decision regarding alternative choices

7/28/2019 decision regarding alternative choices

1/29

PRICING DECISIONS

Fixing of selling prices the most important function ofmanagement.

Marginal costing technique will determine prices undervarious circumstances :

Pricing under normal conditions- prices arebased upon TC of sales to cover both FC n VC.

Pricing under stiff competion prices below TC butabove MC.

Pricing under special orders, bulk orders, additionalorders, exports -


2/29

Example

Q-- MC-5/unit, FC-100000 , SP-6/unit and unitssold are 50000.

Marginal cost of 50000 units @rs 5/unit 250000

Fixed expenses 100000

Total cost 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 3,00,000

Less : TC 3,50,000

loss 50,000

Loss due to FC, If product is discontinued 100000

Loss reduced if product is continued 50000


3/29

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 marketprice. 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.


4/29

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 1500

Direct labor 2475

Power 130

Bottles 550

Misc supplies 390

Fixed exp 11000

Total 16045

Company received offer for export of 1,20,000 bottles of juice at 12,000 bottles per

month @83paisa a jar.


5/29

Marginal cost statement

Per unit Present

capacity 50%

Proposed

another

50%capacity@83paisa/unit

Total capacity

100%

Sales 12000 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

.899617 10795

11000

4915 15710

11000

PROFIT/LOSS (205) 4915 4710


6/29

At present level we are having a loss of 205 eventhough the VC is .420383 against the price of1.32/unit. This is because the price of 1.32 is notcovering FC of 1.337.

But if additional offer for 12,000 is sold then we getan profit of 4710 even though the price is 83paisa.All this is because of the fact that additional salesgave a contribution of of 4915.

Therefore the offer should be accepted as noadditonal FC is involved.


7/29

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 thereforemarginal costs help in determining such changes on profit.DESIRED SALES = fixed cost+profit

profit-volume ratio

Q Materials - 65

labour - 30

Variable overheads - 20115

fixed overheads - 55

profit - 60

selling price - 230

Total manufacturer of 1,00,000 scooters. Due to competition firm has to reduceprices. 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%.


8/29

Solution :

Fixed expenses = 55/fridge

Present profit = 60/fridge

Total no of fridge= 100000

FC = 55*100000=55,00,000TOTAL PROFIT = 60,00,000

If selling price is reduced by 15%

New selling price = 230 15% = 230 34.5= 195.5desired 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


9/29

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.


10/29

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.


11/29

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.


12/29

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.


13/29

A B C

0(initial yrs) 1,00,000 Nil - 10,00,000

1- 25yrs -- 2,00,000 27,50,000

After 25yrs -- 1,50,000 3,00,000

Net cash flow 1,00,000 3,50,000 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 .


14/29

Effect of change in sales price

Components RS

sales 60,000

Variable cost 30,000

Fixed cost 15,000

The effect of change s in sales prices can be easily analyzedwith the help of contribution technique.

Following data are available from the record of a company:

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.


15/29

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


16/29

Alternative method for Production:-

The management has to Choose from amongalternative methods of production. For complexsituation management applied Marginal costingtechnique and the method which gives the highest

contribution can be adopted keeping in view, ofcourse, the limiting factor.

Q. Product A can be manufactured either by machine X ormachine Y. Machine X can produced 50 unit of A per hour andmachine Y ,100 unit per hour. Total machine hours availableare 2000 hours per annum. Taking into account the followingcost data, determine the profitable method of manufacture:


17/29

Machine X (Rs)

Per unit A

Machine Y (Rs)

Per unit A

Direct material 8 10

Direct wages 12 12Variable over head 4 4

Fixed over head 5 5

Total 29 31

Selling price 30 30

Less : Material Cost (Direct material +Direct

wages + Fixed over head)

24 26

Contribution per Unit 6 4

Output per hour 50 Unit 100 Unit

Contribution per hour Rs 300 Rs 400

Total machine hour (per annum) 2,000 2,000

Total contribution Rs 6,00,000 Rs 8,00,000

Hence, production of Machine Y is more profitable


18/29

Determination of optimum Level of

Activity

Marginal costing technique used for finding different level ofactivity 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.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:

Material 100 Rs.

Labour cost 30 Rs

Overhead 50 Rs

Selling price 200 Rs/unit

If Working capacity Selling price falls by50% 3%

90% (5% Fall in material cost also) 5%

calculate the profit and BEP at both capacity level.


19/29

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


20/29

50% capacity 90% capacity

Per unit Rs. Total Rs. Per Unit Rs. Total Rs.

a).Sales 200 (3x200)/100

= 194

12,500x194

= 2,425,000

200-(5x200)/100

=190

4,275,000

b).Variable cost =(Material +wages + variable

overhead

100+30+20= 150 1,875,000 (100-5)+30+20=

145

3,262,500

c).Contribution (a-b)

d).fixed overheads

(60%of 5)x10,000

44 5,50,000

3,00,000

45 1,012,500

3,00,000

Profit(c-d) 2,50,000 7,12,500

Break even point =

Fixed expenses

contribution

BEP= 3,00,000/44

=6,818 Unit

chair

BEP=3,00,000/45

=6,667 unit chair


21/29

9. Evaluation of Performance

Evaluation of performance efficiency of various

departments, product lines or markets can also bemade 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.


22/29

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 productsare as follows:

Product Selling Price Direct Material Direct Labour

Dept. X Dept.Y Dept.Z

Rs. Rs. Rs. Rs. Rs.A 100 20 8 4 4

B 80 12 4 8 4

C 90 16 4 4 8


23/29

Contd

Overhead rates for each department per rupee

of direct labour are as follows:Dept. X Dept. Y Dept. Z

Rs. Rs. Rs.

Variable Overhead 2.50 1 2

Fixed Overhead 2.50 4 3

5 5 5

What advice would you give to the management about the profitibility of

product B ? Give reasons.


24/29

Solution

Comparative Profitability Statement

Product A Product B Product C

Rs. Rs. Rs. Rs. Rs. Rs.

Selling PriceLess: Marginal Cost

Direct MaterialDirect Labour

Variable Overhead

Dept. X

Dept. Y

Dept. Z

Contribution

P/V Ratio

100 80 90

20 12 1616 16 16

10 5 5

2 4 2

4 52 4 41 8 47

48 39 43

48% 48.75% 47.77%

48/100x100 39/80x100 43/90x100


25/29

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.


26/29

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 New small car Old bigger carRs. Rs.

Purchase price 35,000 20,000

Sale price after 5 yrs. 19,000 12,000

Repairs and servicing(per annum) 1,000 1,200

Taxes and insurance(per annum) 1,700 700

Petrol consumption per ltr. 10 km. 7 km.

Petrol price Rs. 3.50 per ltr.


27/29

ContdHe 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 break-

even and why? Ignore income tax and interests.


28/29

Comparative Cost statement

New Small Car Old Bigger Car Taxi

Rs. Rs. Rs.

Purchase price 35,000 20,000

Less : Sale Price (after 5 yrs.) 19,000 12,000

Depriciation for 5 yrs. 16,000 8,000

Depriciation for one year 3,200 1,600

Repair and Servicing 1,000 1,200

Taxes And Insurance 1,700 700

Fixed cost per annum 5,900 3,500

Variable cost per annum :

(i) Petrol for 10,000 km.

New small car @ RS. 3.50 for 10 km 3,500

Old big car @ rs. 3.50 for 7 km. 5,000

(ii) Petrol for 19,000 km. 6,650 9,500

Total Cost (Fixed + Variable)

for 10,000 km. 9,400 8,500 9,000

(10,000x0.90)

for 19,000 km. 12,550 13,000 17,100

(19,000x0.90)


29/29

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 anannual 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

Documents

decision regarding alternative choices