Top 4 Applications of Marginal Costing | Cost Accounting

The following points highlight the top four applications of marginal costing. The applications are: 1. Cost Control 2. Profit Planning 3. Evaluation of Performance 4. Decision Making.

Marginal Costing: Application # 1. Cost Control:

Marginal costing divides the total cost into fixed and variable cost. Fixed cost can be controlled by the top management and that to a limited extent. Variable costs can be controlled by the lower level of management. Marginal costing by concentrating all efforts on the variable costs can control and thus provides a tool to the management for control of total cost.

There may be situations where the profits of the concern are decreasing in-spite of increase in sales. If the data is presented on the basis of absorption costing basis, the management may not be able to comprehend the results. Marginal costing analysis will correctly bring out the reasons as to why the profits are decreasing in-spite of increase in sales.

Moreover, it should be noted that in marginal costing fixed costs are not eliminated at all. These are shown separately as a deduction from the contribution instead of merging with cost of sales and inventories. This helps the management to have control on fixed costs also in the long period as these costs are programmed in advance.

Marginal Costing: Application # 2. Profit Planning:

Marginal costing helps the profit planning i.e., planning for future operations in such a way as to maximise the profits or to maintain a specified level of profit. Absorption costing fails to bring out the correct effect of change in sale price; variable cost or product mix on the profits of the concern but that is possible with the help of marginal costing.

Profits are increased or decreased as a consequence of fluctuations in selling prices, variable costs and sales quantities in case there is fixed capacity to produce and sell.

Illustration 1:

Two businesses, Y Ltd. and Z Ltd., sell the same type of product in the same type of market.

You are required to:

(a) Calculate the breakeven point of each business;

(b) Calculate the sales volume at which each of business will earn Rs 5,000 profit;

(c) Calculate at which sales volume both the firms will earn equal profits.

(d) State which business is likely to earn greater profit in conditions of :

(i) Heavy demand for the product;

(ii) Low demand for the product and briefly give your reasons.

Solution:

Thus, at sales volume of Rs.1, 50,000 profits will be equal.

(d) (i) In conditions of heavy demand, a concern with larger P/V ratio can earn greater profits because of greater contribution. Thus, Z Ltd. is likely to earn greater profit.

(ii) In conditions of low demand, a concern with lower breakeven point is likely to earn more profit because it will start earning profits at lower level of sales. In this case Y Ltd. will start earning profits when its sales reach the level of Rs.75,000, whereas Z Ltd. will start earning profits when its sales reach the level of Rs.1, 05,000.

Therefore, in case of low demand breakeven point should be reached as earlier as possible so that the concern may start earning profits.

Marginal Costing: Application # 3. Evaluation of Performance:

The different products, departments, markets and sales divisions have different profit earning potentialities. Marginal cost analysis is very useful for evaluating the performance of each sector of a concern.

Performance evaluation is better done if distinction is made between fixed and variable expenses. A product, department, market or sales division giving higher contribution should be preferred if fixed expenses remain same.

Illustration 2:

(Elimination of a product). A company manufactures 3 products A, B and C. There are no common processes and the sale of one product does not affect prices or volume of sales of any other.

The Company’s budgeted profit/loss for 2010 has been abstracted thus:

On the basis of the above 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 advice? Give reasons for your answer.

Solution:

From the above it is clear that product 0 is contributing Rs.10,200 towards the fixed expenses of the company. If product C is eliminated the profit of the company will be reduced to Rs.19,800 (i.e., Rs.30,000 – Rs.10,200). Moreover, the P/V Ratio of product C is the highest as compared to other products. Hence it is not advisable to eliminate product C.

Illustration 3:

(Profitability of a product). The Novelties Ltd. is not keen on making special efforts to push the sales of product B, one of three main products it deals in, since the product B is not considered to be as profitable as the other two.

The selling prices and cost of the three products are:

Overhead rates for each department per rupee of direct labour are as follows:

What will be your advice about the profitability of product B ? Give reasons.

Solution:

The attitude of Novelties Ltd. towards product B is based on wrong considerations. Though product E is giving a little less contribution as compared to other products but it has the maximum profit volume ratio. The wrong attitude of company towards this product may be due to the inequitable apportionment of fixed overhead cost and that is why the profit of product B is less as compared to A and C.

But this is not the right attitude of the company. Product B sales must be pushed up as long as it gives good contribution. Moreover, it has the maximum profit volume ratio as compared to other products.

Illustration 4:

(Profitability for discontinuation of sales). A company which sells four products, some of them unprofitable proposes discontinuing the sale of one of them. Following information is available regarding its income, costs and activities for a year:

Its overhead costs and basis of allocation are:

You are required to:

(а) Prepare a profit and loss statement showing percentage profit or loss to sales for each product.

(b) Compare the profit if the company discontinues sales of product B with the profit if it discontinues product C.

Solution (For Statement of Profit & Loss):

Conclusion:

Since contribution is case of product B is negative, it is better to discontinue ‘B’; only thereby the profit will be maximum, i.e., Rs.79,000 as compared to the existing profit of Rs.65,000.

Illustration 5:

(Utilisation of resources for improvement of profitability).

A Ltd. manufactures three products and the cost particulars for a year are as follows:

The company imports one of the raw material which is used in manufacture of all products, the consumption of material is as follows:

X 2,000 kgs.; Y 5,000 kgs. and Z 3,000 kgs.

There is restriction in import of the material. The management is planning to close down one of the lines of product, and utilize the materials for other two lines to improve the profitability. As the cost and management accountant of the company, prepare a report for the closure of one line for improving the profitability.

Solution:

Product Z gives the lowest contribution per kg. of imported materials. Hence it may be discontinued and raw material rendered surplus i.e. 3,000 kgs. should be utilised for production of Y which gives the highest contribution per kg of raw material.

If it is done, the contribution will increase by Rs.48,000 i.e., Rs 16 (i.e., Rs.36 – Rs 20) x 3,000 kgs. Hence the total profit will increase to Rs.2, 38,000 (i.e., Rs.1,90,000 + Rs.48,000). In case the full quantity 3,000 kgs. cannot be utilized on Y due to market constraints, the balance can be used for production of X (second priority).

Marginal Costing: Application # 4. Decision Making:

The information provided by the total cost method is not sufficient in solving the management problems. Marginal costing technique is used for providing assistance to the management in vital decision-making, especially in dealing with the problems requiring short-term decisions where fixed costs are excluded.