You are on page 1of 27

DR.

AVIJIT ROYCHOUDHURY
INSPECTOR OF COLLEGES
VIDYASAGAR UNIVERSITY
Marginal costing is an extremely valuable technique in the
hands of the management. The cost-volume-profit
relationship has proved to be a key to plethora of solutions to
many situations faced by the management.

Product pricing is a very significant purpose of the


management. One of the commitments of cost accounting is
the ascertainment of cost in advance for fixation of selling
price. Marginal cost of a particular product represents the
least price for that merchandise and any sale below the
marginal cost would involve in a loss.

Although prices are more controlled by market conditions


and other economic issues than by decisions of management,
yet fixation of selling prices is one of the most important task
of management.
This function is to be performed:

 In normal circumstances.

 In some special circumstances.

 In times of trade depression.

 In accepting additional orders to supplement idle


capacity.

 While exporting and exploring new markets.


In normal circumstances

the selling price must be fixed to cover total expenses to


earn profit. It can also be fixed on the basis of adding a
margin to marginal cost which may be enough to
contribute towards the combination of fixed expenses and
profits.

But in some impending circumstances

like competition, trade depression, additional orders for to


make use of extra capacity, exploring new markets,
liquidation of excess stock etc., products may have to be
sold at a price below total cost.
Thus, in special circumstances,

price may be below the total cost but it is prudent to be


equal to marginal cost plus a certain amount. Moreover,
this should be only a short term measure taken with the
expectation that better times will prevail when prices will
be increased. Pricing decisions are thus affected both by
long term and short term objectives.
Illustration 1.

(Computation of Selling Price simultaneously under


monopoly and competitive conditions):

In a purely competitive market situation 7,500 units of a


product can be produced and sold and a certain amount of
profit is generated. It is projected that 1,750 units of that
product need to be produced and sold in a monopoly market
to achieve the same amount of profit.

Profit under both the market conditions is targeted at


₹1,50,000. The variable cost per unit is ₹80 and the total fixed
cost is ₹50,000. The selling prices under both monopoly and
competitive conditions are required to be determined.
Let the Selling Price per unit = x

In a monopoly market :

Total Sales = 1500x


Variable Cost = 1,500 x 100 = 1,50,000
Fixed Cost = 50,000
Total Cost = 2,00,000
Desired Profit = 1,50,000
In Competitive conditions :

Total Sales = 7,000x


Variable Cost = 7,000 x 100 = 7,00,000
Fixed Cost = 50,000
Total Cost = 7,50,000
Profit = 1,50,000

₹7,50,000 + ₹1,50,000
𝑆𝑒𝑙𝑙𝑖𝑛𝑔 𝑃𝑟𝑖𝑐𝑒 = = ₹120
7,500 𝑢𝑛𝑖𝑡𝑠

Hence monopoly price is ₹200 per unit

And in competition, price is ₹120 per unit


Pricing in the event of a Depression:

In the event of a depression the prices fall and the product


may have to be sold below the total cost. If the situation is
temporary necessitating drastic reduction in prices, the
minimum selling price should be made at least equal to the
marginal cost to avoid loss. In this case the production of the
product should be continued, because Fixed expenses will be
incurred even if the production is withdrawn, which can be
minimized if the product can be sold at a price which is a
little more than marginal cost.
Illustration

Let, marginal cost per unit of a product is ₹8 and fixed cost


be ₹1,05,000. Sales price per unit is ₹10 and 30,000 units are
the selling units.

Marginal Cost : 30,000 units @ ₹8 2,40,000


Fixed Expenses 1,05,000
Total Cost 3,45,000

₹3,45,000
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 = = ₹11.50
30,000
Even though the selling price of ₹10 is below the total cost, it
is above the marginal cost of ₹8, hence it is beneficial to sell
the product at the selling price of ₹10, to reduce the loss on
account of fixed expenses (if the product is discontinued) by
₹40,000 as shown below:

 Loss if the product is discontinued (Fixed Expenses)₹


1,00,000

 Reduced Loss if the product is continued ₹40,000


Selling Price below the Marginal Cost:

If the selling price is below the marginal cost, it will be


imprudent to continue production as even the variable cost
will not be recovered fully and the loss incurred will be more
than the fixed costs. Hence, efforts should be made to sell the
product at a price which is equal to or more than the marginal
cost.

But, on the other hand, in the following situations,


production may be continued even if the marginal cost is
higher than the selling price:
a. Introduction of a new product in the market:
Initially, the new product is made to sell at a low price to gain
prominence and with the hope that gradually, with the elapse
of time, sales will gain momentum, thereby reducing the cost
of production. Eventually cost of production will be at par
with the selling price and the organisation will start making
profit.

b. When foreign market is to be explored to earn foreign


exchange:
Government sometimes permits import quotas against
foreign exchange made and profits from import quotas may
be much more than the loss on exporting the product at a
price beneath the marginal cost.
c. When the organisation has already piled up large
quantities of Raw Materials:
It is better to convert the material into finished goods and sell
these at a price below the marginal cost if the loss on sale of
such raw materials surpasses the loss incurred in the event of
such conversion.
d. Shut down of Business:
When business needs to be shut down with an eye to re-
establish it incurring considerable expenditure on
advertisement and sales endorsement. In that event, it is wise
to continue the production and sell the product at a price
below the marginal cost.
e. When the sales of one product at a price below the
Marginal Cost will boost the sales of other profitable
products:
The loss in one product will be compensated by profits in
other products.
f. When employees cannot be retrenched:
In such a case, it is prudent to continue with the
production even it has to be sold below the marginal cost.
g. When it is necessary to maintain the market share of
the product and weed out weak competitors.
h. When facing severe competition from a new entrant
into the firm’s line of business.
i. When the goods are of perishable nature:
It is better to sell off the perishable goods at a price below
the marginal cost to avoid total loss from perishing.
Accommodating supplementary contracts, venturing
additional markets and exporting:
While accommodating supplementary contracts or additional
markets are ventured, beneath the normal price, employing
the idle capacity, utmost care should be taken to ensure
retention of existing market share, bond of the concern with
the other customers purchasing the goods at normal price
and goodwill of the company.
In case of foreign markets, goods may be sold at a price below
normal price utilising the direct and indirect benefits
available for exporting e.g. import quotas, subsidies offered by
the Government, reputation of exporting etc.
Factors to be considered while accepting export orders:
The decision making envisages consideration of two factors,
i.e., (i) Cost Factors and (ii) Non-Cost Factors.
(i) Cost Factors:
The bone of contention while deciding about export orders is
that the export price should be greater than the variable cost
of the product. If that be the case, the export sales will make a
contribution as there will be no involvement of fixed cost and
consequently, the contribution is equal to profit.
If there be involvement of additional fixed cost for production
of export goods, then such fixed cost should also be reckoned
with to make the export order profitable.
(ii) Non-Cost Factors:
These are qualitative factors e.g.;
(a) Status of the export house; (b) Inflow of foreign
exchange; (c) Goodwill enrichment of the company; (d)
Creating employment opportunities.
Illustration 2: (Acceptance or rejection of a foreign order)
Consider a Cost Sheet of a product as under:
Direct Materials 4.50
Direct Labour 2.50
Factory Overheads :
Fixed 0.30
Variable 0.30 0.60
Administrative Expenses 0.50
Selling & Distribution Overheads :
Fixed 0.20
Variable 0.45 0.65
8.75
The selling price per unit is ₹11.
The above figures are for an output of 45,000 units, whereas the
capacity for the firm is 60,000 units. In the event of an export
order of 15,000 units at a price of ₹9 per unit, let us see whether
the order should be accepted.
What may be the decision if the same order were from a local
merchant?
Solution:
MARGINAL COST FOR ADDITIONAL 15,000 UNITS
Per unit For 15,000 units
₹ ₹
Direct Materials 4.50 67,500
Direct Labour 2.50 37,500
7.00 1,05,000
Variable Overheads :
Factory 0.30 4,500
Selling & Distribution 0.45 6,750
Marginal Cost 7.75 1,16,250
Sales 9.00 1,35,000
Contribution 1.25 18,750
The export order will deliver an additional contribution as well
as the profit to the tune of ₹18,750, as the fixed expenses have
already been covered from the internal market. Therefore, the
order should be accepted.
The order from the local merchant should be rejected at a price
of ₹9 because it is below the normal price of ₹11.
Illustration 3: (Acceptance or rejection of foreign offer)
The XYZ Co. produces and sells direct to the customers 11,000
packets of shaving razors of per month at ₹2 per razor. The
company’s normal production capacity is 21,000 razors per
month. An analysis of cost for 10,000 razors show:

Direct material 1,500
Direct Labour 2,500
Power 220
Misc. supplies 480
Razor wrappers 700
Fixed expenses 7,600
Total 13,000
The company has received an opportunity for export under a
altered brand name of 1,20,000 razors at 10,000 razors per
month at ₹1.50 a razor.
Let us see whether the offer may be accepted or rejected.
Solution:
Existing position Position after receipt of
export order
₹ ₹ ₹ ₹
Sales Price 22,000 (22,000+15,000) 37,000
Less : Variable Costs
Direct Material 1,500 3,000
Direct Wages 2,500 5,000
Power 220 440
Misc. Supplies 480 960
Razor wrappers 700 1,400
5,400 10,800
Contribution 16,600 26,200
Less : Fixed Costs 7,600 7,600
Profit (Loss) 9,000 18,600

From the above analysis it is clear that the offer for export
should be accepted as it delivers excess profit of ₹9,600.