Marginal Cost Analysis

1.2.1. Applications of Marginal Costing Techniques

(i) Profit Planning

Marginal costing techniques are also used in Profit planning. One of the critical functions of Management is to plan for profits.

Profit planning is a set of steps that are taken by organisations to achieve the desired level of profit. What factors play an important role in profit planning? They are Selling price and cost price. Selling price is controlled by external environment. However, costs can be to a large extent influenced by actions of the management. An increase in cost of a product decreases the profit and a reduction in the cost increases the profit.

Using marginal costing technique we get information about fixed costs, variable costs and contribution. Using

price – fixed cost) 24 20 16

Total Fixed cost = (10,000 x 6 ) + ( 5,000 x 6) + (8,000 x 4 ) = 60,000 + 30,000 + 32,000 = 1,22,000

Current Profit = Contribution – Fixed cost =[ (10,000 x 24) + ( 5,000 x 20 ) + ( 8,000 x 16 )] – 1,220,000 = (240,000 + 100,000 + 1,28,000) – 1,22,000 = 468,000 –

Acceptance of an Order

The management of a manufacturing company may receive a large order from a client. There may also be a situation where the Marketing department is positive in making a decision to enter into new market(s). It may also be possible that the organisation may have decided to exploit the potential of exporting products to market(s) overseas.

Marginal costing tools help to evaluate the overall effect on profitability under such decisions. However, before making a decision on accepting or rejecting an order, the management has to also consider other non-cost factors such as the opportunity to get a new client, entering new geographies or market territory, earning in foreign currency in case of an export order, goodwill enhancement of the company and creating employment opportunities.

Accepting or rejecting an overseas order is a crucial decision that the management has to make. The management of a company needs to consider two factors for this process. The first one is that the export price offered should be higher than the marginal cost. The second is to comply with the overseas norms of additional fixed costs that are incurred.

Let us take a look at a similar situation via an example.