost + profit).
Note that we can talk about contribution per unit of a product but under marginal costing we cannot
talk about profit from any one product since fixed costs are only considered in total and are not
apportioned to the individual products. A number of decisions can, however, be made by looking
at the contribution. If the company maximizes its contribution it is also maximizing its profit,
provided fixed costs are truly fixed.
A profit statement for three products built up on a marginal costing basis may appear as follows:
Product
A
$
2,688,000
Product
B
$
1,680,000
Product
C
$
1,360,000
732,000
403,200
537,600
588,000
336,000
336,000
748,000
272,000
408,000
2,008,000
1,011,200
1,281,600
Marginal cost
1,672,800
1,260,000
1,428,000
4,300,800
Contribution
1,075,200
420,000
(68,000)
1,427,200
Sales
Direct materials
Direct labour
Variable overhead
Fixed overhead
Profit
Total
$
5,728,000
227,200
1,200,000
Relevant costs
These are future and differential costs.
- costs that have been incurred in the past (sunk costs) are not relevant to future decisions,
except in assisting the accountant to estimate future costs.
- anything that remains the same regardless of the alternative selected should be ignored,
even if it is a future costs (only differential future costs are relevant)
Uses of Marginal Costing
- deciding on a selling price
- whether to accept an additional contract
- setting a selling price for additional work
- whether to cease production of unprofitable items
- whether to make or buy
Deciding on selling price
Marginal costing can be useful as a price-fixing tool when the organaisation has carried some
market research to ascertain the likely sales of a product at different selling prices.
Illustration 1
Variable cost of a component is $10. The firm has carried market research that indicates that the
likely sales at each of a number of possible selling prices would be:
Selling Price
$12
$15
$20
Sales
20
10
4.5
Which selling prices should the firm adopt?
Solution
$12
Selling Price
$15
$20
(a) Contribution per unit (selling price – variable cost)
$2
$5
$10
(b) Sales
20,000
10,000
4,500
Total contribution [ (a) x (b) ]
40,000
50,000
45,000
It is clear that the firm should sell the product at $15 per component since this maximizes the
contribution it makes.
Whether to accept an additional contract
A firm can accept additional work (esp in times it is short of work) provided sales revenue covers
marginal cost of that work and any additional fixed costs incurred. Although the new work might not
show profit on a full costs basis (where it was given a share of the total fixed costs), it provides an
additional contribution thereby reduce any overall loss (or increase) overall profit. However, in the
long term a firm will not survive unless it covers all its fixed costs.
Illustration 2
A firm manufactures articles at a variable cost of $6 per article and normally sells them at $10 per
article. Fixed costs are $10,000 per month. The firm is currently short of work – it is selling only
2,000 units a month. It has the chance of an additional contract for 500 units a month for 4 months
if it accepts a selling price of $8 per unit.fixed costs will not increase if the contract is accepted.
Advise the company whether or not to accept the contract.
Solution
Contribution per unit of additional contract = $2 ($8 - $6). Since it is positive i.e. selling price is
greater than marginal cost, the contract should be accepted since it will reduce loss as shown
below:
On present sales of 2,000 units the contribution is $4 per unit ($10 - $6)
Total contribution is 2,000 x $4 = $8, 000 per month
Fixed costs
=10,000 per month
Loss
2,000 per month
If the new contract is accepted, the additional contribution is 500 x $2 = $1,000 per month.
Therefore the loss is reduced by $1,000 to $1,000.
It should be noted that the contract is for 4 month and the firm would have to take into account the
likelihood of ales at the normal selling price to pick up with that period. If sales pick up the firm
would prefer full price sales rather than being tied to a reduced price contract. The reduced price
contract is, however, better than nothing if sales are unlikely to pick up.
Illustration 4
A company manufactures articles at a variable cost of $5 each, and usually sells them for $10
each. It has the chance of an additional contract for 600 articles at $9 each but is unsure where to
accept as fixed cost would be increased by $1,500.
Please advise company.
Solution
Contribution per unit on the extra sales
=$
4
Total additional contribution = 600 x $4
2,400
Additional fixed costs incurred
1,500
Additional profit
The company should accept the contract.
900
Setting a selling price for additional work
In the long run a company must set selling prices, which ensure that all its costs are covered.
However, in the short term it accepts work at lower prices than normal instead of losing the work
altogether if it is in short of work. Marginal costing can be sused to determine the minimum price
which should be charged for such additional work.
Illustration 4
A firm manufactures articles at a marginal cost of $12 each, which it sells for $20. it has been
approached by a charity organization which intends to buy 2,000 articles if a mutually acceptable
reduced price could be negotiated. Fixed costs are expected to increase by $6,000 if the extra
2,000 articles are produced.
What is the minimum price which the firm should quote for the contract?
Solution
The contribution from the extra 2,000 articles must at least cover the extra fixed costs incurred:
Extra contribution needed per unit is $3 minimum (i.e. $6,000/2,000)
Minimum price to be quoted is marginal cost + $3 = $15 each
Therefore minimum price for the whole order is 2,000 x $15 = $30,000
Whether to make or buy
Illustration 5
A firm makes several components, one of which, X, has the following cost structure:
$ per unit
Direct material
10
Direct labour
5
Variable overhead
5
Fixed overhead
6
26
The component could be purchased from an outside supplier for 23 per unit. The total fixed
overhead bill would be unchanged if outside purchases were adopted.
Should the company make or but the component X?
Solution
Since the total fixed overhead bill is unaffected, the absorbed fixed overhead of $6 per unit is
irrelevant. The cost of purchase ($23) must be compared with the marginal cost of manufacture
($20). On this basis, continued production is preferable.