The industries which use marginal costing as a managerial tool for decision making are in a position to establish a relationship between cost, volume of output and profits.
For any organization, the calculation of Profit and Loss involves incomes on one side and expenditure on the other. While taking management decisions, these expenses can be classified into 2 broad heads:
1. Variable Cost (VC)
2. Fixed Costs (FC)
1. Variable Cost (VC)
2. Fixed Costs (FC)
There are some expenses which are partly variable and partly fixed. These expenses ultimately are segregated into variable component and fixed component. This can be expressed as follows:
The VC can also be called as Marginal Cost (MC). Marginal Costing can be used by corporate for various decisions making. The effort of any management is to optimize profits or minimize losses. In their effort to do so, they have to review the existing production, pricing and marketing policies from time to time and make necessary adjustments, if needed. Some of the following decisions can be initiated by using the MC concept:
1. Determining the relative profitability of products.
A company engaged in production of multiple products is interested in the study of the relative profitability of its products so that it may suitably change its production and sales policies in case of those products which it considers less profitable or unproductive. While taking this decision the concept of profit volume ratio can be applied.
Profit Volume ratio (P/V ratio) = Contribution / Sales * 100
It is always profitable to encourage the production of that product which shows higher profit volume ratio.
2. Determining profitability of alternative product -mix.
Since the objective of an enterprise is to maximize profits, the management would prefer that product mix which is an ideal one in the sense which yields maximum profits. In this case maximizing Contribution is maximizing profit.
3. Make in-house or outsource.
If the similar product is available outside then the firm can compare its marginal cost and take a decision to produce or buy it from outside. In other words, the firm should prefer to buy if the marginal cost is more than the bought out price and make in-house when the marginal cost is lesser than the bought out price.
4. Pricing decisions for domestic /international markets.
A foreign market can be kept separate from a domestic market as such different pricing strategy can be adopted for export pricing. Any company which enjoys surplus production capacity can increase its production to sell in the foreign market at a lower price if its total FC is already recovered from the production of domestic market.
5. Profit Planning.
The process of Profit Planning involves the calculation of expected costs and revenues arising out of operations at different levels of plant capacity for the production of different types of goods during a given period of time. The Cost and Revenues at different level of outputs are different and a firm has to choose one level at which its profits are maximum. It also guides the management in selecting the best product mix for attaining a specified level of profit.
The industries which use marginal costing as a managerial tool for decision making are in a position to establish a relationship between cost, volume of output and profits. Once a certain relationship is established, it is continued under the given conditions of production and sales. Sales and MC of Sales have a fixed relation as they vary in the same proportion.
For e.g.
If MC is Rs. 75/- and Sales value is Rs. 100/- then for a sale of Rs. 120/- (20% increase in Sales) the MC will be Rs. 90 (Rs. 75 + 20% of Rs. 75). The proportion between Rs. 100 and Rs. 75 and Rs. 120 and Rs. 90 is the same.
Cost Volume Profit relations may be used to determine the level of output at which a firm will Break Even i.e. it will neither make profit nor incur loss. Generally, the new firms are interested to know the minimum output / sales which will enable to just cover the total cost of that output fully. Any output in excess of the minimum output (break even output) contributes towards profits of the firms.