Ref.
- Cost Management by Jawaharlal
Cost concept in decision CMA Padmaja Buzruk
making
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Marginal costing for decision making
Application of marginal costing
Marginal costing is a decision making tool.
It provides great help to management in number of crucial situations like
• Make or Buy Decision.
• Accepting or rejecting an order decision.
• Pro t planning.
• Operating or shut down decision.
• Exploring foreign market decision.
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Make or Buy Decision
A business rm may make some products, parts or tools
or
may buy the same thing from outside.
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Make or Buy Decision
• Many times management is in dilemma to purchase a particular component or part
from outside supplier or to produce it in the factory itself, if there is small difference
in the purchase price and total cost of the production.
• Marginal costing helps management in such situations. In such situations cost
comparison should be made between the marginal cost of manufacture and price
at which the component could be obtained from outside.
• If the marginal cost of making the product is lower than the price of buying from
outside, then the rm can make the product.
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Make or Buy Decision
Example - 1
A radio manufacturing company nds that it costs Rs.625 to make each component
X, the same is available in the market at Rs.485 each, with the assurance of
continued supply.
Should you make or buy?
The cost breakup is
Material 275
Labour 175
Other variable cost 50
Depreciation & other xed cost 125
Total 625
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Make or Buy Decision
Solution
The marginal cost of making the product is
Material 275
Labour 175
Other variable cost 50
Total marginal / variable cost 500
The product is available in the market at Rs.485 with an assurance of continued
supply.
It is pro table to buy the component from outside market.
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Make or Buy Decision
Example - 2
X Co. Ltd purchases a component A at a price of Rs.18 per unit.
The management decides to manufacture the component at a marginal cost of Rs.12 per unit
with a processing time 4 hours in a particular machine.
State whether the decision of management is correct
i.When there is spare capacity in the machine
ii.When machine is at present working to the full capacity by manufacturing another product M
with selling price Rs.200, marginal cost Rs.110 and processing time 40 hours.
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Make or Buy Decision
Solution
i.When there is spare capacity in the machine
As the cost of making is lower (Rs.12 per unit) than cost of buying
(Rs.18 per unit)
the decision of management is correct.
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Make or Buy Decision
Solution
ii.When machine is at present working to the full capacity by manufacturing another product M
with selling price Rs.200, marginal cost Rs.110 and processing time 40 hours.
In this case relevant cost of making per unit will be
Variable cost of manufacture 12
Opportunity cost 9
Total 21
As the relevant cost of manufacture is higher than cost of purchase the decision of
management is not correct.
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Accepting or Rejecting an order Decision
• Normally prices are xed as total cost plus expected pro t.
• But in certain situations price xation becomes dif cult.
• An order will be accepted if it increases the contribution.
• Relevant cost approach may prove useful for such type of decision
making.
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Accepting or Rejecting an order Decision
Example - 3
X Ltd. manufactures a wide range of products and absorbs production overheads into cost @ 400% of
direct wages. This rate was calculated from the following budgeted costs -
Rs.
Variable Production overhead 1,20,000
Fixed Production overhead 2,80,000
Total 4,00,000
Direct labour cost 1,00,000
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Accepting or Rejecting an order Decision
Example - 3
One of the company’s product P has normal selling price of Rs.40 and unit production cost of
Rs.
Direct Material cost 15
Direct Labour cost 3.75
Total Production overhead 15
Factory cost 33.75
A customer has offered to buy 500 units of P at a price of Rs.30 each.
If the order is accepted, normal sales will remain unaffected and the company has existing capacity to make the
extra units.
Should the order be accepted?
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Accepting or Rejecting an order Decision
Solution
Variable overhead rate is 1,20,000 / 1,00,000 x 100 = 120% of direct wages
Rs.
Direct Material cost 15
Direct Labour cost 3.75
Variable Production overhead 4.50
Factory cost 23.25
If offer of 500 units of P at a price of Rs.30 each is undertaken
Increase in contribution will be 500 (30 - 23.25) = Rs.3,375
The order is to be accepted.
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Accepting or Rejecting an order Decision
Example - 4
R Ltd. makes a single product which it sells for Rs.40 each and has a variable cost per unit as follows
Rs.
Direct Material cost 8
Direct Labour cost (2 hours) 12
Variable Production overhead 4
Factory cost 24
There is a heavy demand for the product. The labour force is currently working at full capacity and no
overtime work is possible.
A customer is willing to pay Rs.11,000 for a special offer which will require Rs.4,000 for direct material
and 500 hours of direct labour.
Should the order be accepted?
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Accepting or Rejecting an order Decision
Solution
Labour is a limiting factor, if special order is accepted there will be loss of contribution for 500 hours
from the standard product.
Contribution per labour hour = (40 - 24) / 2 = Rs.8
Loss of contribution for 500 hours = Rs.4,000 (opportunity cost)
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Accepting or Rejecting an order Decision
Solution
Rs.
Revenue from special order 11,000
Revelant cost
Direct Material cost 4,000
Direct Labour cost (500 x 6) 3,000
Variable Production overhead (500 x 2) 1,000
Opportunity cost 4,000 12,000
Loss in accepting special order 1,000
R Ltd. is advised to reject the special order.
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Thank You
CMA Padmaja Buzruk
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