The following points highlight the eleven main areas of marginal costing. The areas are: 1. Fixation of Selling Prices 2. Key Factor 3. Make or Buy Decision 4. Selection of a Suitable Product Mix 5. Effect of Change in Sales Price 6. Maintaining a Desired Level of Profits 7. Alternative Methods of Production 8. Cost Indifferent Point 9. Diversification of Products 10. Suspending Activities 11. Alternative Course of Action.
Areas of Marginal Costing:
- Fixation of Selling Prices
- Key Factor
- Make or Buy Decision
- Selection of a Suitable Product Mix
- Effect of Change in Sales Price
- Maintaining a Desired Level of Profits
- Alternative Methods of Production
- Cost Indifferent Point
- Diversification of Products
- Suspending Activities
- Alternative Course of Action
Marginal Costing: Area # 1. Fixation of Selling Prices:
Although prices are more controlled by market conditions and other economic factors than by decisions of management yet fixation of selling prices is one of the most important functions of management.
This function is to be performed:
(a) Under normal circumstances.
(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.
Illustration 1. (Determination of Selling Price under both monopoly and competitive conditions):
In a purely competitive market 10,000 units of a product can be manufactured and sold and a certain amount of profit is generated. It is estimated that 2,000 units of that product need to be manufactured and sold in a monopoly market to earn the same amount of profit.
Profit under both the market conditions is targeted at Rs.2, 00,000. The variable cost per unit is Rs.100 and the total fixed cost is Rs.60,000. You are required to determine the selling prices under both monopoly and competitive conditions.
Pricing in Depression:
Prices fall during depression and the product may be sold below the total cost. In case there is a serious but temporary fall in the demand on account of depression leading to the need for a drastic reduction in prices temporarily, the minimum selling price should be equal to the marginal cost.
If the selling price at which the goods can be sold is equal to marginal cost or more than marginal cost the product should be continued.
Fixed expenses will be incurred even if the product is discontinued during depression for a short period. If the product can be sold at a price which is a little more than marginal cost, loss on account of fixed expenses will reduce because price will recover fixed expenses to some extent.
This can be made clear by giving the following example:
Suppose, marginal cost per unit is Rs.10 and fixed expenses amount to Rs.1, 50,000. Selling price per unit is Rs.11 and 40,000 units can be sold at this price.
Even though the selling price of Rs.11 is below the total cost, yet it is advantageous to sell the product at the selling price of Rs.11 which is more than the marginal cost of Rs.10. This will reduce the loss on account of fixed expenses (if the product is discontinued) by Rs.40,000 as shown below:
Loss if the product is discontinued (Fixed Expenses) 1, 50,000
Loss reduced if the product is continued 40,000
Selling Price below the Marginal Cost:
If the selling price is below the marginal cost, loss will be more than the fixed costs because variable expenses will not be recovered fully. Hence, efforts should be made to sell the product at a price which is equal to the marginal cost or more than the marginal cost. Production should be discontinued if the price obtained is below the marginal cost so that loss may not be more than the fixed costs.
But, in the following circumstances, production may be continued even if the selling price is below the marginal cost:
a. When a New Product is Introduced in the Market:
The new product is sold at a very low price to make it popular. This is done with the hope that sales will increase with the passage of time and cost of production will come down as a result of increase in sales. Ultimately cost of production will be in line with the selling price and the concern will start earning profit from the new line of production.
b. When Foreign Market is to be Explored to Earn Foreign Exchange:
Government sometimes allows import quotas against foreign exchange earned and profits from import quotas may be much more than the loss on exporting the product at a price below the marginal cost.
c. When the Concern has already Purchased Large Quantities of Materials:
It is better to convert the material into finished goods and sell these at a price below the marginal cost if the sale of materials will give rise to loss which is more than the loss incurred if the production is done.
d. When Closure of Business:
When closure of business may mean breaking of business connections and connections may be re-established by a heavy expenditure on advertisement and sales promotion. In such a case, it is better to continue the production and sell the product at a price below the marginal cost.
e. When the Sales of One Product at a Price below the Marginal Cost will Push up the Sales of other Profitable Products:
The loss in one product will be made up by profits ii other products.
f. When Employees cannot be Retrenched:
In such a case, it is better to maintain the production even if the price is below the marginal cost.
g. When weak competitors are to be eliminated from the market.
h. When facing severe competition from a new entrant into the firm’s line of business.
i. For Publicity and Advertisement:
Price below marginal cost is only for a limited quantity.
j. When the Goods are of Perishable Nature:
It is better to sell the perishable goods at a price which they can realize; otherwise these goods will perish and nothing will be realized.
Accepting Additional Orders, Exploring Additional Markets and Exporting:
When additional orders are accepted or additional markets explored at a price below normal price to utilize idle capacity, it should be very carefully seen that they will not affect the normal market and goodwill of the company.
The order from a local merchant should not be accepted at a price below normal price because it will affect relationship of the concern with the other customers purchasing the goods at normal price. In case of foreign markets, goods may be sold at a price below normal price keeping in view the direct and indirect benefits of exporting such as import quotas, subsidies of Government, prestige of exporting etc.
Factors to be considered before Launching a Product in the New Market:
Following are the main factors to be considered before launching a product in the new market (whether Indian or foreign):
(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.
Factors in Accepting Export Orders:
The decision making by management requires the consideration of two types of factors, i.e., (i) Cost Factors and (ii) Non-Cost Factors.
(i) Cost Factors:
The most important cost factor in deciding about export sales is that export price should be more than the variable cost of the product. In such cases, the export sales will make a contribution and since there generally is no fixed cost involved the contribution is equal to profit.
If the company has to incur an additional fixed cost for export production, then such fixed cost should also be covered to make the export order profitable.
(ii) Non-Cost Factors:
These are qualitative factors such as;
(a) Export house status; (b) Earning of foreign exchange; (c) Goodwill enhancement of the company; (d) Creating employment opportunities.
(Acceptance or rejection of a foreign order). The Cost Sheet it of a product is given as under:
The selling price per unit is Rs.12.
The above figures are for an output of 50,000 units, the capacity for the firm is 65,000 units. A foreign customer is desirous of buying 15,000 units at a price of Rs.10 per unit. Advise the manufacturer whether the order should be accepted. What will be your advice if the order were from a local merchant?
The order from the foreign customer will give an additional contribution of Rs.15,000. Hence, the order should be accepted because additional contribution of Rs.15,000 will increase the profit by this amount because fixed expenses have already been met from the internal market.
The order from the local merchant should not be accepted at a price of Rs 10 which is less than normal price of Rs.12. This price will affect relationship with other customers and there will be a general tendency of reduction in the price.
(Acceptance or rejection of foreign offer). The Everest Snow Company manufactures and sells direct to customers’ 10,000 jars of ‘Everest Snow’ per month at Rs 1.25 per jar. The company’s normal production capacity is 20,000 jars of snow per month. An analysis of cost for 10,000 jars show:
The company has received an offer for the export under a different brand name of 1,20,000 jars of snow at 10,000 jars per month at 75 paise a jar.
Give your view on acceptance or non-acceptance of the offer.
From the above statement it in clear that the offer for export should be accepted as it converts the loss of Rs.100 into a net profit of Rs.2,755.
(Acceptance or rejection of an offer). Chair Manufacturers Ltd. present the following information for the past year:
The available capacity is a production of 20,000 units per year. The firm has an offer for the purchase of 5,000 chairs at a price of Rs.40 per unit. It is expected that by accepting this offer there will be saving of Rs.1 per unit in material costs on all units manufactured, the fixed overheads will increase by Rs.35,000 and the overall efficiency will drop by 2 per cent on all production.
Draft a report to the management giving your recommendations as to whether or not the offer should be accented.
The offer to accept the order of 5,000 chairs has been evaluated with the help of the following statement:
Though there is a marginal increase of Rs.30 in profits by accepting the offer, but it is desirable to accept taking into consideration the possibilities of getting orders in future. But at the same time, it has to be ensured that there will not be general reduction in price because of the acceptance of this order.
Marginal Costing: Area # 2. Key Factor:
A key factor is that factor which puts a limit on production and profit of a business. Usually the limiting factor is sales. A concern may not be able to sell as much as it can produce. But, sometimes a concern can sell all it produces but production is limited due to the shortage of materials, labour, plant capacity, or capital.
In such a case, a decision has to be taken regarding the choice of the product whose production is to be increased, reduced or stopped. Ordinarily, when there is no limiting factor, the choice of the product will be on the basis of the highest P/V ratio.
But when there are scarce or limited resources, selection of the product will be on the basis of contribution per unit of scarce factor of production. In short, scarce resources should be utilized in those directions where contribution per unit of limited resources is the maximum.
For example, materials are limited in supply and products X and Y use the same materials. Three units of materials are used for producing product X and five for Y. Suppose further contribution per unit is Rs.12 in case of product X and Rs.15 in case of product Y.
In this case, contribution per unit of materials is Rs.4 (i.e. Rs.12 ÷ Rs.3) in case of product X and Rs.3 (i.e. Rs.15 ÷ Rs.5) in case of product Y. Hence the available material should first be used for manufacturing product X up-to limit of demand for it and the balance of materials (if any) should be used for Y because product X yields more contribution per unit of scarce resource i.e., materials.
Therefore, in addition to limiting factor from the production side, limiting factor may also be difficulty in selling the items produced. In such a case ranking of items produced will be based on relatives contribution per unit of limiting factor of production but the number of units of a product to be produced getting rank one will be restricted to the number of units as per demand for that product and then the production of the other product getting second rank will be done but restricted to sales demand if balance of limiting factor is available and so on.
(When priorities are to be fixed for different products with reference to the key factor). A company manufactures and markets three products X, Y and Z. All the three products are made from the same set of machines. Production is limited by machine capacity. From the data given below, indicate priorities for products X, Y and Z with a view to maximising profits:
Marginal Costing: Area # 3. Make or Buy Decision:
A concern can utilize its idle capacity by making component parts instead of buying them from market. In arriving at such a make or buy decision, the price asked by the outside suppliers should be compared with the marginal cost of producing the component parts.
If the marginal cost is lower than the price demanded by the outside suppliers, the component parts should be manufactured in the factory itself to utilize unused capacity.
Fixed expenses are not taken in the cost of manufacturing component parts on the assumption that they have been already incurred, the additional cost involved is only variable cost. For example, the total cost of making a component part comes to Rs.8 consisting of Rs.6 as variable cost and Rs.2 as fixed cost. Suppose further an outside supplier is ready to supply the same component part at Rs.7.
On the basis of total cost method, it appears that it is cheaper to buy the component. But on the basis of marginal cost, the offer of the outside supplier should be rejected because the acceptance will mean that the total cost of the purchased part from the outside supplier will come to Rs.9 i.e., Rs.7 (supplier’s price) plus Rs.2 (fixed cost which cannot be saved even if the component is purchased from outside source).
Factors that Influence Make or Buy Decision:
In a make or buy decision the following cost and non-cost factors must be considered specifically:
a. Availability of plant facility.
b. Quality and type of item — which affects the production schedule.
c. The space required for the production of item.
d. Any special machinery or equipment required.
e. Any transportation involved due to the location of production i.e. the ‘Feeder Point’
f. Cost of acquiring special know how required for the item.
g. As to purchase of raw material the factors like market price, price trend, availability and other must be kept in view.
h. As to labour factors like availability of the required labour.
i. As to overhead expenses, adoption of lease for apportioning them must be taken into consideration including other factors.
j. An to application of the techniques of costing it must be viewed for marginal costing, differential costing or otherwise alike one.
k. In view of above and generally the production of an item will mean an outlay on machines and other facilities including employment of staff which may be permanent and of fixed nature. Thus fixed expenses burden may tend to increase.
So our production is kept at the estimated minimum requirement keeping in view the possible fluctuations in demand and the excess quantity required to be purchased from outside. The effect is that, should demand fall orders from outsiders can be cut down; the cost to be incurred will then be in proportion to the effective demand.
l. Having decided to purchase, it is also to be seen whether the released capacity can be put to more profitable use or not.
Non -Cost Factors:
Among the non-cost factors specifically:
a. In favour of making, the factors like
(i) Secrecy of company production.
(ii) Idle facility available
(iii) Quality and stability of market supply
(iv) Tax considerations
(v) Desirability of maintaining certain facilities.
b. In favour of buying factors like
(i) Lack of capital required
(ii) Passing the know how to suppliers or not
(iii) Uneven production of end product
(iv) Wide selection.
c. Generally the following as
(i) If quality cannot be ensured in our production, the article concerned should be purchased from outside; if outside supplier cannot be relied upon in this respect the article should be produced by the firm itself, whatever be the cost,
(ii) In case there are large fluctuations in demand, it is better to purchase from outside, but if the demand is likely to increase substantially, own production may lead to lower costs latter.
(iii) Ensure the capability and reliability of the outside suppliers to supply without any interruption.
In this regard the following factors are to be considered:
(a) The general reputation enjoyed by supplier for reliability
(b) Financial position and reputation
(c) Technical knowhow and production facilities
(d) His relation with his workmen etc.
(iv) If the business secrecy is to be maintained the manufacturing know how should not be passed on to the supplier, then it is better to produce,
(v) The outside supplier should not be a competitor.
In fact, it is a very crucial decision and both cost and non-cost factors must be weighted well.
A manufacturing company finds that while the cost of making a component part is Rs.10, the same is available in the market at Rs.9 with an assurance of continuous supply. Give your suggestion whether to make or buy this part. Give also your views in case the supplier reduces the price from Rs.9 to Rs.8.
The cost information is as follows:
Other Variable Expenses Rs.1.00
Direct Labour Rs.4.00
Fixed Expenses Rs.1.50
To take a decision on whether to make or buy the component part, fixed expenses being irrelevant cost should not be added to the cost because these will be incurred even if the part is not produced.
Thus, additional cost of the part will be as follows:
The company should produce the part if the part is available in the market at Rs.9.00 because the production of every part will give to the company a contribution of 50 paise (i.e., Rs.9.00 – Rs.8.50). The company should not manufacture the part if it is available in the market at Rs 8 because additional cost of producing the part is 50 paise (i.e., Rs.8.50 – Rs.8) more than the price at which it is available in the market.
In some cases in-spite of lower variable cost of production, there may be an increase in the fixed costs. In such a case increase in fixed cost becomes the relevant cost and should be considered for make or buy decision. It becomes essential to find out the minimum requirement of volume in order to justify the making instead of buying. This volume can be calculated by the following formula:
A firm can purchase a separate part from an outside source Rs.11 per unit. There is a proposal that the spare part be produced in the factory itself. For this purpose a machine costing Rs.1, 00,000 with annual capacity of 20,000 units and a life of 10 years will be required.
A foreman with a monthly salary of Rs.500 will have to be engaged. Materials required will be Rs.4.00 per unit and wages Rs.2.00 per unit. Variable overheads are 150% of direct labour. The firm can easily raise funds 10% p.a. Advice the firm whether the proposal should be accepted.
In order to accept the proposal it is essential that the volume should be at least 13,000 units. If there is no idle capacity and making of the spare part in the factory involves the loss of other work, the loss of contribution arising from displacement of work should also be considered along-with variable cost of production.
The loss of contribution is found with reference to key or limiting factor. If the purchase price is higher than the total variable cost of production plus traceable fixed costs plus the loss of contribution of production, it will be more profitable to manufacture.
Marginal Costing: Area # 4. Selection of a Suitable Product Mix:
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.
Present the following information to show to the management:
(i) The marginal product cost and the contribution per unit.
(ii) The total contribution and profits resulting from each of the following sales mixtures,
(iii) The proposed sales mix to earn a profit of Rs.250 and Rs 300 with total sales of A and B being 300 units.
Small Tools Factory has a plant capacity adequate to provide 19,800 h6urs of machine use. The plant can produce all A type tools or all B type tools or a mixture of the two types. Following information is relevant.
Market conditions are such that no more than 4,000 A type tools and 3,000 B type tools can be sold in a year. Annual fixed costs are Rs.9,900.
Compute the product-mix that will maximise the net income to the company and find that maximum net income.
From the above, it is clear that type B should be produced to the maximum extent and the balance machine hours should be utilized for production of A type tools.
Marginal Costing: Area # 5. Effect of Change in Sales Price:
Management is confronted with the problem of cut in prices of products from time to time on account of competition, expansion programme or government regulations. It is, therefore, necessary to know the effect of a cut in prices of the products. The effect of a cut in selling price per unit will be that contribution per unit will reduce.
Hansa Ltd. manufacturing a single product is facing severe competition in selling it at Rs.50 per unit. The company is operating at 60% level of activity, at which level sales are Rs.12, 00,000. Variable costs are Rs.30 per unit.
Semi-variable costs may be considered as fixed at Rs.90,000 when output is nil and the variable element is Rs.250 for each additional 1% level of activity. Fixed costs are Rs.1, 50,000 at the present level of activity, but if a level of activity of 80% or above are reached; these costs are expected to increase by Rs.50,000.
To cope with the competition, the management of the company is considering a proposal to reduce the selling price by 5%. You are required to prepare a statement showing the operating profit at levels of activity of 60%, 70%, 80% and assuming that:
(a) The selling price remains at Rs.50; and
(b) The selling price is reduced by 5%.
Show also the number of units which will be required to be sold to maintain the present profits if the company decided to reduce the selling price of the product by 5%.
(b) When Selling Price is Rs.47.50 i.e. 5% less than Rs.50
The revenue account of Goodwill Co. Ltd. has been summarised as shown below:
The licensed capacity of the company is Rs.80, 00,000 but the key factor is sales demand. It is proposed by the management that in order to utilize the existing capacity, the selling price of the product should be reduced by 5%.
You are required to prepare a forecast statement showing the effect of the proposed reduction in selling price after taking into account the following changes in costs:
(i) Sales forecast Rs.76, 00,000 (at reduced prices).
(ii) Direct wages rates and variable overheads are expected to increase by 5%.
(iii) Direct material prices are expected to increase by 2%.
(iv) Fixed overheads will increase by Rs.80,000.
Thus production is expected to increase by 33⅓% because sale volume is increased by this percentage.
Consequently, variable expenses will also increase by 33⅓% if there is no change in prices.
Marginal Costing: Area # 6. Maintaining a Desired Level of Profits:
Management may be interested in maintaining a desired level of profits. The volume of sales needed to have a desired level of profits can be ascertained by the marginal costing technique as is shown in the following illustration.
A company produces and markets industrial containers and packing cases. Due to competition the company purposes to reduce the selling price. If the present level of profit is to be maintained, indicate the number of units to be sold if the proposed reduction in selling price is:
(a) 5%; (6) 10%; (c) 15%.
Following additional information is available:
Marginal Costing: Area # 7. Alternative Methods of Production:
Marginal costing is helpful in comparing the alternative methods of production, i.e., in chine work or hand work. The method which gives the greatest contribution (assuming fixed expenses remaining same) is to be adopted keeping, of course, the limiting factor in view. Where, however, fixed expenses change, the decision will be taken on the basis of profit contributed by each.
Product X can be produced either by machine A or machine B. Mach ne A can produce 100 units of X per hour and machine B 150 units per hour. Total machine hours available during the year are 2,500. Taking into account the following data determine the profitable method of manufacture:
Marginal Costing: Area # 8. Cost Indifferent Point:
Sometimes there are two alternatives—one having low variable cost and high fixed cost and the other having high variable cost and low fixed cost. The cost indifferent point has to be determined by linking the incremental fixed overhead by the savings in variable costs.
A indifferent point the total cost of the two alternatives will be the same. In case of selection of machine, this point will be helpful in calculating the levels of sales at which both machines earn equal profits and the range of sales at which one is more profitable than the other.
Distinction between Cost Indifferent Point and Break Even Point:
Cost Indifference Point:
a. It is the point at which total cost lines under the two alternatives intersect each other.
b. It is that activity level at which total costs under two alternatives are equal.
c. It is used to chose between two alternative processes for achieving the same objective. The choice depends on the estimated activity level.
Break Even Point:
a. It is the point where the total cost line and total revenue line for a particular alternative intersect each other.
b. It is that activity level at which total contribution from a product or product mix is equal to its fixed cost.
c. it is used for profit planning.
(Selection of Machine). X Limited has been offered a choice to buy a machine between ‘A’ and ‘B’. You are required to compute:
(a) Break-even point for each of the machines.
(b) The level of Sales at which both machines earn equal profits.
(c) The range of Sales at which one is more profitable than the other.
The relevant data is as given below:
(b) As the selling price of the pre ducts produced A and B are equal, the machines will earn equal profit when total cost of operation of both machines are the same.
If x be the output when total cost of the machines are the same, we have total cost of machine A’ = 4x + Rs 30,000
and machine ‘B’ 6x + Rs.16,000
4x + Rs.30,000 = 6x + Rs.16,000
2x = 14,000
X = 7,000
At a production level of 7,000 units the profits made by the machines ‘A’ and ‘B’ are equal,
(c) The breakeven point of ‘A’ is at 5,000 units compared to that of 4,000 units in case of B and at a production level of 7,000 units they earn equal profit.
It is quite clear that the profit earning capacity for machine ‘B’ is more in the range of 4,000 to 6,999 units as it starts earning profit at lower point. But ‘A’ will earn more beyond 7,000 units as it has a higher P/V ratio which will enable it to earn more incremental contribution on the increasing sales.
S manufactures a component that it sells for Rs.8 per unit. The company is contemplating an increase in selling price to Rs 9 per unit. If selling price is increased, the volume of sales is expected to decline. Company is willing to increase the price if resulting net income is greater than Rs.30,000, which company earns presently as follows:
How far can the volume of sales decline before the price indifference point is reached?
Determination of sales levels at which profit of Rs 30,000 is earned with revised selling price:
We know that
(Selling Price per unit x Units sold = (Variable Cost x Units sold + Fixed Costs + Target Profit) Suppose, X represents number of units sold, then
9X = 5X + Rs.45,000 + Rs.30,000
or 4X = Rs.75,000 or X = Rs.18,750 units
This means that, if new price is to be accepted, sales must be more than 18,750 units, which represents price indifference point.
Marginal Costing: Area # 9. Diversification of Products:
Sometimes it becomes necessary for a concern to introduce a new product to the existing product or products in order to utilize the idle capacity or to capture a new market or for other purposes. The new product must be profitable.
In order to decide about the profitability of the new product, it is assumed that the manufacture of the new product will not increase fixed costs of the concern and if the price realized from the sale of such product is more than its variable cost of production it is worth trying. If this data is presented under absorption costing method, the decision will be wrong.
But if with the introduction of new product there is an increase in the fixed costs, then such specific increase in fixed costs must be deducted from the contribution for making any decision. General fixed costs will, however, be charged to the old product/products.
Evenheel Ltd. manufactures and sells a single product X whose selling price is Rs 40 per unit and the variable cost is Rs.16 per unit.
(а) If the fixed costs for this year are Rs.4 80,000 and the annual sales are at 60% margin of safety, calculate the rate of net return on sale, assuming an income-tax level of 40%.
(b) For the next year, it is proposed to add another product line Y whose selling price would be Rs 50 per unit and the variable cost Rs.10 per unit. The total fixed costs are estimated at Rs.6, 66,600. The sales mix of X, Y would be 7: 3. At what level of sales next year, would Evenheel Ltd., breakeven? Give separately for both X and Y the break even sales in rupees and quantities.
Marginal Costing: Area # 10. Suspending Activities:
Sometimes it becomes necessary for a firm to temporarily suspend or close the activities of a particular product, department or factory as a whole due to trade recession. The decision to close down or suspend its activities will depend on whether products are making a contribution towards fixed costs or not.
If the products are making a contribution towards fixed costs, it is preferable not to close business or suspend its activities to minimise the losses.
If the business is closed down there may be certain fixed costs which could be avoided but there will be certain expenses which will have to be incurred at the time of closing the operation like redundancy payments, necessary maintenance of plant or overhauling of plant on reopening, training of personnel etc.
Such costs are associated with closing down of the business and must be taken into consideration before taking any decision. Fixed costs may be general or specific. General fixed costs may or may not remain constant while, specific costs will be directly affected by the closing down of the operation.
To conclude, if general fixed costs are likely to come down in the event of closure or suspension of activities, the excess of contribution over specific fixed costs will have to be compared with reduction in general fixed cost.
If the former exceeds the latter it is profitable to continue the activities and close down or suspend activities if the latter exceeds the former. In addition to cost consideration, there may be some non-cost considerations which may weigh in taking the decision to close down or suspend its activities or not.
Following non-cost considerations are relevant in this respect:
(i) Once the business is closed down, competitors may establish their products and our business may be lost. It may be difficult to recapture the lost market again; heavy advertisement charges may have to be incurred to recapture the business again.
(ii) Fear of retrenchment of worker If workers are discharged it may be difficult to get experienced and skilled workers again at the restart of the business.
(iii) Plant may become obsolete with the closure of the business and heavy capital expenditure may have to be incurred on restart of the business.
(iv) Reputation of the firm may suffer if some activities are closed down or suspended.
(v) Temporary closing down or suspending activities may not be desirable if the relationship with the suppliers is adversely affected.
(vi) Fear of non-collection of dues from customers in case of close of business may not go in favour of closure of business.
The annual flexible budget of a company is as follows:
Owing to trade difficulties the company is operating at 50% capacity. Selling prices have had to be lowered to what the directors maintain is an uneconomic level and they are considering whether or not their single factory should be closed down until the trade recession has passed.
A market research consultant has advised that in about twelve months’ time there is every indication that sales will increase to about 75% of normal capacity and that the revenue to be produced from sales in the second year will amount to Rs.90,000. The present revenue from sales at 50% capacity would amount to only Rs.49,500 for a complete year.
If the directors decide to close down the factory for the year, it is estimated that:
(а) The present fixed costs would be reduced to Rs.11,000 a year.
(b) Closing down costs (redundancy payments etc.) would amount to Rs.7,500.
(c) Necessary maintenance of plant would cost Rs.1,000 p.a.
(d) On reopening the factory the cost of overhauling plant, training and engagement of new personnel would amount to Rs.4,000.
Prepare a statement for the directors presenting in such a way as to indicate whether or not it is desirable to close the factory.
From the above it is clear that the amount of loss can be reduced by Rs.13,500 (i.e. Rs.23,500 − Rs.10,000) if the factory is continued to operate at 50% capacity. There will be profit of Rs.10,250 in the second year, so closing down of factory is undesirable.
Marginal Costing: Area # 11. Alternative Course of Action:
When deciding between alternative courses of action, it shall be kept in mind that whatever course of action is adopted, certain fixed expenses will remain unaffected.
The criterion, therefore, which weighs is the effect of alternative course of action upon the marginal (i.e., variable) costs in relation to the revenue obtained. The course of action which yields the greatest contribution is the most profitable to be followed by the management.
The cost per unit of the three products, A, B and C of a concern is as follows:
Production arrangements are such that if one product is given up, the production of the others can be raised by 50%. The directors propose that C should be given up because the contribution in that case is the lowest. Do you agree?
Fixed expenses under the present arrangement are Rs.61,000 calculated as follows:
From the three production arrangements we see that the profit is the maximum when product B is given up. Therefore, we do not agree with the directors that C should be given up and recommend that product B should be given up in order to have the maximum profit.