MARGINAL COSTING & DECISION MAKING

Marginal Costing helps the management in taking rational decisions regarding

the production or purchase of material.

Specific areas where Marginal Costing is helpful in decision making are:

1. Fixation of selling Price

2. Make or Buy

3. Explore New Market

4. Discontinue Product Line

5. Select Suitable Product Mix

6. Closure of Business

7. Alternate methods of Production

 1. Fixation of Selling Price

Although prices are regulated more by market conditions of

demand and supply then by management, yet fixation of selling
prices is one of the important functions of management.

While fixing prices, the management has to keep in view the level
of profits to be earned.
This function is to be performed:
(a) Under normal circumstances - Price fixed
must cover total cost
(b) Under special circumstances.
(c) In times of trade depression.
(d) In accepting additional orders for utilizing
idle capacity.
(e) In exporting and exploring new markets.
• In Normal Circumstances the price fixed
must cover total cost as otherwise profits
cannot be earned. It can also be fixed on the
basis of marginal cost by adding a high margin
to marginal cost which may be sufficient to
contribute towards fixed expenses and profits.
• Thus, in the long run the selling price should cover
all costs variable and fixed and bring the desired
margin of profit.

• But under special circumstances, products may

have to be sold at a price below total cost, if such a
step is necessary to meet the situation arising due
to competition, trade depression, additional orders
for utilizing spare capacity, exploring new markets,
liquidation of excess stock etc.
• Thus, in special circumstances, price may be
below the total cost and it should be equal to
marginal cost plus a certain amount (if
possible).
• This is only a short term step taken with the
hope that bettor times will come when prices
will be increased.
• Pricing decisions are thus affected by long
term and short term objectives.
 Why Prices fixed during depression may be
below total cost ?
• This is because fixed costs will have to be incurred even if production is
discontinued for a short period. If the products can be sold at a price
above marginal cost, the loss on account of fixed cost can be reduced to
that extent.

• In other words, any contribution towards the recovery of fixed costs will
reduce the losses which will be incurred if production is stopped.

• As a word of caution, fixation of prices below total cost should be made

only on a short-term basis because no firm can afford losses on a long-
term basis.
Circumstances, selling prices may have to be
fixed even below the marginal cost:
i. When a new product is introduced in the market and it has to be made popular.

ii. When competitors are to be eliminated from the market.

iii. When goods are of perishable nature and there is a stock of such goods.

iv. When depression seems temporary and closure of business may mean breaking of
business connections that can be re-established only at a heavy expenditure.

v. When plant and machinery have to be kept in gear as idle machines are liable to
deteriorate.
 2. MAKE OR BUY DECISION
 Marginal costing helps management to decide whether the
firm should itself manufacture a component part or buy it
from an outside firm.
 This is particularly so when a component part is available in
the market at price below the firm’s own cost.
 This decision can be arrived at by comparing the supplier’s
price with firm’s own marginal cost.
 Example
• For example, if total cost of making a component
part is Rs. 18,
• It consisting of Rs. 15 as variable cost and Rs. 3 as
fixed cost.
• Suppose, the same component part is available in the
market at Rs. 17. The prima facie conclusion is that it
is cheaper to buy the component part from outside.
• But a study of cost analysis shows that each unit produced also
contributes Rs. 3 towards the fixed cost.

• If purchased from outside, it will cost Rs. 20, i.e., Rs. 17 + 3

(fixed cost). This fixed cost has to be incurred whether to
make or buy. Thus, this component should not be purchased
from outside unless it is available at below Rs. 15, which is its
marginal (variable) cost.
 Example:
Furniture Inn manufactures computer tables. Recently a supplier has offered the tables
of the same quality @ $14 each with an assurance of continued supply. The following
is the budget for 4000 units prepared for the quarter ending 30 September 2016:

(a) Should Furniture Inn accept the offer from the supplier?
(b) What would be the decision if the supplier offered the tables at $12 each?
Calculation of per table marginal cost of
production
 Case (a)
• Decision ?????
A. Make in own factory
B. Buy from supplier
 Decision on Buy & Make

• (a) As marginal cost of production is less than the buying price

offered by the supplier so Furniture Inn should continue
production of tables. The distribution, administration and fixed
production are irrelevant in the decision as presumptively they
will be incurred in either case.
 Case (b)
• Decision ?????
A. Make in own factory
B. Buy from supplier
 Decision on Buy & Make

• (b) As in this case they buy in price $12 is less than the
marginal cost of production so Furniture Inn should buy the
tables from the supplier and discontinue production of tables
provided other things are favorable.
Points to consider for taking such decision:

1. The part to be bought should be available

whenever it is needed and at the same price at
which we are considering to buy it at present.
2. If there is difference in quality, specification etc.
of the component to be bought, it must be
workable.
3. If production is not carried out, labour problems
should not crop up. The surplus labour force
should be absorbed in other productive work.
3. EXPLORE NEW MARKET
(i) Whether the firm has surplus capacity to meet the new demand?
(ii) What price is being offered by the new market? In any case, it
should be higher than the variable cost of the product plus any
additional expenditure to be incurred to meet the specific
requirements of the new market.
(iii) Whether the sale of goods in the new market will affect the
present market for the goods? It is particularly true in case of sale of
goods in a foreign market at a price lower than the domestic market
price. Before accepting such an order from a foreign buyer, it must
be seen that the goods sold are not dumped in the domestic market
itself.
4. Discontinue Product Line
(i) The contribution given by the product – The
contribution is different from profit. Profit is
arrived at after deducting fixed cost from
contribution. Fixed costs are apportioned over
different products on some reasonable basis
which may not be very much correct. Hence,
contribution gives a better idea about the
profitability of a product as compared to
profit.
(ii) The capacity utilization, i.e., whether the firm
is working to full capacity or below normal
capacity. In case a firm is having idle capacity,
the production of any product which can
contribute towards the recovery of fixed costs
can be justified.
(iii) The availability of product to replace the
product which the firm wants to discontinue
and which is already accounting for a
significant proportion of total capacity.
(iv) The long-term prospects in the market for
the product.
(v) The effect on sale of other products. In some
cases the discontinuance of one product may
result in heavy decline in sales of other
products affecting the overall profitability of
the firm.
 5. Selection of a Suitable Product Mix
• When a concern manufactures more than one product, the
management has to decide the proportion in which these
products should be manufactured.
• This is known as product mix or sales mix. The production and
sales of those products should be pushed up which give the
maximum profits and production of comparatively less
profitable products should be reduced.
• Marginal costing helps management in deciding the best
product mix so that profits can be maximized. The best
product mix is one that yields the maximum contribution.
• When a factory manufactures more than one
product, a problem is faced by the
management 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 favourable if it increases the P/V

ratio and reduces the breakeven point.
 6. Alternative Methods of Production:

When management is faced with the problem of choosing from

amongst alternative methods of production, marginal costing
helps by furnishing relevant cost information for taking a right
decision.

For example, management may be faced with the problem of

using an automatic machinery or manufacturing entirely by
manual labour.

The method of manufacture which yields the greatest

contribution should be selected, of course, keeping in view
certain other factors.
Marginal costing is helpful in comparing the
alternative methods of production, i.e., in
chine work or hand work.
7. CLOSURE OF BUSINESS
The management, under certain
circumstances, may be faced with the problem
of suspending the activities, i.e., closing down
the business.

This type of situation usually arises when

sufficient volume of business cannot be
secured.
The closure of business may take one of the
two forms:
i. Temporary closure.
ii. Permanent closure.
 TEMPORARY CLOSURE
Short-term concept with an object to stop operations
until trade depression has passed.

But if products are making a contribution towards

fixed cost, then generally speaking, production
should continue.

In other words, if prices exceed marginal (variable)

cost, losses will tend to be minimized by continuing
production.
 SIGNIFICANCE OF PROFIT-VOLUME (P/V) RATIO

• Ascertainment of profit on a particular level of sales

volume.
• Determination of break-even point.
• Calculation of sales required to earn a particular level
of profit.
• Estimation of the volume of sales required to
maintain the present level of profit in case selling
prices are to be reduced by a stipulated margin.
• Useful in developing flexible budgets for cost control
purposes.
SIGNIFICANCE OF PROFIT-VOLUME (P/V) RATIO (Cont..)

• Identification of minimum volume of activity that the

enterprise must achieve to avoid incurring losses.
• Provision of data on relevant costs for decisions
relating to pricing, keeping or dropping product lines,
accepting or rejecting particular orders, make or buy
decision, sales mix planning, altering plant layout,
channels of distribution specification, promotional
activities etc.
• Guiding in fixation of selling price where the volume
has a close relationship with the price level.
 Breakeven point

• It is that stage where firm is making no profit , no

loss.
• Total sales revenue = total costs incurred

Breakeven point(units) = total fixed cost \

contribution per unit
Breakeven point(Rs.)= Total fixed cost \ (P/V
ratio)
• Sales= 2,00,000
• VC= 120,000
• FC= 30,000
• Calculate the BEP
• New BEP if SP is reduced by 10%
• New BEP if VC increases by 10%
• NEW BEP if FC increases by 10%
 Sales to earn desired profit
• To earn desired level of profit, which the firm
intends to earn should have to be combined with
the fixed cost, are the two different components
to be covered only in order to find out the
contribution level to the tune of unchanged
selling price and variable cost per unit.

• = Fixed Cost + Desired Profits / (P/V Ratio)

 Margin of Safety

• Margin of safety is the difference between the actual sales

and sales at break-even point. Sales beyond break-even
volume brings in profits.

• The size of margin of safety indicates soundness of

business
 Formula

• The margin of safety formula is calculated by

subtracting the break-even sales from the budgeted
or projected sales.
 How to improve the margin of safety? ?

(i) Lowering fixed costs.

(ii) Lowering variable costs so as to improve marginal contribution.
(iii) Increasing volume of sales, if there is unused capacity.
(iv) Increasing the selling price, if market conditions permit, and
(v) Changing the product mix as to improve contribution.