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Decision-Making using Marginal Costing-I

Learning Objectives

• To apply marginal costing technique to decision-making

• To use the knowledge of contribution analysis and CVP analysis for a single firm and
understand its utility and limitations
• To use the knowledge of contribution analysis and CVP analysis for a multi-product firm
and understand its utility and limitations


In this lesson, we will be dealing with practical problems and cases related to CVP analysis and
multi-product situations.

Understanding Decision-Making for Multi-Product Firm

1. Ascertaining Relative Profitability of Products

We know that a manufacturing concern engaged in the production of various products is interested
in the study of the relative profitability of its products. This is so because it may suitably change its
production and sales policies in case of those products which it considers to be less profitable or

This is where the concept of P/V ratio, provided by the marginal costing technique, is much
helpful in understanding the relative profitability of products. It is always profitable to encourage
the production of that product which shows a higher P/V ratio.

You can also be at ease when sometimes the management is confronted with a problem of loss and
has to decide whether to continue or abandon the production of a particular product which has
resulted in a net loss. Marginal costing technique properly guides the management in such a
situation. If a product or department shows loss, the absorption costing method would hastily
conclude that it is of no use to run the department and it should be closed down.

Or sometimes, this type of conclusion will mislead the management. The marginal costing
technique would suggest that it would be profitable to continue the production of a product if it is
able to recover the full marginal cost and a part of the fixed cost.

Let us look at an example to understand this.

Illustration 1

A company manufactures three products X, Y and Z. It has prepared the following budget for the
year 2003:

Total Product X Product Y Product Z

Sales 4,20,000 80,000 2,50,000 90,000
Factory Cost
Variable 2,90,500 40,000 1,74,000 76,500
Fixed 29,500 5,000 16,000 8,000
Production Cost 3,20,000 45,000 1,90,000 85,000
Selling and
Administration Cost
Variable 35,000 14,000 14,000 7,000
Fixed 8,000 3,500 3,200 1,300
Total Cost 3,63,000 62,500 2,07,200 93,300
Profit 57,000 17,500 42,800 - 3,300 (loss)

On the basis of above information, we understand that the company management is thinking to
discontinue with the production of product Z which has shown loss. The management seeks your
expert opinion on the issue before they take a final decision. You are required to comment on the
relative profitability of the products.


The information contained in the budget may be rearranged in the form of a marginal cost
statement as shown below:

Marginal Cost Statement

Particulars Total Product X Product Y Product Z
Sales 4,20,000 80,000 2,50,000 90,000
Variable Costs:
Factory Cost 2,90,500 40,000 1,74,000 76,500
Selling and Admn.
35,000 14,000 14,000 7,000
Total Marginal Cost 3,25,500 54,000 1,88,000 83,500
Contribution 94,500 26,000 62,000 6,500
Fixed Costs 37,500 8,500 19,200 9,800
Profit 57,000 17,500 42,800 -3,300 (loss)
Profit-Volume Ratio 22.5% 32.5% 24.8% 7.2%

Profit-Volume (P/V) ratio is the ratio of contribution to sales. It is expressed in terms of

percentage. After preparing the above statement and analysis, we can make the following

As discussed in the marginal cost statement, the contribution of product Z is Rs. 6,500 which goes
toward the recovery of fixed cost of Rs. 9,800. If the production of product Z is discontinued, the
company will lose the marginal contribution of Rs. 6,500 while it will have to incur the fixed cost
of Rs. 9,800. The total profit of Rs. 57,000 will be reduced to Rs. 50,500 (57,000 - 6,500). Thus, it
is advisable that the production of Z should not be discontinued. As regards the relative
profitability, product X is more profitable than Y and Z as the P/V ratio in this case is highest. The
production and sales of product X should, therefore, be encouraged.

2. Determining Profitability of Alternative Product Mix

The objective of an enterprise is to maximize profits. The management of business enterprise
would prefer the product mix which is ideal in the sense that it yields maximum profits.

Product mix means combination of products which is intended for production and sales.

A firm producing more than one product has to ascertain the profitability of alternative
combinations of units or values of products and select the one which maximizes profits. How
marginal cost analysis helps the management in this regard is illustrated with the help of the
following example:

Illustration 2

A manufacturing firm supplies you with the following information:

Product P Product Q
(Rs.) (Rs.)

Direct material per unit 16 14

Direct wages paid 5 4
Variable expenses (100% of wages) 5 4
Fixed expenses ......... Rs. 1,300
Sales price per unit 32 26

Sales-mixtures are as follows:

• 400 units of product P and 400 units of product Q

• 500 units of product P and 300 units of product Q
• 600 units of product P and 200 units of product Q

You are required to prepare the marginal cost statement to show contribution per unit and suggest
the sales mix which optimizes profits.


Marginal Cost Statement

Product A Product B
(Rs.) (Rs.)
Sales Per Unit 32 26
Direct Material Per Unit 16 14
Direct Wages Per Unit 5 5
Variable Expenses 5 4
Marginal Cost Per Unit 26 22
Contribution Per Unit 6 4

Profit from Different Sales Mix

1. 400 units of P and 400 units of Q

Total Contribution - Fixed Cost = Profit
(400 x 6) + (400 x 4) - 1,300 = 2,700

2. 500 units of A and 300 units of B

(500 x 4) + (300 x 4) - 1,300 = 2,900

3. 600 units of A and 200 units of B

(600 x 6) + (200 x 4) - 1,300 = 3,100

Based on the above analysis, we can suggest that the firm should produce and sell 600 units of P
and 200 units of Q. This combination yields maximum profit of Rs. 3,100.

3. Determination of Sales Mix

There is another condition where marginal cost helps in the decision-making and in determining
sales mix.

Presuming that fixed costs will remain unaffected, decisions regarding sales/production mix are
taken on the basis of contribution per unit of each product. The product which gives the highest
contribution should be given the highest priority and the product whose contribution is the least
should be given the least priority. A product giving a negative contribution should be discontinued
or given up unless there are other reasons to continue its production.

Illustration 3

The following information has been made available from the cost records of Nike Automotives
Ltd. manufacturing spare parts:

Direct Materials Per Unit

X Rs.8
Y 6
: Direct Wages
X 24 Hours @ 25 Paise Per Hour
Y 16 Hours @ 25 Paise Per Hour
Variable Overheads 150% Of Direct Wages
Fixed Overheads (Total) Rs. 750
Selling Price
X Rs. 25
Y Rs. 20

The directors want to be acquainted with the desirability of adopting any of the following
alternative sales mixes in the budget for the next period.

• 250 units of X and 250 units of Y

• 400 units of Y only
• 400 units of X and 100 units of Y
• 150 units of X and 50 units of Y

State which of the alternative sales mixes you would recommend to the management.


Marginal Cost Statement (Per Unit)

Direct Materials 8 6
Direct Wages 6 4
Variable Overheads 9 6
-- --
Marginal Cost 23 16
Contribution 2 4
-- --
Selling Price 25 20

Selection of Sales Alternatives

Situation a) 250 units of X and 250 units of Y

Contribution: Product X 250 Units x 2 Rs. 500

Product Y 20 Units x 4 1000
Less: Fixed Overheads 750

Profit 750

Situation b) 400 units of Product Y only

Contribution: 400 x 4 Rs. 1600

Less: Fixed Overheads 750

Profit 850

Situation c) 400 units of X and 100 units of Y Contribution

Product X 400 x 2 Rs. 800

Product Y 100 x 4 Rs. 400
Less: Fixed Overheads 750

Profit 450

Situation d) 150 units of X and 350 units of Y

Contribution: Product X 150 x 2 300
Product Y 350 x 4 1400
Less: Fixed Overheads 750
Profit 950

After doing the above calculations, we find that the alternative (d) is most profitable since it gives
the maximum profit of Rs. 950. So, we recommend the same to the company.

Illustration 4

The budgeted results for Associate Company Ltd. included the following:

Rs. in Lacs Variable Cost as % of Sales Value

Sales: Product P1 50.00 60%

P2 40.00 50%
P3 80.00 65%
P4 30.00 80%
P5 44.00 75%
244.00 65.77%

Fixed overheads for the period are Rs. 90 lacs.

You are asked to (a) prepare a statement showing the amount of loss expected and (b) recommend
a change in the sales volume of each product which will eliminate the expected loss. Assume that
the sale of only one product can be increased at a time.


Statement showing the Estimated Loss and the Increased Sales required to set off the Loss
(Rs. in Lacs)
Particulars P1 P2 P3 P4 P5 Total
(i) Sales 50.00 40.00 80.00 30.00 44.00 244. 00
(ii) Variable Cost 30.00 20.00 52.00 24.00 33.00 159.00
(iii) Contribution
20.00 20.00 28.00 6.00 11.00 85.00
Fixed Overheads 90.00
Loss 5.00
P/V Ratio (iii)/(i) 40% 59% 35% 20% 25%
Increased Sales
required to set
off the Loss 12.50 10.00 14.29 25.00 20.00

As we can see, there is a budgeted loss of Rs. 5 lacs and the sales of only one product can be
increased. This loss has to be set off by additional contribution. As the fixed overheads are
constant, additional contribution has been calculated by dividing the budgeted loss of Rs. 5 lacs by
the P/V ratios of respective products. The sales of any of the products to the extent of the amount
stated in the table would be sufficient to set off the loss.

4. Discontinuance of Product Line

Another type of condition of decision-making in multi-product firm is regarding the

discontinuance of a product line.

The following factors should be considered before taking a decision about the discontinuance of a
product line:

1. The contribution given by the product-- This 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.
2. 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 toward the recovery of fixed costs can be justified.
3. The availability of product to replace the product which the firm wants to discontinue and
which is already accounting for a significant proportion of the total capacity.
4. The long-term prospects in the market for the product.
5. The effect on sale of other products. In some cases, discontinuance of one product may result
in heavy decline in sales of other products affecting the overall profitability of the firm.

Illustration 5

A manufacturer is thinking whether he should drop one item from his product line and replace it
with another. Given below are his present cost and output data:

Product Price Variable Cost Percentage

Per Unit of Sales
Chairs 60 40 30%
Cupboard 100 60 20%
Tables 200 120 50%

Total Fixed Costs Per Year Rs. 7,50,000

Sales Last Year Rs. 25,00,000

The change under consideration consists of dropping the line of cupboards in favor of cabinets. If
this dropping and change is made, the manufacturer forecasts the following cost and output data:

Product Price Variable Cost Percentage

Per Unit Of Sales
Chairs 60 40 50%
Cabinet 160 60 10%
Tables 200 120 40%

Total Fixed Costs Per Year Rs. 7,50,000

Sales This Year Rs. 26,00,000
Should this proposal be accepted? Comment.


Comparative Profit Statement

Chairs Cupboards Table Total Chairs Cabinet Table Total
Sales 7,50,000 5,00,000 12,50,000 25,00,000 13,00,000 2,60,000 10,40,000 26,00,000
Less: 5,00,000 3,00,000 7,50,000 15,50,000 8,66,666 97,500 6,24,000 15,88,166
2,50,000 2,00,000 5,00,000 9,50,000 4,33,333 1,62,500 4,16,000 10,11,833
Less: 7,50,000

The above analysis shows that the manufacturer will stand to gain in case he drops the production
of cupboards in preference to cabinets. However, the demand for cabinets should be of a
permanent nature.

Working Notes

Existing Situation

Computation of Sales and Variables Costs:

Sales Variable Costs

Chairs 25,00,000 x 30/100 7,50,000 x 40/100

= Rs. 7,50,000 = Rs. 5,00,000

Cupboards 25,00,000 x 20/100 5,00,000 x 60/100

= Rs. 5,00,000 = Rs 3,00,000

Tables 25,00,000 x 50/100 12,50,000 x 120/100

= Rs. 12,50,000 = Rs. 7,50,000

Proposed Situation

Computation of Sales and Variable Costs

Sales Variable Costs

Chairs 26,00,000 x 10/100 13,50,000 x 40/60

= Rs. 13,50,000 = Rs. 8,66,667

Cabinets 26,00,000 x 10/100 26,00,000 x 60/160

= Rs. 2,60,000 = Rs. 97,500
Tables 25,00,000 x 40/100 10,40,000 x 120/200
= Rs. 10,40,000 = Rs. 6,24,000

Illustration 6

A company manufactures three products X, Y and Z. There are no common processes and the sale
of one product does not affect the prices or volume of sale of any other.

The company's budgeted profit/loss for 2000 has been abstracted as thus:

Total (Rs.) X (Rs.) Y (Rs.) Z (Rs.)

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 and Administration Costs:

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 2,01,000 30,900

Profit 30,000 7,800 23,100 (-) 900

On the basis of above data, 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 advise? Give reasons for your answer.


In order to comment upon the profitability of different presentation of costs, according to marginal
costing system, we have to compute P/V ratios first.

X Y Z Total
Rs. Rs. Rs. Rs.
Sales 45,000 2,25,000 30,000 3,00,000
Production Cost (Variable) 24,000 1,44,000 12,000 1,80,000
Selling and Admn. (Variable) 8,100 8,100 7,800 24,000
Total Variable Costs 32,100 1,52,100 19,800 2,04,000
(Sales - Variable Costs) 12,900 72,900 10,200 96,000
Less: Total Fixed Cost 5,100 49,800 11,100 66,000

Profit 7,800 23,100 (-) 900 30,000

P/V Ratio 28.7% 32.4% 34.10%

If product Z is discontinued, the fixed cost of Rs. 10,200 being recovered now cannot be recovered
since product Z is making a contribution of Rs. 10,200 toward fixed cost. Considering the P/V
ratio, product Z does not seem to be unprofitable as compared to other two products. Therefore, if
the heavy burden of fixed cost which has been apportioned to product Z being 39% of the total of
such burden is not taken into account, product Z is most profitable. Its P/V ratio is higher as
compared to the other two products.

This leads us to conclude that total profit will increase if Z's output and sales can be increased.

Illustration 7

As a prelude to finalizing the plans for the coming year, the executives thought it advisable to have
a look at the product-wise performance during the current year just completed. The following
information is furnished:

Product X Product Y Product Z

Rs. Rs. Rs.
Unit Selling Price 80 60 16
Direct Material 28 24 16
Direct Labor 20 12 12
Factory Overheads:
Variable 8 6 4
Fixed 8 6 1.28
Cost of Production 64 48 33.28

Selling, Distribution and

General Administration
Variable 4 2 2
Fixed 4 6 1.52
Unit Cost (I) 72 56 36.80
Unit Profit (Loss) (Ii) 8 4 (0.80)
Sales Volume (Units) 10,000 15,000 15,000
Profit (Loss) 80,000 60,000 (12,000)

For the coming period, the selling prices and the cost of three products are expected to remain
unchanged. There will be an increase in the sales of product X by 1,000 units and the increase in
sales of product Z is expected to be 8,000 units. The sales of product Y will remain to be
unchanged. Sufficient additional capacity exists to enable the increased demands to be met without
incurring additional fixed costs. Some among the executives contend that it will be unwise to go
for additional production and sale of product Z, since it is already making losses at Rs. 0.80 per
unit. The suggestion is that product Z should be eliminated altogether.

Do you agree? Substantiate with necessary analysis and determine the product-wise and overall
profits for the coming year.

XYZ Co. Ltd.
Statement showing Product-wise Contribution
and Total Profit
Product X Product Y Product Z Total
Particulars Per Unit Total Per Unit Total Per Unit Total

Sales Volume
(Units) 10,000 15,000 15,000
Selling Price (Rs.) 80 8,00,000 60 9,00,000 36 5,40,000 22,40,000
Direct Material 28 2,80,000 24 3,60,000 16 2,40,000 8,80,000
Direct Labor 20 2,00,000 12 1,80,000 12 1,80,000 5,60,000
Variable Factory
Overheads 8 80,000 6 90,000 4 60,000 2,30,000
Variable Selling, 4 40,000 2 30,000 2 30,000 1,00,000
Distribution and
General Admn. Overheads
Total Variable Cost 60 6,00,000 44 6,60,000 34 5,10,000 17,70,000
Contribution 20 2,00,000 16 2,40,000 2 30,000 4,70,000
Fixed Factory
Overheads 80,000 90,000 19,200 1,89,200
Fixed Selling, Distribution and
General Admn. Overheads 40,000 90,000 22,800 1,52,800
Total Fixed Overheads 3,42,000
Total Profit 1,28,000

The above analysis shows that product Z makes a contribution of Rs. 2 per unit. The loss sustained
in the previous year is because of the falling sales volume below breakeven level.

ABC Co. Ltd.

Budgeted Performance for the Coming Year
Product X Product Y Product Z
Unit Contribution (Rs.) 20 16 2
Sales Volume (Units) 11,000 15,000 23,000
Total Contribution (Rs.) 2,20,000 2,40,000 46,000
Less: Fixed Cost (Rs.) 1,20,000 1,80,000 42,000
Profit (Rs.) 1,00,000 60,000 4,000

The company makes a total profit of Rs. 1,64,000 if all the products are continued. However, if the
production of product Z is discontinued, there will be an adverse effect on the overall profit of the
company. This is because product Z also contributes toward meeting the fixed costs of the