One of the main functions of management is decision-making. Many of the decisions are of a short-term nature. Only rarely is a manager faced with a decision which has a long term impact eg. buying a new machine, expanding the factory, take-over of another company. Since most of the decisions have a short-term impact it can be assumed that the capacity of the factory will not change. Therefore fixed or periodic costs are not affected by tactical short-run decisions. The only costs which are affected are variable costs ie. those costs which vary directly with the level of activity of the factory. These would include direct materials, direct labour and variable overheads.
Also all the decisions comprise a choice between alternative courses of action. Therefore, past costs can have no relevance for future decisions. Past costs can consist of sunk costs or committed costs.
In marginal costing all costs are classified according to how they behave. They are either variable or fixed. The fixed costs are treated as periodic ie. they are related to time . Examples of fixed costs would be rent, rates, insurance, depreciation etc. These costs stay constant in the short-term regardless of the decision that management takes. Therefore, in making decisions, in choosing between different alternative courses of action management identifies the variable costs and treats the fixed costs as irrelevant.
To summarize the technique of marginal costing:
· Costs are classified as either fixed or variable.
· In the short-run all fixed costs remain unchanged and therefore treated as irrelevant.
· The only relevant costs are variable costs ie. those costs which increase/decrease as output increases/decreases.
Definition: Marginal costing is a costing principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period are written off in full against the contribution for that period. (ICMA)
Marginal cost = variable cost = direct materials
direct labour
direct expense
variable overhead
Contribution = sales revenue - variable(marginal) costs
Contribution is the amount which helps to pay off the fixed costs and any excess represents profit. Contribution is not profit.
Example Format of a Marginal Costing Income Statement
| Products | A | B | C | Total |
| Sales revenue | X | X | X | X |
| Less Variable costs | (X) | (X) | (X) | (X) |
| | ------ | ------ | ------ | ------ |
| Contribution | X | X | X | X |
| | ------ | ------ | ------ | ------ |
| Fixed costs | | | | (X) |
| | | | | ------ |
| | | | | X |
| | | | | ------ |
Marginal cost is the amount at any given volume of output by which total costs are changed if the volume of output is increased or decreased. It is the cost of making one extra unit of output. The definition stesses the manner in which costs behave in relation to the volume of activity. It concerns the identification of variable and fixed costs ie. the costs that increase or decrease as output increases or decreases. Only the variable costs both production and non-production change as the output changes.
Example:
A company manufacture units with avaiable cost per unit of £2 and fixed costs of £5,000.
| Volume (costs) | 0 | 1 | 1,000 | 10,000 |
| | £ | £ | £ | £ |
| Variable costs | --- | 2 | 2,000 | 20,000 |
| Fixed costs | 5,000 | 5,000 | 5,000 | 5,000 |
| | ------- | ------- | ------- | ------- |
| Total cost | 5,000 | 5,002 | 7,000 | 25,000 |
| | ------- | ------- | ------- | ------- |
| | | | | |
| | | | | |
Note £2 is the marginal cost or variable cost per unit.
Applications of marginal costing
(a) Acceptance of a special order.
X Ltd. makes a product which sells for £1.50. The output for the period is 80,000 units of product which represents 80% capacity . Total costs are £90,000 and of these it is estimated that £26.000 are fixed costs. A potential customer offers to buy 20,000 units at £1.10 and this will use up the company’s spare capacity.
Should management accept this special order?
| Sales | £120,000 |
| Marginal costs( 80p per unit) | 64,000 |
| | -------- |
| Contribution | 56,000 |
| Fixed costs | 26,000 |
| | -------- |
| Profit | 30,000 |
| | -------- |
Special order:
Sales(20,000 units @ £1.10) £22,000
Less Variable costs(20,000 @ 80p) 16,000
----------
Extra contribution 6,000
----------
Profits can be increased by an additional £6,000 since fixed costs are already covered. However management must consider other relevant factors in arriving at the final decision.
How will existing customers react? They may wish to buy at £1.10 per unit. Could the spare capacity be used more profitably rather than accepting the special order?
2 Shut-down decisions
Often management wish to analyse the performance of their products, branches, divisions.
Consider the following example.
Example:
| Product | A | B | C | Total |
| | £ | £ | £ | £ |
| Sales | 20,000 | 50,000 | 25,000 | 95,000 |
| Less | | | | |
| Direct materials | 1,000 | 15,000 | 10,000 | 26,000 |
| Direct labour | 3,000 | 16,000 | 14,000 | 33,000 |
| Fixed overheads | 2,000 | 7,000 | 9,000 | 18,000 |
| | -------- | -------- | -------- | -------- |
| | 6,000 | 38,000 | 33,000 | 77,000 |
| | -------- | -------- | -------- | -------- |
| Profit/(Loss) | 14,000 | 12,000 | (8,000) | 18,000 |
With product C making a loss management might consider discontinuing this product. However, using marginal costing principles, with fixed costs treated as irrelevant for short-run decision-making the income statement can be reformatted.
| Prtoduct | A | B | C | Total |
| | £ | £ | £ | £ |
| Sales | 20,000 | 50,000 | 25,000 | 95,000 |
| Less | | | | |
| Variable costs | 4,000 | 31,000 | 24,000 | 59,000 |
| | -------- | -------- | -------- | -------- |
| Contribution | 16,000 | 29,000 | 1,000 | 36,000 |
| Fixed costs | | | | 18,000 |
| | | | | -------- |
| Net profit | | | | 18,000 |
| | | | | -------- |
Since product C makes a contribution it may be inadvisable to close it down. If Product C is closed down the company will lose £1,000 contribution and the overall effect would be to reduce profits to £17,000.
3 Make or Buy
Sometimes management may have to consider whether it is best to manufacture products or components or to sub-contract them out and purchase them externally.
Example:
A company makes product P. A component Q used in the manufacture of P can be purchased from a supplier for £8. The costs to make the component are as follows:
Direct materials £2
Direct wages £3
Variable overheads £2
------
Variable cost of production £7
------
Assume spare capacity and the fixed costs remain unchanged.
Obviously it is cheaper to make than to buy.
However, if the firm is working at full capacity and to make component Q involves moving some of the capacity from product P then the decision is a little more involved.
The following data applies to product P.
Selling price £16
Direct materials £6
Direct labour £4
Variable overhead £2
------
Contribution £4
------
The production rate for product P is 5 units per hour and for component Q is 10.
The effective cost of making a unit of component Q is:
Marginal cost of production £7
Plus Opportunity cost of £2
-----
The effective cost is £9
-----
By switching capacity from product P to component Q there is £2 contribution lost. This is an opportunity cost ie. it is the benefit foregone by choosing one course of action over the other.
4 Limiting factor decisions
Often a company finds that there is a limiting factor or constraint which inhibits its capacity to meet the desired production level. The limiting factor may be any resource eg. materials, labour or machine hours. Management has to decide what is the best way to allocate the scarce resource among the product range in the most effective way so that profits are maximised.
Example:
| Product | X | Y | Z |
| Desired production (units) | 1,000 | 2,000 | 500 |
| | £ | £ | £ |
| Selling price per unit | 35 | 25 | 15 |
| Variable cost per unit | 15 | 10 | 5 |
| | ----- | ----- | ----- |
| Contribution per unit | 20 | 15 | 10 |
A special machine is used to manufacture the three products and there are only 15,000 machine hours available.
Product X uses 20 machine hours per unit.
Product Y uses 5 machine hours per unit.
Product Z uses 2 machine hours per unit.
| | X | Y | Z |
| Contribution per unit | 20 | 15 | 10 |
| No. of machine hrs. | 20 | 5 | 2 |
| Contribution per machine hr. | 1 | 3 | 5 |
| Ranking | (3) | (2) | (1) |
Desired production level
| Product Z | 500 units x 2 hrs. | 1,000 hrs | | |
| Product Y | 2,000 x 5 hrs | 10,000 hrs | | |
| Product X | 200 x 20 | 4,000 hrs | | |
Product Z earns 500 units x £10 = £5,000 contribution
Product Y earns 2,000 units x £15 = £30,000 contribution
Product X earns 200 units x£20 = £4,000 contribution
---------
£39,000 contribution
----------
5 Profit Planning or cost profit volume analysis
Management feels it helpful to ascertain the level of profits earned at certain levels of output and sales.
Example:
A company makes product X which has a selling price of £10 per unit and variable costs of £5 per unit with fixed costs of £20,000.
| Sales (units) | 2,000 | 4,000 | 6,000 | 8,000 | 10,000 |
| | ------- | ------ | ------- | ------- | -------- |
| | £ | £ | 3 | £ | £ |
| Sales revenue | 20,000 | 40,000 | 60,000 | 80,000 | 100,000 |
| Variable costs | 10,000 | 20,000 | 30,000 | 40,000 | 50,000 |
| | -------- | -------- | -------- | -------- | -------- |
| Contribution | 10,000 | 20,000 | 30,000 | 40,000 | 50,000 |
| Fixed costs | 20,000 | 20,000 | 20,000 | 20,000 | 20,000 |
| | -------- | -------- | -------- | -------- | -------- |
| Net profit (loss) | (10,000) | --- | 10,000 | 20,000 | 30,000 |
| | -------- | -------- | ------- | ------- | -------- |
At sales of 4000 units the company is at break-even point ie. contribution is equal to the fixed costs.
No comments:
Post a Comment