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PRICING DECISIONS

Fixing of selling prices the most important function of management. Marginal costing technique will determine prices under various circumstances : Pricing under normal conditions- prices are based upon TC of sales to cover both FC n VC. Pricing under stiff competion prices below TC but above MC. Pricing under special orders, bulk orders, additional orders, exports -

Example
Q-- MC-5/unit, FC-100000 , SP-6/unit and units sold are 50000.
Marginal cost of 50000 units @rs 5/unit Fixed expenses Total cost 250000 100000 350000

Cost per unit = 350000/50000 =7/unit Now our SP-6/unit which is below TC of rs7/unit but more than MC of 5/unit.
Sales value of 50,000 units @rs 6/unit Less : TC loss Loss due to FC, If product is discontinued Loss reduced if product is continued 3,00,000 3,50,000 50,000 100000 50000

CONTI
We will accept this price because SP of 6/unit is still covering MC of 5/unit. MC @5/unit = 250000 and sale value @6/unit= 300000. But if SP = 5/unit then sale value = 250000 which equals MC then below this point we will not the price.

PRICING UNDER SPECIAL ORDERS


Special orders often comes with a price lower than the market price. So a decision is made on whether to accept this order or not. P> MC , can be accepted. Order from local customers should not be accepted as it can affect relations with other customers. But exports can be done.

Under special orders


Q-A juice manufacturer produces 12,000 bottles of juice @rs 1.32/bottle. Normal production capacity is 24,000bottles per month. Analysis of cost of 12000 bottles is given:
Direct material Direct labor Power Bottles Misc supplies Fixed exp Total 1500 2475 130 550 390 11000 16045

Company received offer for export of 1,20,000 bottles of juice at 12,000 bottles per month @83paisa a jar.

Marginal cost statement


Per unit Present capacity 50% Proposed another 50%capacity @83paisa/unit 12000 Total capacity 100%

Sales

12000

24000

Less: marginal cost : direct mate. Direct labor Power Misc. supplies Bottles

0.125 .20625 .010833 0.0325 .0458

1500 2475 130 390 550

1500 2475 130 390 550

3000 4950 260 780 1100

Contribution FC PROFIT/LOSS

.899617

10795 11000 (205)

4915 4915

15710 11000 4710

At present level we are having a loss of 205 even though the VC is .420383 against the price of 1.32/unit. This is because the price of 1.32 is not covering FC of 1.337. But if additional offer for 12,000 is sold then we get an profit of 4710 even though the price is 83paisa. All this is because of the fact that additional sales gave a contribution of of 4915. Therefore the offer should be accepted as no additonal FC is involved.

Profit planning and maintaining it


Marginal costing can be applied for profit planning as well. Changes in sales price, variable costs and product mix affect profitability of a firm and therefore marginal costs help in determining such changes on profit. DESIRED SALES = fixed cost+profit profit-volume ratio Q Materials - 65 labour - 30 Variable overheads - 20 115 fixed overheads - 55 profit - 60 selling price - 230 Total manufacturer of 1,00,000 scooters. Due to competition firm has to reduce prices. How many scooters will have to be made to get same amount of profit if: 1. The selling price is reduced by 15%. 2. The selling price is reduced by 25%.

Solution : Fixed expenses = 55/fridge Present profit = 60/fridge Total no of fridge= 100000 FC = 55*100000=55,00,000 TOTAL PROFIT = 60,00,000 If selling price is reduced by 15% New selling price = 230 15% = 230 34.5= 195.5 desired sales = 5500000+60,00,000 / (195.5 115) = 142857.1429 fridges if selling price reduced by 25% new SP = 230-25% = 230-57.5= 172.5 desired sales = 55,00,000+ 60,00,000/(172.5 115) = 200000 fridges

Opportunity cost concept


The opportunity cost is helpful to managers in evaluating the various alternatives available when multiple inputs can be employed for multiple uses. Examples The opportunity cost of using a machine to produce a particular product is the earnings foregone that would have been possible if machine produced another product . The opportunity cost of funds invested in a business is the interest that could have been earned by investing in a bank.

EXAMPLE
Estimated direct material requirements for ABC ltd is 1,00,000units.Unit cost for orders below 1,20,000units is rs10. When size of order equals 1,20,000 or more,a discount of 2% on above quotes price is received. Keeping in view two alternatives : But 1,20,000 at start of yr. But 10,000 per month . Calculate opportunity cost ,if concern has the facility of investing surplus funds in bonds @10% interest.

Solution :
Average investments in inventory 1. (1,20,000*9.80)/2= 5,88,000 2. (10,000*10)/2 = 50,000 surplus amt= 5,88,000-50,000 = 5,38,000 firm can invest 5,38,000 @10% and can earn 53,800 as interest. This amt of 53,800 is the opportunity foregone if (1)alternative is chosen.

Conti
The concept of opportunity cost is also used in capital expenditure decision using time value of money. Example : A manufacturer owns a plot of land and has three proposals as under : Sell plot now for net income of 1lakh. Rent out land at annual rent of 8000 for 25yrs and thereafter sell it for 150,000. Spend 10,00,000 in construction of building now and thereafter rent it for annual rent of 1,10,000 for 25yrs. Afterwards sell it for 3,00,000. rate of return 10%, see which is more profitable.

A 0(initial yrs) 1- 25yrs After 25yrs Net cash flow 1,00,000 --1,00,000

B Nil 2,00,000 1,50,000 3,50,000

C - 10,00,000 27,50,000 3,00,000 20,50,000

Net present value of cash flow@10%

1,00,000

86,416

26,163

Since 1st alternate has max present value then it most preferable .

Effect of change in sales price


The effect of change s in sales prices can be easily analyzed with the help of contribution technique. Following data are available from the record of a company:
Components sales Variable cost Fixed cost RS 60,000 30,000 15,000

You are required to :(a) Calculate the P/V Ratio, Break-Even Point and Margin of Safety at this level. (b) Calculate the effect of 10% increase in sale price. (c) Calculate the effect of 10% decrease in sale price.

Solution
(a) P/V Ratio P/V ratio = contribution / Sales x 100 contribution = Sales variable cost = (60,000 30,000)Rs =rs30,000 P/V ratio = 30,000/60,000 x100 = 50% Break- even point = Fixed cost/ (P/V ratio ) = 15,000 x 100 /50 = 30,000 Margin of safety = present sales sale ay B.E.P. =Rs. 60,000 30,000= Rs. 30,000 (b) Effect of 10% increase in sale price :Sale =Rs. 60,000 + 10% =Rs. 66,000 P/V ratio = (66,000 30,000)X100/66,000 = 54.55% B.E.P.= 15,000/54.55% = Rs. 27,500 Margin of safety =Rs. 66,000 27,500 =Rs. 38,500 (C) Effect of 10% decrease in sale price :- sales = Rs. 60,000 10%= rs 54,000 similarly P/V ratio =44.44% B.E.P. = Rs. 33,750 Margin of safety =54,000 33,750 = Rs. 20,250

Alternative method for Production: The management has to Choose from among alternative methods of production. For complex situation management applied Marginal costing technique and the method which gives the highest contribution can be adopted keeping in view, of course, the limiting factor.
Q. Product A can be manufactured either by machine X or machine Y. Machine X can produced 50 unit of A per hour and machine Y ,100 unit per hour. Total machine hours available are 2000 hours per annum. Taking into account the following cost data, determine the profitable method of manufacture:

Machine X (Rs) Per unit A Direct material Direct wages Variable over head Fixed over head Selling price Less : Material Cost (Direct material +Direct wages + Fixed over head) Contribution per Unit Output per hour Contribution per hour Total machine hour (per annum) Total contribution 8 12 4 5 Total 29 30 24 6 50 Unit Rs 300 2,000 Rs 6,00,000

Machine Y (Rs) Per unit A 10 12 4 5 31 30 26 4 100 Unit Rs 400 2,000 Rs 8,00,000

Hence, production of Machine Y is more profitable

Marginal costing technique used for finding different level of activity and activity which gives the highest contribution will be the optimum level. The level of production can be raised till the marginal cost does not exceed the selling price.

Determination of optimum Level of Activity

Q.

A factory engaged in manufacturing in manufacturing plastic chair is working at 40% capacity and produces 10000 chair per annum. The present cost break-up for one chair is as under:
If Working capacity Material Labour cost Overhead 100 Rs. 30 Rs 50 Rs Selling price falls by

50% 90%

3% (5% Fall in material cost also) 5%

Selling price

200 Rs/unit

calculate the profit and BEP at both capacity level .

Solution :- output at 40% capacity =10,000 units


so output at 50% capacity =10,000x50/40 =12,500 and output for 90% capacity=10,000x90/40=22,500

50% capacity Per unit Rs. a).Sales b).Variable cost =


(Material +wages + variable overhead

90% capacity Total Rs. Per Unit Rs. 200-(5x200)/100 =190 (100-5)+30+20= 145 45 Total Rs. 4,275,000 3,262,500 1,012,500 3,00,000 7,12,500 BEP=3,00,000/45 =6,667 unit chair

200 (3x200)/100 12,500x194 = 194 = 2,425,000 100+30+20= 150 44 1,875,000 5,50,000 3,00,000 2,50,000 BEP= 3,00,000/44 =6,818 Unit chair

c).Contribution (a-b) d).fixed overheads (60%of 5)x10,000 Profit(c-d) Break even point = Fixed expenses contribution

9. Evaluation of Performance
Evaluation of performance efficiency of various departments, product lines or markets can also be made with the use of the technique of marginal costing. Sometimes, the management may have to decide to discontinue the production of non profitable products or departments so as to maximise the profits. In such cases, the contribution of different products, department or sales divisions can be compared and the one with lowest P/V ratio should be discontinued.

ILLUSTRATION
This illustration explains how the technique of marginal costing can be applied to evaluate the performance of different products or departments. The management of the company considers that product B, one of its three main lines, is not as profitable as the other two with the result that no particular efforts are being made to push its sales.the selling price and costs of these products are as follows:
Product Selling Price Rs. 100 80 90 Direct Material Rs. 20 12 16 Dept. X Rs. 8 4 4 Direct Labour Dept.Y Rs. 4 8 4 Dept.Z Rs. 4 4 8

A B C

Contd

Overhead rates for each department per rupee of direct labour are as follows:
Dept. X Rs.
Variable Overhead 2.50 Fixed Overhead 2.50 5

Dept. Y Rs.
1 4 5

Dept. Z Rs.
2 3 5

What advice would you give to the management about the profitibility of product B ? Give reasons.

Solution
Comparative Profitability Statement Product A Product B Product C Rs. Rs. Rs. Rs. Rs. Rs. Selling Price
Less: Marginal Cost Direct Material Direct Labour Variable Overhead Dept. X Dept. Y Dept. Z 20 16 10 2 4

100
12 16 5 4 4

80
16 16 5 2 8

90

52 48 48%

41 39 48.75%

47 43 47.77%

Contribution P/V Ratio

48/100x100

39/80x100

43/90x100

10. Capital Investment Decisions


The technique of marginal Costing Also helps the management in taking capital investment decisions. These decisions are very crucial for the management. There is an example to illustrate how marginal costing can be used while making such decisions.

Illustration
A person now spends Re. 0.90 per kilometer on taxi fares for his work. He is considering two other alternatives, the purchase of a new small car or an old bigger car.the estimated cost figures are:

Items
Purchase price

New small car Rs.


35,000 19,000 1,000 1,700 10 km.

Old bigger car Rs.


20,000 12,000 1,200 700 7 km.

Sale price after 5 yrs. Repairs and servicing(per annum) Taxes and insurance(per annum) Petrol consumption per ltr. Petrol price Rs. 3.50 per ltr.

Contd
He estimated that he does 10,000 km. annually. Which of the three alternative is cheaper? If his practice expands and he has to do 19,000 km per annum, what shuould be the decision? At how many km per annum will the costs of the two cases breakeven and why? Ignore income tax and interests.

Comparative Cost statement


New Small Car Rs. Purchase price Less : Sale Price (after 5 yrs.) Depriciation for 5 yrs. Depriciation for one year Repair and Servicing Taxes And Insurance Fixed cost per annum Variable cost per annum : (i) Petrol for 10,000 km. New small car @ RS. 3.50 for 10 km Old big car @ rs. 3.50 for 7 km. (ii) Petrol for 19,000 km. Total Cost (Fixed + Variable) for 10,000 km. for 19,000 km. 35,000 19,000 16,000 3,200 1,000 1,700 5,900 Old Bigger Car Rs. 20,000 12,000 8,000 1,600 1,200 700 3,500 Taxi Rs.

3,500 5,000 6,650 9,500

9,400 12,550

8,500 13,000

9,000 (10,000x0.90) 17,100 (19,000x0.90)

Conclusion. For present practice requiring 10,000 km, an old bigger car is the cheapest as the annual cost is Rs. 8,500 which is the lowest of the three alternatives. But if his practice expands to 19,000 km, a new small car will be the cheapest with an annual cost of Rs. 12,550. Calculation of Km at which the cost of two cars will break-even : Variable cost of new small car, for 10,000 km. =Rs. 3,500 Variable cost of new small car, per km = 3,500/10,000 Re. 0.35 Variable cost of old bigger car, for 10,000 km. =Rs. 5,000 Variable cost of bigger car, per km. =5,000/10,000 Re. 0.50

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