In this article we will discuss about the marginal cost analysis.
Marginal cost analysis requires analysis of cost into fixed and variable elements.
Suppose that selling price per unit of a product is Rs.100 and variable cost per unit is Rs.60. Contribution per unit is Rs.40. You may say contribution as gross margin.
Profit Volume ratio (P/V ratio):
P/V ratio of two products are given above. Which of the two products would you prefer?
Comparing two products by P/V ratio:
You can’t compare two products simply by P/V ratio, as it simply indicates degree of profitability. Product B has higher profitability. But what is about fixed cost? Higher profitability may not come without a price.
Fixed cost of Product A is Rs.4, 00,000 but fixed cost of Product B is Rs.6, 00,000.
Break Even Point – Understand what is Break Even Point.
How many units should be produced to cover fixed cost?
What is breakeven point?
At this level of production and sales, cost is equal to revenue. It is a no profit no loss situation.
Let us now study what should be the profit/loss of two products at different level of production and sales. Production range is 7000 – 16000 units within which fixed cost of the two products would remain the same.
See below breakeven chart of Product A.
Breakeven point is the point wherein total cost line intersects total revenue line.
See below breakeven chart of Product B.
Now which of the two products would you select?
Be sure about the demand for the product. Product B can be selected only if demand is high. What is the level of demand at which both the product are equally attractive?
PA * D – FCA – VCA *D = PB – FCB – VCB*D
PA = Price per unit of Product A, PB= Price per unit of Product B, FCA = Fixed cost of Product A, FCB = Fixed cost of Product B, VCA = Variable cost of Product A, VCB = Variable cost of Product B, D = Demand.
D [PA – VCA] – D [PB – VCB] = FCA – FCB
D [CA – CB] = FCA – FCB CA = contribution of product A and CB = contribution of product B.
See Comparative Profit Graph of Product A and Product B
In case demand is above 25000 units, then only Product 2 should be produced.