Lecture 2-APPLICATION OF MARGINAL COSTING

Marginal costing technique is frequently used for short-term decision-making. The contribution
margin helps to forecast income, since fixed cost remains unchanged. It has to be remembered that
the fixed cost remains unchanged over a relevant period, not a long period, and within the relevant
range, perhaps not if production doubles the capacity. Within this parameter, variable costs, which
vary in direct proportion to the changes in the activity level are the only relevant costs for short-term
decision-making.
In such decisions, fixed costs do not count. The basic consideration in all decision-making is that
marginal contribution is a reliable index of profitability. When alternative courses of action are
available, the most suitable course will be one which gives highest contribution, provided there are
no limiting factors. Fixed costs will not be taken into consideration except where these are liable to
change as a result of the proposed action. For example for an additional product, if a machine has to
be purchased or a conveyor belt has to be extended, the fixed cost will increase marginally.
Marginal costing technique helps short-term decision-making in the following areas —
 Profit planning
 Key of limiting factor analysis
 Optimizing product mix
 Contribution analysis
 Make or buy decisions
 Price fixation.
 Diversification of product line.
 accept or reject special offers and subcontracting
 Break even analysis
 Cost volume profit analysis . 
Out of the above, let us consider a few problems.

Profit planning -.
The behavior study of cost in marginal costing techniques helps the management in profit planning
exercise. Constant in Science and Technology makes the long-run situation more uncertain and
unpredictable. Long or short run and maximizing contribution in which will lead to profit
maximization in the long run. Profit figure is plant and active level is determined to achieve that
planned profit. Medals in doing sensitive analysis by observing different cost and revenue situation
and its result impact on Profit and guide in the determination of active level to achieve target profit.
An analysis of contribution made by each product provides a basis for profit-planning in an
organization with wide range of products having varying output and contribution. In effect,
contribution per unit becomes the profitability index for each product

Width of a business concern can be improved in the following ways

 By increasing volume
 By increasing selling price
 By decreasing variable cost ,and
 By decreasing fixed cost.

By a careful selection of product-mix, the profit can be planned as indicated in the given
Example:

PRODUCT-WISE PROFIT STATEMENT

Cost elements Product X Product Y Product Z Total Rs

Rs Rs Rs
Sales units - Pcs. 500 300 200 1000
Sales value - (A) 6000 4500 4000 14500
Less : Direct cost
of sales :
Material 2000 2400 2000 6400
Labour 1000 600 400 2000
Expenses 500 300 200 1000
Total (B) 3500 3300 2600 9400
Contribution (A 2500 1200 1400 5100
– B)
Less: Fixed cost 3000
Profit 2100

Total contribution as indicated above can be reduced to unit-ratio, showing unit selling price ,unit
cost of each elements, viz. material, labour and expenses and unit contribution by each product.

In-depth analysis of each of them will reveal scope for improvement of contribution, such as,
reduction of material cost by usage, price, substitution, scrap reduction, etc., reduction of labour cost
by improving efficiency and increasing productivity, control over expenses revision of selling price
or increasing the volume by better marketing strategies, etc. As result of the above, the following
changes may occur in respect of the same products.

Statement showing changes in respect of products

Product X Product Y Product Z

Rs Rs Rs
Original Revised Original Revised Original Revised
Sales units - 12 12.50 15 15 20 18
Pcs.
Less : Direct
cost of sales :
Material 4 3.75 8 7.25 10 8.50
Labour 2 1.75 2 1.75 2 1
Expenses 1 1 1 1 1 0.75
Total (B) 7 6.5 11 10 13 11
Contributio 5 6 4 5 7 7
n (A – B)
Less: Fixed 500 500 300 320 200 300
cost
Profit 2500 3000 1200 1600 1400 2100

Original Revised
Total contribution 5100 6700
Less fixed cost 3000 3500
Profit 2000 3200

It will be observed that in Product A, selling price has been corrected upwards while material and
labour costs are marginally reduced. In Product B, there was no scope for selling price increase, but
by substitution of some imported material by indigenous one, some cost reduction was effected. In
Product C, a price-correction has been taken as the product was overpriced. However, a simultaneous
reduction in material cost, labour productivity and avoidance of some expense neutralized the effect
of price-reduction. Total contribution, however, increased as sales volume goes up by 50%. There
has been a marginal increase of Rs. 500 towards fixed cost.

Example 2: A company manufactures four products the cost data per unit as below:

Particular A B C D
Selling Price 90 71 100 86
 Direct 30 20 40 40
Materials
Direct Labour 24 18 30 12
Vaiable over 12 9 15 6
head

The fixed cost estimate at Rs 200000 per month. The company employs 250 direct workers who
worked 8 hours a day for 25 days. The direct wages rate is rupees 6 per hour, it is not possible for the
company to increase its operative in the short run . in the practicable to work overtime. The
companies’ policy do not allowed subcontracting of worker. The marketing director as focus the
following demand for a month:
Product Units
A 5500
B 5000
C 6250
D 8250

The management desire you to revise the product mix in the following matter
a) To yields the maximum profit for the month
b) In production to the quantity forecast by the marketing director
c) In proportion to the labour requirements calculate the forecasts of the sales of the marketing
director .
Present statements showing the sales, cost and profits in respect of each of the aforesaid of the
product mix

Solution :
Particular A B C D
Direct labour 24 18 30 12
cost per unit
Direct labour 6 6 6 6
Hour rate
Direct labour 4 3 5 2
hour per unit

Computation of contribution per direct hour

Particular A B C D
Selling Price 90 71 100 86
(A)
Direct Materials 30 20 40 40
Direct Labour 24 18 30 12
Variable over 12 9 15 6
head
Total cost (B) 66 47 85 58
Contribution(A- 24 24 15 28
B)
Contribution per 6 8 3 14
direct labour
Hour
Ranking 3 2 4 1
Total labour hour =250*25*8=50000hours
A.Statement of product mix of maximum profit
Product Maximum Hour per Production Hour Balance hour
unit unit quality
D 8250 2 8250 16500 33500
B 5000 3 5000 15000 18500
A 5500 4 4625 18500 --

Statement of profitability
Production A B D Total
(units) 4625 5000 8250
Sales 416250 355000 709500 1480750
Less variable 305250 235000 478500 1018750
cost
Contribution 111000 120000 231000 462000
Fixed 200000
overhead
Profit 262000

B Product Mix in Proportion to quantity forecast:

Product Quantity % of total Direct Direct Unit to be

labour hour labour produced
hour per
unit
A 5500 22 11000 4 2750
B 5000 20 10000 3 3333
C 6250 25 12500 5 2500
D 8250 33 16500 2 8250
Total 25000 100 50000

Production A B C D Total
(units) 2750 3333 2500 8250
Sales 247500 236643 250000 709500 1443643
Less variable 181500 156651 212500 478500 1029151
cost
Contribution 66000 7992 37500 231000 414492
Fixed 200000
overhead
Profit 214492

C. Product Mix in proportion to the labour hour of sales forcast

Product Quantity Direct Total per %Direct DLR Product
labour unit labour avalability quantity
hour hour
A 5500 4 22000 22.96 12980 3245
B 5000 3 15000 17.70 8850 2950
C 6250 5 13250 31.87 18435 3687
D 8250 2 16500 19.47 9735 4867
Total 84750 100 50000

Statement of Profitability
Production A B C D Total
(units) 3245 2950 3687 4867
Sales 292050 209450 368700 418562 1288762
Less variable 214170 138650 313395 282286 948501
cost
Contribution 77880 70800 55305 136276 340261
Fixed 200000
overhead
Profit 140261

2.A toy manufacturer makes an average net profit of 2.50 per piece on a selling price of
14.30 by producing and selling 60,000 pieces or 60% of the potential capacity. His cost of
sales is:
Direct material 3.50
 Direct wages 1.25
Works overhead 6.25 (50% fixed)
Sales overhead 0.80 (25% variable)
During the current year, he anticipates that his fixed charges will go up by 10%, while rates
of direct material and direct labour will increase by 6% and 8% respectively. But he has no
option of increasing the selling price. Under this situation he obtains an offer for an order
equal to 20% of his capacity. The concerned customer is a special customer.

What minimum price will you recommend for acceptance to ensure the manufacturer an overall
profit of 1,67,300?
Solution

Particulars Cost at Present in Anticipated cost in

Current Year in
No of Units 60,000
Sales value 8,58,000 8,58,000
Variable Cost:
Direct Material 3.50 3.71 (3.50  106%)
Direct Labour 1.25 1.35 (1.25  108%)
Variable Cost
Work overhead 3.125 (6.50  50%) 3.125
Sales Overhead 0.600 (0.80  25%) 0.600
Total Variable Cost per unit 8.075 8.385
Fixed Cost
Work overhead 60,000 (6.250 – 3.125) 2, 06,250 (1, 87,500 
= 1,87,500 110%)
Sales Overhead 60,000 (0.80  75%) 39,600 (36,000  110%)
= 36,000
Total Fixed Cost 2,23,500 2,45,850
Present selling Price 14.30 14.30
Contribution per unit 14.30-8.075 14.30 – 8.385
Contribution in ` 3,73,500 3,54,900
Profit ( Contribution-Fixed Cost) 1,50,000 1,09,050
Profit desired in current year 1,67,300
Increase in profit 58,250
Sales in No of units by = `60,000/60%  80%
increasing the Sales level by
20%
= `20,000
Additional Variable Cost of = `20,000  8.385
20,000 units
= `1, 67,700
Minimum sales price for 20,000 = ` (1, 67,700 +
additional units 58,250)/20,000
= `11.297
3. The following data relate to a manufacturing company:
Plant capacity: 4,00,000 units

per annum Present utilization: 40%

Actuals for the year were:
Selling price 50 per unit
Materials cost 20 per unit
Variable manufacturing costs 15 per unit
Fixed costs 27 lakhs
In order to improve capacity utilization the following proposals are being
considered:
Reduce selling price by 10%.
Spend additionally 3 lakhs on sales promotion.
How many units should be made and sold in order to earn a profit of`5 lakhs per year?
Solution:

Revised selling price (`50 less 10%) 45 per unit

Variable cost:
Material cost 20
Variable manufacturing cost (per unit) 15
Total variable cost 35 per unit
Contribution 10 per unit
Total contribution required:
Fixed costs 27,00,000
Additional promotion expenses 3,00,000
Profit 5,00,000
Total 35,00,000
Total number of units to be made and sold to earn a contribution of 35,00,000

Total Contribution = 3500000/10 =3,50,000units

= Contribution per unit