Marginal Costing : Product Mix and Outsourcing Decision | Cost Accounting

Marginal costing technique is used for short-term decision-making. It assumes that fixed costs are not affected by the decision to allocate resources to different activities. Therefore, variable costs are the only relevant costs for decision-making. However, in practice, this assumption is seldom valid. Therefore, marginal costing technique has limited use in practice.

To arrive at the final decision, managers consider qualitative factors that cannot be incorporated in cost models. E.g., outsourcing decisions are significantly influenced by qualitative factors such as the credibility of the vendor, financial and technical stability of the vendor, the bargaining power of the vendor, and dysfunctional effects within the organization.

Product Mix:

If a firm has a choice to decide the product that it can produce and sell, it will choose the product that will earn maximum contribution.

If a particular factor limits the activity level, it will choose the product that will earn maximum contribution per unit of the limiting factor. E.g., if machine hour is the lim­iting factor, the firm will choose the product that will earn maximum contribution per machine hour.

Suppose a firm can produce four products M, N, P, and Q, which earn con­tributions of CU 20, CU 40, CU 50, and CU 60, respectively. Production of M, N, P, and Q requires use of 1, 4, 4, and 5 hours, respectively, of a machine whose capacity is 100,000 machine hours. Contribution per machine hour of M, N, P, and Q is CU 20, CU 10, CU 12.50, and CU 12, respectively.

The maximum total contribution that each of the products can earn is as follows:

M- CU 20 X 100,000 = CU 2,000,000

N- CU 10 X 100,000 = CU 1,000,000

P- CU 12.50 X 100,000 = CU 1,250,000

Q- CU 12 X 100,000 = CU 1,200,000

Therefore, the firm will prefer to produce M to maximize the contribution and consequently the operating profit. If the machine hour is not scarce, the firm will prefer to produce Q, whose contribution per unit is the highest among the four products, to maximize its contribution.

Outsourcing Decision:

When a firm outsources an activity, in the short term, it avoids the variable cost of carry­ing out the activity. Therefore, in deciding whether to outsource an activity, it compares the variable cost of carrying out the activity internally and the price it will have to pay the vendor. If the bought-out price is lower than the variable cost, the contribution from the activity improves by outsourcing the activity.

If the bought-out price is higher than the variable cost, the contribution from the activity reduces by outsourcing the activity. However, total contribution of the firm may improve. E.g., if the capacity of a workstation in which a component is produced is limited and is a constraint in the total production process, the firm improves the production capacity of the facility to produce the finished good by outsourcing a part of the total requirement of the component.

Sometimes a firm may decide to outsource a part of the total requirement of the finished product in order to increase the sales without immediate capital investment to augment the production capac­ity. In those situations a firm outsources an activity even if the bought-out price is higher than the variable cost.

If a firm has a choice to decide which activity, among some identified activities, to be outsourced, it will prefer to outsource the activity for which the loss of contribution is the lowest among that for all the identified activities. If a limiting factor is in opera­tion, the firm will prefer to outsource the activity for which the loss of contribution per unit of the limiting factor is the lowest among that for all the identified activities.

Decision on Manufacturing Method:

Marginal costing technique can be used to choose from alternative methods of manufacturing. The method, which generates the highest contribution, is the most desirable method. The decision, therefore, rests on the contribution per unit or the contribution per unit of the limiting factor, if a limiting factor is identified.

Shutting Down Decisions:

Marginal costing technique may be used in deciding whether to discontinue a section of the business, provided the discontinuance will not change the total fixed costs of the firm. The decision will hinge on whether the particular section of the business is contributing towards fixed overheads.

Closure of an activity, which generates positive contribution, reduces the current operating profit, or increases the operating loss. In certain situations, a part of the fixed cost is avoided by temporary closure. In such a situation, if avoidable fixed cost is higher than expected contribution, the business segment should be closed.

Marginal Cost and Product Pricing:

For survival and growth, a firm should recover from customers more than the ‘full cost’ to ensure a reasonable return on capital employed. Marginal cost may be used as a basis for short-term pricing decisions. Usually, marginal cost is used to determine prices for non- repetitive orders under difficult business conditions or to use spare capacity. A product that is sold at a price higher than the marginal cost contributes towards fixed cost and operating profit.

The following factors should be considered in fixing selling prices when demand is below normal:

(a) Amount and the rate of contribution which the proposed selling price would yield;

(b) Probability of securing an order with higher contribution during the period of execution of the order;

(c) Proposed concession, when compared with the normal selling price on full cost basis;

(d) Probable adverse effects on future sales.

When one or more resources are scarce, (e.g. material is scarce), the first consideration must be to reserve the same for orders that would yield the highest contribution per unit of the scarce resource (the limiting factor).

A decision to sell at a lower price might also have an adverse effect on the firm’s general level of selling prices in its established market. This aspect should also be carefully examined before accepting an order with contribution lower than the normal contribution.

The following are the reasons that strongly justify acceptance of an order with lower contribution at the time of adverse trade situations:

(a) It helps to hold together the skilled labour force;

(b) It keeps the plant and machinery in operation and the workers busy;

(c) It helps to utilize materials already received;

(d) It helps to avoid costs involved in the closing and re-opening of the plant;

(e) It helps to maintain the sales of complementary products at a satisfactory level; and

(f) It helps to hold its position in established markets to avoid additional sales promotion expenses in re-establishing the markets.

Selling below full cost prices, even under a normal situation, may be adopted in order to:

(a) Introduce a new product;

(b) Execute an order in a special market segment (say, defense supply) which is immune from other market segments;

(c) Expand the export market; and

(d) Dispose of a product which deteriorates fast.