CP 202 (A) - Unit IV (12-06-20)

Application of Marginal Costing Technique

(Under Guidance of Prof. Amrit Lal Ghosh)

Submitted By
Kumardeep Singha
MBA 2nd Semester
Roll No. 22

Application of Marginal Costing Technique

1. Fixation/Determination of Optimum Selling Price:
Determining the optimum selling price of any product or service is big challenge for a manager
of any company because company wants to profit of each unit of any product or service. In
marginal costing technique, fixed cost will not be changed at any level of production. Only
variable cost is changed for getting optimum selling price where company can achieve expected
profit.

Example:
Suppose a company wants to earn 15% net profit margin on 20,000 unit sold. What price
will company fix?
Following relevant information is given:
Fixed Cost = ₹ 1, 80,000
Variable Cost = ₹ 25

Solution:
The decision can be easily taken with the help of Marginal Costing’s Formula.

Break-Even Units at Desired Profit = (Fixed Cost + Desired Profit) / Selling Price –
Variable Cost per Unit
Or
No. Of Units expected to sell = (Fixed Cost + Desired Profit) / Contribution per Unit
⇒ 20,000 = 1, 80,000 + 15% (20,000 × S.P) / Selling Price - ₹ 25
⇒ 20,000 × (Selling Price - ₹ 25) = 1, 80,000 + 15% (20,000 × S.P)
⇒ 20,000 S.P × (-) 5, 00,000 = 1, 80,000 + 3,000 S.P
⇒ 20,000 S.P – 3,000 S.P = 1, 80,000 + 5, 00,000
⇒ 17,000 S.P = 6, 80,000
⇒ S.P = 6, 80,000 / 17,000
⇒ S.P = ₹ 40
∴ Expected Selling Price = ₹ 40 per unit

2. Helps in Profit Planning:

Marginal costing helps the profit planning i.e., planning for future operations in such a way as to
maximize the profits or to maintain a specified level of profit. Absorption costing fails to bring
out the correct effect of change in sale price; variable cost or product mix on the profits of the
concern but that is possible with the help of marginal costing.

Profits are increased or decreased as a consequence of fluctuations in selling prices, variable

costs and sales quantities in case there is fixed capacity to produce and sell.

Example:
Two businesses, Y Ltd. and Z Ltd., sell the same type of product in the same type of
market.

Their Budgeted Profit and Loss Accounts for the coming year as follows:

X Ltd. Y Ltd.
(₹) (₹)
Sales 1, 50,000 1, 50,000
Less: Variable Cost 1, 20,000 1, 00,000
Contribution 30,000 50,000
Less: Fixed Cost 15,000 35,000
Budgeted Net Profit 15,000 15,000

You are required to:

(a) Calculate the breakeven point of each business;
(b) Calculate the sales volume at which each of business will earn Rs 5,000 profit;
(c) Calculate at which sales volume both the firms will earn equal profits.
(d) State which business is likely to earn greater profit in conditions of:
(i) Heavy demand for the product;
(ii) Low demand for the product and briefly give your reasons.

Solution:
We can get answers of all the Question raised, by following Marginal Costing Technique’s
Formula:
Y Ltd. Z Ltd.
(a) P/V Ratio = Contribution ÷ Sales = 30,000 ÷ 1,50,000 = 50,000 ÷ 1,50,000
= 20% =33.33% or 1/3rd

Break-Even Point = Fixed Cost ÷ P/V Ratio = 15,000 ÷ 20% = 35,000 ÷ 33.33% (1/3rd)
= ₹ 75,000 = ₹ 1,05,000

(b) Sales Volume = = (15,000 +5,000) ÷ 20% = (35,000 + 5,000) ÷ 1/3

(Fixed Cost + Desired Profit) ÷ P/V Ratio = ₹ 1,00,000 = ₹ 1,20,000

(c) Sales Volume (for both the firms to earn equal profits):
Sales Volume = Difference in Fixed Cost ÷ Difference in P/V Ratio
= ₹ (35,000 – 20,000) ÷ (33.33% - 20%)
= ₹ 20,000 ÷ 13.33% or 13 1/3
= ₹ 1, 50,000

Thus, at sales volume of Rs.1, 50,000 profits will be equal.

(d) (i) In conditions of heavy demand, a concern with larger P/V ratio can earn greater profits
because of greater contribution. Thus, Z Ltd. is likely to earn greater profit.

(ii) In conditions of low demand, a concern with lower breakeven point is likely to earn more
profit because it will start earning profits at lower level of sales. In this case Y Ltd. will start
earning profits when its sales reach the level of ₹75,000, whereas Z Ltd. will start earning
profits when its sales reach the level of ₹1, 05,000.

Therefore, in case of low demand breakeven point should be reached as earlier as possible so
that the concern may start earning profits.

3. Evaluation of Performance:
The different products, departments, markets and sales divisions have different profit earning
potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector
of a concern.
Performance evaluation is better done if distinction is made between fixed and variable
expenses. A product, department, market or sales division giving higher contribution should be
preferred if fixed expenses remain same.

Example (Elimination of a Product):

A company manufactures 3 products A, B and C. There are no common processes and the sale
of one product does not affect prices or volume of sales of any other.
The Company’s budgeted profit/loss for 2010 has been abstracted thus:
 Total (₹) A (₹) B(₹) C(₹)
Sales 3,00,000 45,000 2,25,000 30,000

Production Cost:
Variable 1,80,000 24,000 1,44,000 12,000
Fixed 60,000 3,000 48,000 9,000

Factory Cost 2,40,000 27,000 1,92,000 21,000

Selling & Administrative Cost:
Variable 24,000 8,100 8,100 7,800
Fixed 6,000 2,100 1,800 2,100

Total Cost 2,70,000 37,200 2,01,900 30,900

Profit(Sales – Total Cost): 30,000 7,800 23,100 (-) 900

On the basis of the above the Board had almost decided to eliminate product C, on which a loss
was budgeted. Meanwhile they have sought your opinion. As the company’s Cost Accountant
what would you advice? Give reasons for your answer.

Solution:

Product A (₹) Product B (₹) Product C (₹) Total

Particulars (₹) (₹) (₹) (₹) (₹) (₹) (₹)
Sales 45,000 2,25,000 30,000 3,00,000
Less: Marginal Cost:
Product Cost 24,000 1,44,000 12,000
Selling & Distribution Cost 8,100 8,100 7,800
32,100 1,52,100 19,800 2,04,000
Contribution: 12,900 72,900 10,200 96,000

Less: Fixed Cost (₹ 60,000 + 66,000

6,000)
30,000
Profit:

P/V Ratio =
28.67% 32.4% 34%
(Contribution / Sales ) ×
100

From the above it is clear that product C is contributing ₹10,200 towards the fixed expenses of
the company. If product C is eliminated the profit of the company will be reduced to ₹19, 800
(i.e., ₹30,000 – ₹10,200). Moreover, the P/V Ratio of product C is the highest as compared to
other products. Hence it is not advisable to eliminate product C.

4. To Check the Effect of Reducing of Current Price on profit:

We all know, this is the time of competition, customer has become king. He wants product at
minimum price. One example, we can see free video on YouTube. Instead of buying costly CDs
and DVD, customers of entertainment industry see free films and movies on YouTube. But on
the other side, company wants to maintain his current profit. At that time, manager will be in
tension because it is not possible to maintain profit even after reducing price. But if manager
learns marginal costing techniques and uses it effective way, they can check the effect of
reducing of current price on net profit, after this, he can decide to reduce production or increase
production. It is the law of economics, variable cost will reduce by reducing units of production
in same proportion but when we increase production, fixed cost will fastly decreases due to
constant nature.

Example:
Sale of a product amount to 1000 units per annum at Rs. 500 per unit. Fixed overheads are
Rs. 100000 per annum and variable cost Rs. 300 per unit. There is a proposal to reduce the
price by 20% due to survive in competition. How many units must be sold to maintain total
profit after reducing the price by 20%?

Solution:
First of all we check the effect of reducing of current price on  profit

Our Gross profit ratio or P/V Ratio without reducing price

= Gross profit or Contribution / Sale per unit X 100 = Sale per unit - variable cost per unit / sale
per unit X 100

= 500 - 300/500 X 100 = 40%

Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/
200 = 500 units

After reducing 20% of sale price , our gross profit or P/V ratio will be

= 500- 300 / 500 - 500 X 20%  X 100 = 25%

It means our Gross profit will reduce 15% ( 40% -  25%) if we reduce our sale prices 20%.

Break Even Point ( in units where profit is zero ) = Fixed cost / Contribution per unit = 100000/
100 = 1000 units
Now No. of Units Sold at Break Even point at desired profit :-

For this we have to know present profit

Present Gross profit or contribution = 40% gross margin on sale X( total no. of sale units X sale
per unit) =

= 40% X ( 1000 units X Rs. 500 per unit )

= 2,00,000

Present Net Profit = Contribution or gross profit - Fixed cost = 200,000 - 1,00,000 = 1,00,000

Now, number of units required to maintain same net profit

= Fixed cost + Net profit / New contribution after reduction of sale prices

= 1,00,000 + 1,00,000 / Rs. 100 = 200,000 / 100 = 2000 units

Now, manager has to take decision to produce more 1000 units if he wants to earn same gross
margin 40% instead of 25%

5. Choose of Good Product Mix:

It may be possible that company is producing more than one product, at that time company has
to calculate each product's contribution margin or gross profit margin. After this, manager see
which product is giving high contribution margin. Company manager will give preference to that
product whose contribution will high. One more decision can be taken by manger. He can check
contribution by producing different quantity of different products. If he see any quantity of
products is producing maximum contribution, it will be equilibrium point. Production of units at
that quantity will be benefited to company.

6. Calculation of Margin of Safety:

 Marginal costing can be utilized for calculating margin of safety. Margin of safety is difference
between actual sale and sale at break-even point. According to marginal costing rules,
production will follow sales. Suppose current sale is ₹ 4, 00,000 and BEP is ₹ 3, 00,000, margin
of safety is ₹1, 00,000. We can calculate it with following formula

= Profit/ P/V ratio

If company's sale is less than margin of safety, then manager can take step to reduce both fixed
and variable cost or increase prices.

7. Decision regarding to sell goods at Different Prices to Different Customers:

Sometime, company has to give special discount to special customers. These customers may be
govt., foreign companies or wholesaler. At that time manager has to take decision at what limit,
we can give discount to special customers. Marginal costing may help in this decision.