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It is the amount by which total cost increases when one extra unit is produced, or
the amount of cost which can be avoided by producing one unit less.
Accordingly, marginal cost may also be defined as the variable cost incurred due to
a specific activity. It is concerned with variable costs, because fixed costs by
definition do not change with the volume produced.
1) Suspension of activities:
Sometimes, management may be confronted with the problem of closing down an
unprofitable department, branch or a line of activity. In such a situation, the
guiding principle to be followed is the contribution by the product, branch or
department to the pool or fund. The object of the analysis is to increase profits by
dropping an unprofitable line of activity and replace the same with a profitable
one.
Illustration:
MOM Ltd., is engaged in three distinct lines of production. Their production cost
per unit and selling prices are as under:
A B C
Production (units) 3,000 2,000 5,000
Rs. Rs. Rs.
Material Cost 18 26 30
Wages 7 9 10
Variable Overheads 2 3 3
Fixed Overheads 5 8 9
32 46 52
Selling Price 40 60 61
8 14 9
The management wants to discontinue 1 line & gives you assurance that
production in 2 other lines shall rise by 50%. They intended to discontinue the line
which produces article A as it is less profitable.
a) Do you agree to the scheme in principle? Do you think that line A should be
discontinued?
Solution:
Marginal Cost Statement (Present Position)
2) Pricing Decisions:
One of the purposes of cost accounting is the ascertainment of cost for fixation of
selling price. Although market price is the result of market forces, the absence of
perfect competition has the effect of empowering every firm to fix its own price.
However, price fixation is one of the fundamental problems that management has
to face. Whether the cost plus formula of pricing, differential pricing or product-
line pricing, depends upon the cost which sets the lowest limit to pricing.
During normal circumstances, price is based on full cost. This is in fact, the
principle underlying absorption costing. However, during business recession, this
principle of full cost pricing cannot be followed. Further, when spare capacity
exists, and it is necessary to make use of the same to execute a bulk order at a
lower price, the question arises as to what extent the price could be reduced. The
same would be the case when a buyer in a foreign country desires to buy the
product at a lower price. In these cases, it is the techniques of marginal costing that
aids pricing decisions.
The principle that should govern the fixation of price in these special cases is that
the price should cover the marginal cost. Sometimes, it may become necessary to
reduce the price even below the marginal cost. The circumstances necessitating the
fixation of price at or below cost are the following:
vi) When it is felt that lowering the price is much better to keep the business going
rather than close it temporarily, and meet the costs of closing and subsequent re-
opening.
vii) To retain the old customers who may be lost to competitors in the activities are
suspended.
ix) To keep plant and machinery quite fit for production which could not otherwise
be possible if business is stopped.
Illustration:
The following details were extracted from the budget for the forthcoming year:
Rs. Rs.
Sales (40,000 units) 3,60,000
Direct Materials 1,20,000
Direct Labour 80,000
Variable Overheads 40,000
Fixed Overheads 1,00,000
3,40,000
Net Profit 20,000
In order to improve the amount of net profit budgeted; it is proposed to reduce the
selling price from Rs.9 to Rs.8 per unit. It is anticipated that if this reduction is
made, the volume of sale would increase by 30,000 units.
Assuming that if the selling price were reduced as suggested, calculate the net
profit that will be achieved.
Solution:
Marginal Cost Statement
Thus, a price reduction by Re.1 would increase the contribution by Rs.20, 000 and
the net profit also by the same amount. The reduction is desirable provided the
market is capable of absorbing the additional output and there is no increase in
fixed costs.
In the case of a multi-product concern, the question often arises as to the product
mix or sales mix which will yield maximum profit. Such a question cannot be
easily answered because when a concern is engaged in different lines of activity, it
is quite unlikely that each line of activity is as profitable as the other in view of
different cost structures and different sales prices.
Under such circumstances, management may alter the existing product mix by
pushing up the production or sale of the less profitable ones. In other words, it is
necessary to select, from amongst the available alternative combinations of
products which gives maximum contribution. Such a combination is known as the
optimum product mix. If there is a key factor, the contribution per unit of that
factor has to be compared in order to know the profitability of the products.
Illustration:
The following 3 alternative plans are being considered for the next accounting
year:
X Y
Rs. Rs.
Selling Price 8 7
Direct Material Cost 3 3
Direct Wages cost 2 2
Variable overhead 0.50 0.25
Calculate the budgeted profit that would result from each of the 3 alternatives and
suggest the most profitable alternative. The budgeted fixed cost are Rs.1, 500.
Solution:
X Y
Selling Price 8 7
Marginal Cost 5.50 5.25
Contribution per unit 2.50 1.75
Plan A, with 1,000 units of product X and 500 units of product Y is the best mix
since the contribution and the profit are the highest. However, before the decision,
consideration should be given to the limiting factors if any.