The following points highlight the top five applications of marginal costing. The applications are: 1. Key or Limiting Factor Analysis 2. Make or Buy Decisions 3. Discontinuance and Diversification of Product 4. Accept or Reject New Order and Sub-Contracting 5. Temporary Cessation or Close-Down of Operations.
Application # 1. Key or Limiting Factor Analysis:
Marginal costing can also be used in budgeting, to help management to determine the profit- maximizing budget. Planning is necessary when one or more factors of production or other business resources are in short supply. Marginal costing really shows its merit when scarce resources are being considered.
Examples of resource restrictions which may apply are as follows:
(a) Limit to the availability of a particular grade of labour,
(b) Shortage of raw materials,
(c) Limit to machine capacity, and
(d) Shortage of cash to finance production (working capital).
If labour supply, materials availability, machine capacity or cash availability limit production to less than the volume which could be achieved, management is faced with the problem of deciding what to produce and what not to produce, because there are insufficient resources to make everything.
The limiting factor is often sales demand itself, in which case the business should produce enough goods or services to meet the demand in full, provided that sales of the goods earn a positive contribution towards fixed costs and profits.
However, when the limiting factor is a production resource, the business must decide which part of sales demand it should meet, and which part must be left unsatisfied. Marginal costing analysis can be used to indicate the profit- maximizing.
Analysis When Only One Limiting Factor:
If fixed costs are constant, regardless of the level of output and sales within a relevant range of output, marginal costing principles should lead us to the conclusion that profits will be maximized if total contribution is maximized. If there is a shortage of one particular production resource, it is inevitable that all the available supply of that resource will be used up.
For example, if a business has a chronic shortage of skilled manpower, it will plan to use all the skilled manpower that it does have available. Total contribution will be maximized if the maximum possible contribution is obtained per unit of that scarce resource. In other words, a business should get the best possible value out of the scarce resources that it uses up.
Analysis When More Than One Limiting Factor:
Where only one key factor is experienced, a simple marginal costing statement can show the level of activity which would optimize contribution. Where two or more such key factors exists, linear programming technique is more suitable.
Key Factor Control:
Some of the actions which may be taken by management to reduce the effect or eliminate key factors which you may have thought of, are listed below:
Labour supply can be increased by:
(a) Retraining existing personnel,
(b) Overtime working,
(c) Shift working,
(d) Incentive schemes,
(f) Acquiring labour-saving machinery and equipment,
(g) Reducing the idle/non-productive time,
(h) Providing special facilities for working mothers with young children,
(i) Offering better terms and conditions, e.g., better rates of pay, and
(j) Recruiting from overseas labour markets, etc.
Production capacity may be extended by:
(a) Improving plant layout,
(b) Better production scheduling,
(c) Using better quality materials which take less time to manufacture, and
(d) Better product design, e.g., variety reduction etc.
To increase warehouse capacity, management could:
(a) Use subcontractors who store the raw materials which are to be used in the production process on their own premises,
(b) Improve the stores/warehouse layout,
(c) Purchase storage racks which make better use of the space,
(d) Acquire more warehouse space,
(e) Improve inventory control to keep stock levels to an acceptable minimum,
(f) Introduce production systems such as JIT (Just in Time),
(g) Improve material requirements planning (MRP),
(h) Introduce the use of sub-stores in the factory production departments for various items,
(i) Identify and dispose obsolete/surplus stocks and surplus fixed assets, to free space, and
(j) Improve distribution, e.g., cut-down the time that finished goods are held before being delivered to customers etc.
More finance is usually available, but at a price. Some of the ways of increasing the finance or reducing the need for finance are:
(a) The use of subcontractors. They provide the labour force, the materials and the fixed assets in terms of production machinery and plant,
(b) Introducing JIT and improving MRP and inventory control, which could result in less finance being tied up in stock of raw materials, work-in-progress and finished goods,
(c) Identifying and disposing of surplus assets, e.g., stocks and fixed assets such as redundant machinery and equipment,
(d) Making use of alternative methods of financing assets, e.g., hire purchase, leasing and renting,
(e) Acquire more finance via issue of shares, debentures or long-term loans,
(f) Sale and/or lease of building or property,
(g) Achieving a better utilization of labour and machinery, and
(h) Seeking out and applying for Government grants and subsidies.
The above actions illustrate the need for business functions/managers to work together, e.g., marketing, production and finance.
i. Profit Planning:
The behavioural study of costs in marginal costing technique helps the management in profit planning exercise. Constant development in science and technology makes the long-run situation more uncertain and highly unpredictable. Long-run consists of a series of short-runs and one must aim at maximizing contribution in each short-run which will lead to profit maximization in the long-run.
Profit figure is planned and activity level is determined to achieve that planned profit. It helps in doing sensitivity analysis by observing different cost and revenue situations and its resultant impact on profit and guides in the determination of activity level to achieve target profit.
ii. Optimizing Product Mix:
In case of multi products and multi lines of activity, the problem arises as to which product or sale mix will yield maximum profit. Such problems can be solved by marginal costing technique. It helps in discontinuance of non-profitable products and lines of activity which will not even cover its variable costs.
When an alternative method of manufacturing a product or alternative is available, the marginal contribution analysis should be made to arrive at the decision. The alternative yielding the highest contribution will be selected.
iii. Contribution Analysis:
The analysis of the contribution per unit each product makes towards fixed or current period costs and profit leads to the preparation of statements showing the total contribution each product class has made towards the recovery of period costs.
These statements may be further refined by deducting any discretionary or separable period costs (i.e., costs such as annual tooling and product advertising) which should be avoided if the product line were dropped.
Application # 2. Make or Buy Decisions:
Make or buy decisions are best taken with full knowledge of the marginal or variable cost of making rather than buying a product. But it is also helpful to know through marginal costing what contribution to fixed costs will result from a ‘make’ decision.
Sometimes, in manufacturing companies, a problem may arise as to whether the component, sub-assembly or product is to be manufactured within the organization or to purchase from the market.
This decision will be taken with the help of marginal costing technique under the following situations:
a. When the company is working at full capacity:
The contribution per unit earned by different components, assemblies or products will be arrived and the contribution thus earned will be lost by not manufacturing the component. This contribution lost will be considered whether to manufacture a component or buy it from outside.
b. When the company is not working at its full capacity:
The lost contribution approach is irrelevant and should manufacture if it earns contribution over variable costs incurred on it. If variable costs in production are more than the purchase price from outside market, then only the company will prefer to procure from outside suppliers.
Considerations in Make or Buy Decisions:
Make or buy decision is simply the choice between making a part or article within the company or purchasing it from outside.
The following considerations apply when taking a make or buy decision:
(a) The capability of the company to make the item in terms of the capacity (people, plant and space) available and the ability to achieve required quality standards.
(b) The availability of outside suppliers who can deliver the item in the quantities, quality and time required.
(c) The differential cost of making or buying the item.
This means that consideration has to be given to these conditions:
(i) If items which are currently purchased are manufactured, what additional or incremental costs will be incurred and how do these compare with the costs being saved?
(ii) If items are purchased which could be manufactured, what costs will be avoided and how do these compare with the costs which will be incurred?
(d) The opportunity cost of using existing capacity to manufacture alternative items which would make a greater contribution to profit and fixed costs than the item under consideration. A make or buy decision is often essentially about how best to utilize existing facilities.
(e) The impact of a decision to make the item on aggregate volumes, an increase in which should contribute to overhead recovery and facilitate the balancing of demand and operations capacity over time.
(f) The level of variable overheads which are charged to the part or article.
Application # 3. Discontinuance and Diversification of Product:
The marginal costing technique is used in taking decisions regarding discontinuance of a product. If any product’s performance is not impressive, then such product should be discontinued only if there is no contribution margin from that product. In other words, any contribution from that product will reduce the burden of total fixed costs of the firm and this will help in better profits than if such product is discontinued.
When a firm intends to introduce a new product into the market, the major consideration in taking such decision is to see whether that particular product is able to recover at least its variable cost and any contribution in excess of variable cost from such new product will improve the overall profitability of the firm. Here, the important point to remember is that all the present fixed costs of the firm are being borne by the existing products.
Application # 4. Accept or Reject New Order and Sub-Contracting:
In times of taking decisions to accept or reject new order or in subcontracting, the contribution analysis is made as to whether it is profitable to accept or reject new order or in subcontracting. The following problems demonstrate the use of the contribution technique.
Application # 5. Temporary Cessation or Close-Down of Operations:
A factory or plant may have to cease its operations temporarily for sometime due to various reasons like labour troubles, material shortage, financial difficulties, major breakdown, lack of orders etc. Shutdown costs are to be incurred in relation to the temporary closing of a department/division/enterprise.
Such costs include those of closing as well as reopening. Shutdown costs may be subdivided into three parts:
(a) Costs incurred on suspension of operations e.g., cost of notifying to customers about shutdown, cost of construction of shelters, sheds for protection of plant and machinery, cost of storage of material, retrenchment compensation and lay off costs payable to employees etc.
(b) Costs incurred during continued shutdown e.g., cost of care and custody of plant and machinery, security measures for protection of assets, maintenance costs etc.
(c) Costs incurred in resuming operations after reopening e.g., cost of recruiting and training new workers, reestablishment of marketing contracts, time lag in picking up production etc.
The marginal costing technique will help the management in taking decision to continue operations or shutdown plant temporarily for some time.
If the existing operations are able to earn at least some contribution to meet fixed costs even otherwise to be incurred during the period of shutdown, then the suggested course of action is to continue operations even if there are losses from operations but it enables to recover at least it’s part of fixed costs. In situation where even variable costs are not covered then the operations may be suspended temporarily until the improvement in business situation.