Cost&Management Accounting Unit-2.PDF (1)

Meridian International School of Business Marginal Costing & Differential Costing2013

SYLLABUS

Unit II

Marginal Costing

Marginal Costing versus Absorption Costing,

Cost-Volume-Profit Analysis and P/V Ratio Analysis and their implications,

Concept and uses of Contribution & Breakeven Point and their analysis for various types of decision-making

like single product pricing, multi product pricing, replacement, sales etc.

Differential Costing and Incremental Costing

Concept,

Uses and applications,

Methods of calculation of these costs and their role in management decision making like sales, replacement,

buying etc.


CONTENT

1.1 MARGINAL COSTING AND COST PROFIT VOLUME ANALYSIS

1.2 DIFFERENTIAL COSTING

1.3 ADVANTAGES OF MARGINAL COSTING

1.4 LIMITATIONS OF MARGINAL COSTING

1.5 COST VOLUME PROFIT ANALYSIS

1.6 MARGINAL COST EQUATION

1.7 CONTRIBUTION

1.8 PROFIT VOLUME RATIO (P/V Ratio)

1.9 BREAK-EVEN POINT

1.10 ASSUMPTIONS UNDERLYING CVP ANALYSIS/BREAK-EVEN CHARTS

1.11 ADVANTAGES OF BREAK-EVEN CHARTS

1.12 LIMITATIONS OF BREAK-EVEN CHARTS

1.13 PROFIT GRAPH

1.14 MARGIN OF SAFETY

1.15 ANGLE OF INCIDENCE

1.16 DIFFERENTIAL COSTS AND INCREMENTAL COSTS

1.17 AREAS OF DECISION MAKING


1.1Marginal Costing and Cost Volume Profit Analysis

Marginal Cost: The term Marginal Cost refers to the amount at any given volume of output by which the

aggregate costs are charged if the volume of output is changed by one unit. Accordingly, it means that the

added or additional cost of an extra unit of output.

Marginal cost may also be defined as the "cost of producing one additional unit of product." Thus, the concept

marginal cost indicates wherever there is a change in the volume of output, certainly there will be some change

in the total cost. It is concerned with the changes in variable costs. Fixed cost is treated as a period cost and is

transferred to Profit and Loss Account.

Marginal Costing: Marginal Costing may be defined as "the ascertainment by differentiating between fixed

cost and variable cost, of marginal cost and of the effect on profit of changes in volume or type of output."

With marginal costing procedure costs are separated into fixed and variable cost.

According to J. Batty, Marginal costing is "a technique of cost accounting pays special attention to the

behaviour of costs with changes in the volume of output." This definition lays emphasis on the ascertainment

of marginal costs and also the effect of changes in volume or type of output on the company's profit.

FEATURES OF MARGINAL COSTING

(1) All elements of costs are classified into fixed and variable costs.

(2) Marginal costing is a technique of cost control and decision making.

(3) Variable costs are charged as the cost of production.

(4) Valuation of stock of work in progress and finished goods is done on the basis of variable costs.

(5) Profit is calculated by deducting the fixed cost from the contribution, i.e., excess of selling price over

marginal cost of sales.

(6) Profitability of various levels of activity is detennined by cost volume profit analysis.

Absorption Costing

Absorption costing is also termed as Full Costing or Total Costing or Conventional Costing. It is a technique of

cost ascertainment. Under this method both fixed and variable costs are charged to product or process or

operation. Accordingly, the cost of the product is determined after considering both fixed and variable costs.

Absorption Costing Vs Marginal Costing: The following are the important differences between

Absorption Costing and Marginal Costing:

(1) Under Absorption Costing all fixed and variable costs are recovered from production while under Marginal

Costing only variable costs are charged to production.

(2) Under Absorption Costing valuation of stock of work in progress and finished goods is done on the basis of

total costs of both fixed cost and variable cost. While in Marginal Costing valuation of stock of work in

progress and finished goods at total variable cost only.

(3) Absorption Costing focuses its attention on long-term decision making while under Marginal Costing

guidance for short-term decision making.


(4) Absorption Costing lays emphasis on production, operation or process while Marginal Costing focuses on

selling and pricing aspects.

1.2Differential Costing

Differential Costing is also termed as Relevant Costing or Incremental Analysis. Differential Costing is a

technique useful for cost control and decision making.

According to ICMA London differential costing "is a technique based on preparation of adhoc information

in which only cost and income differences between two alternatives / courses of actions are taken into

consideration."

Marginal Costing and Differential Costing: The following are the differences between Marginal Costing and

Differential Costing:

(1) Differential Costing can be made in the case of both Absorption Costing as well as Marginal Costing

(2) While Marginal Costing excludes the entire fixed cost, some of the fixed costs may be taken into account as

being relevant for the purpose of Differential Cost Analysis.

(3) Marginal Costing may be embodied in the accounting system whereas Differential Cost are worked

separately as analysis statements.

(4) In Marginal costing, margin of contribution and contribution ratios are the main yardstick for the

performance evaluation and for decision making. In Differential Cost Analysis. differential costs are compared

with the incremental or decremental revenues as the case may be.

1.3Advantages of Marginal Costing (or)

Important Decision Making Areas of Marginal Costing

The following are the important decision making areas where marginal costing technique is used :

(I) Pricing decisions in special circumstances :

(a) Pricing in periods of recession;

(b) Use of differential selling prices

(2) Acceptance of offer and submission of tenders.

(3) Make or buy decisions.

(4) Shutdown or continue decisions or alternative use of production facilities.

(5) Retain or replace a machine.

(6) Decisions as to whether to sell in the export market or in the home market.

(7) Change Vs status quo.

(8) Whether to expand or contract.

(9) Product mix decisions like for example :

(a) Selection of optimal product mix;

(b) Product substitution;

(c) Product discontinuance.

(10) Break-Even Analysis.

1.4Limitations of Marginal Costing

(1) It may be very difficult to segregation of all costs into fixed and variable costs.

(2) Marginal Costing technique cannot be suitable for all type of industries. For example, it is difficult to apply

in ship-building, contract industries etc.


(3) The elimination of fixed overheads leads to difficulty in determination of selling price.

(4) It assumes that the fixed costs are controllable, but in the long run all costs are variable.

(5) Marginal Costing does not provide any standard for the evaluation of performance which is provided by

standard costing and budgetary control.

(6) With the development of advanced technology fixed expenses are proportionally increased. Therefore, the

exclusion of fixed cost is less effective.

(7) Under marginal costing elimination of fixed costs results in the under valuation of stock of work in

progress and finished goods. It will reflect in true profit.

(8) Marginal Costing focuses its attention on sales aspect. Accordingly, contribution and profits are determined

on the basis of sales volume. It does nnt con:::ider other functional aspects.

(9) Under Marginal Costing semi variable and semi fixed costs cannot be segregated accurately.

1.5COST VOLUME PROFIT ANALYSIS

Cost Volume Profit Analysis (C V P) is a systematic method of examining the relationship between changes in

the volume of output and changes in total sales revenue, expenses (costs) and net profit. In other words. it is

the analysis of the relationship existing amongst costs, sales revenues, output and the resultant profit.

To know the cost, volume and profit relationship, a study of the following is essential :

(1) Marginal Cost Formula

(2) Break-Even Analysis

(3) Profit Volume Ratio (or) PN Ratio

(4) Profit Graph

(5) Key Factors and

(6) Sales Mix

Objectives of Cost Volume Profit Analysis

The following are the important objectives of cost volume profit analysis:

(1) Cost volume is a powerful tool for decision making.

(2) It makes use of the principles of Marginal Costing.

(3) It enables the management to establish what will happen to the financial results if a specified level of

activity or volume fluctuates.

(4) It helps in the determination of break-even point and the level of output required to earn a desired profit.

(5) The PN ratio serves as a measure of efficiency of each product, factory, sales area etc. and thus helps the

management to choose a most profitable line of business.

(6) It helps us to forecast the level of sales required to maintain a given amount of profit at different levels of

prices.

1.6Marginal Cost Equation

The Following are the main important equations of Marginal Cost :

Sales = Variable Cost + Fixed Expenses Profit I Loss

(or)

Sales - Variable Cost = Fixed Cost Profit or Loss

(or)

Sales - Variable Cost = Contribution


Contribution = Fixed Cost + Profit

The above equation brings the fact that in order to earn profit the contribution must be more than fixed

expenses. To avoid any loss, the contribution must be equal to fixed cost.

1.7Contribution

The term Contribution refers to the difference between Sales and Marginal Cost of Sales. It also termed as

"Gross Margin." Contribution enables to meet fixed costs and profit. Thus, contribution will first covered fixed

cost and then the balance amount is added to Net profit. Contribution can be represented as:

Contribution = Sales - Marginal Cost

Contribution = Sales - Variable Cost

Contribution = Fixed Expenses + Profit

Contribution - Fixed Expenses = Profit

Sales - Variable Cost = Fixed Cost + Profit

OR

C=S-V.C

C=F.C+P

S-V.C=F.C+P

C-F.C=P

Example

Variable Cost = Rs 50,000

Fixed Cost = Rs 20,000

Selling Price = Rs 80,000

Contribution = Selling Price Variable Cost = Rs 80,000 Rs 50,000 = Rs 30,000

Profit = Contribution Fixed Cost = Rs 30,000 Rs 20,000 = Rs 10,000

Hence, contribution exceeds fixed cost and, therefore, the profit is of the magnitude ofRs 10,000. Suppose the

fixed cost is Rs. 40,000 then the position shall be

Contribution Fixed cost = Profit = Rs 30,000 Rs 40,000 = () Rs 10,000

The amount of Rs 10,000 represents the extent of loss since the fixed costs are more than the contribution. At

the level of fixed cost of Rs 30,000, there shall be no profit and no loss. The concept of the break-even analysis

emerges out of this theory.

1.8Profit/Volume Ratio (P/V Ratio)

This term is important for studying the profitability of operations of a business, Profit volume ratio establishes

a relationship between the contribution and the sale value. The ratio can be shown in the form of a percentage

also. The formula can be expressed thus:


P/V Ratio= Contribution = Sales Variable Cost Sales Sales

or C/S = S V or Variable Costs 1-

S Sales

This ratio can also be called Contribution/Sales ratio. This ratio can also be known by comparing the change in contribution to change in sales or change in profit due to change in sales. Any increase in contribution would

mean increase in profit only because fixed costs are assumed to be constant at all levels of production. Thus,

P/V Ratio = Change in Contribution or Change in Profit

Change in Sales Change in Sales

This ratio would remain constant at different levels of production since variable costs as a proportion to sales

remain constant at various levels.

Example

Sales Rs 2,00,000

Variable Costs 1,20,000

Fixed Costs 40,000

Rs 2,00,000 - Rs 1, 20,000

P/V Ratio = = 0.4 or 40%

Rs 2,00,000

The ratio is useful for the determination of the desired level of output or profit and for the calculation of

variable costs for any volume of sales. The variable cost can be expressed as under:

VC = S (1 P/V Ratio) In the above example if we know the P/V Ratio and sales beforehand, the variable cost can be computed as

follows:

Variable costs = 1 .04 =.06, i.e., 60% of sales = Rs 1,20,000 (60% of Rs 2,00,000)

Alternatively, by the formula

Since

S - V

P/V Ratio= ,

S

.. S V = S P/V ratio or V = S S P/V Ratio or = S (1 P/V Ratio)

The following are the special features of P/V Ratio:

(i) It helps the management in ascertaining the total amount of contribution for a given volume of sales.


(ii) It remains constant so long the selling price and the variable cost per unit remain constant or so long they

fluctuate in the same proportion.

(iii) It remains unaffected by any change in the level of activity. In other words, PV ratio for a product will

remain the same whether the volume of activity is 1,000 units or 10,000 units.

(iv) The ratio also remains unaffected by any variation in the fixed cost since the latter are not at all considered

while calculating the PV ratio.

In case of a multi-product organisation, PV ratio is of vital importance for the management to find out which

product is more profitable. Management tries to increase the value of this ratio by reducing the variable costs

or by increasing the selling price.

1.9Break-even Point

The point which breaks the total cost and the selling price evenly to show the level of output or sales at which

there shall be neither profit nor loss, is regarded as break-even point.At this point, the income of the business

exactly equals its expenditure. If production is enhanced beyond this level, profit shall accrue to the business,

and if it is decreased from this level, loss shall be suffered by the business.

It will be proper here to understand different concepts regarding marginal cost and break-even point before

proceeding further. This has been explained below:

Marginal Cost = Total Variable Cost

or = Total Cost Fixed Cost or = Direct Material + Direct Labour + Direct Expenses (Variable)

+ Variable Overheads

Contribution = Selling Price Variable Cost Profit = Contribution Fixed Cost


Fixed Cost = Contribution Profit Contribution = Fixed Cost + Profit

Profit/Volume Ratio or

Contribution per unit

(P/V Ratio) =

Selling price per unit

Or Total Contribution

Total Sales

In case P/V ratio is to be expressed as a percentage of sales, the figure derived from the formulae as given

above should be multiplied by 100.

Fixed Cost

Break-even Point (of output) =


Fixed Cost Selling Price per unit

Break-even Point (of sales) =


Fixed Cost Total

Or = x Sales

Total Contribution

Fixed Cost Fixed Cost

Or = =

Variable cost per unit P/V Ratio

1-

Selling price per unit

At break-even point the desired profit is zero. In case the volume of output or sales is to be computed for a

desired profit, the amount of desired profit should be added to Fixed cost in the formulae given above. For example:

Fixed Cost + Desired Profit

Units for a desired profit=



Fixed Cost + Desired Profit

Sales for a desired profit =

P/V Ratio

Example- A factory manufacturing sewing machines has the capacity to produce 500 machines per annum.

The marginal (variable) cost of each machine is Rs 200 and each machine is sold for Rs 250. Fixed overheads

are Rs 12,000 per annum. Calculate the break-even points for output and sales and show what profit will result

if output is 90% of capacity?

Solution:

Contribution per machine is Rs 250 Rs. 200 = Rs. 50 Break-even Point for Output

(Output which will give contribution equal to fixed costs Rs. 12,000). Total Fixed Cost

BEP (for output)=


12,000

= =240 machines

50

Break-even Point for Sales

= Output Selling price per unit

= 240 Rs 250 = Rs 60,000.

Break-even point for sales can also be calculated with the help of any of the following formulae:

Total Fixed Cost 12,000

(i) BEP= =

Variable Cost per unit 200

1 1- Selling Price per unit 250

12,000

= = Rs 60,000

1/5

Total Fixed Cost Selling Price per unit

(ii) BEP =



12,000 x 250

= = Rs 60,000

50

Total Fixed Cost

(iii) BEP=

P/V Ratio*

12,000

= = Rs 60,000

20%

Contribution 25,000

*P/V Ratio = x100 = x 100 = 20%.

Sales 1,25,000

Profit at 90% of the capacity has been calculated as follow:

Capacity 500 machines

Output at 90% of capacity 450 machines

Break-even point of output 240 machines

Since fixed overheads will be recovered in full at the break-even point, the entire contribution beyond the

break-even point will be the profit. The profit on 450 units, therefore, will be:

= Rs 50 (450 240) = Rs 10,500

1.10ASSUMPTIONS UNDERLYING CVP ANALYSIS/BREAK-EVEN CHARTS

The following assumptions are common to both Break-even Charts and CVP Analysis:

(i) Fixed costs remain constant at every level and they do not increase or decrease with change in output.

(ii) Variable cost fluctuates per unit of output. In other words, it varies in the same proportion in which the

volume of output or sales varies.

(iii) All costs are capable of being bifurcated into fixed and variable elements.

(iv) Selling price remains constant even when the volume of production or sales changes.

(v) Cost and revenue depend only on volume and not on any other factor.

(vi) Production and sales figures are either identical or changes in the inventory at the beginning and at the end

of the accounting period are not significant.

(vii) Either the sales mix is constant or only one product is manufactured.

1.11Advantages of Break-even Charts

Break even analysis enables a business organization to:

1. Measure profit and losses at different levels of production and sales.

2. To predict the effect of changes in price of sales.

3. To analysis the relationship between fixed cost and variable cost.

4. To predict the effect on profitablilty if changes in cost and efficiency.


.

1.12Limitations of Break-even Charts

Break-even analysis is a very useful risk assessment technique and a useful device for testing the sensitivities

of business performance, the following limitations must be considered:

All costs resolved into fixed or variable

Variable costs fluctuate in direct proportion to volume.

Fixed costs remain constant over the volume range.

The selling price per unit is constant over the entire volume range.

The company sells only one product, or mix of products tends to remain constant.

Volumetric increase is the only factor affecting costs.

The efficiency in the use of resources will remain constant over the period.

1.13PROFIT GRAPH

A graphical representation that indicates the potential profit or loss of an investment at a given time (usually at

the expiration of the option) and at various stock prices, in order to inform business decisions on such

investment. It is also known as a "risk graph" and it allows investors to devise countermeasures if and

where high risk is involved.

The point of graph where the Sales and Total Cost (Expense) lines intersect is the break even point. The graph that is used to compare how alternatives on pricing, variable costs, or fixed costs may affect net

income(profit) as volume changes is called a P/V Chart or Profit-Volume Graph.


1.14MARGIN OF SAFETY

Total sales minus the sales at break-even point is known as the margin of safety. Thus, the formula is: M.S. = T.S. B.E.S. Margin of Safety = Total Sales Break-even Sales. Margin of safety can also be computed according to the following formula:

Net Profit

Margin of Safety=

P/V Ratio

Margin of safety can also be expressed as a percentage of sales:

Margin of Safety

x100

Total Sales

Example

Total Sales Rs 1,50,000

Variable Costs 75,000

Fixed Costs 50,000

The margin of safety can be computed as follows:

Fixed Cost

Break-even Sales =

P/V Ratio

50,000

= =Rs 1,00,000

50%

Net Profit = Contribution Fixed Cost = Rs 75,000 Rs 50,000 = Rs 25,000

Margin of Safety = Rs 1,50,000 Rs.1,00,000 = Rs 50,000

Net Profit

=

P/V Ratio

25,000

= = Rs 50,000

50%

If the margin of safety is large, it is a sign of soundness of the business since even with a substantial reduction

in sales, profit shall be earned by the business. If the margin is small, reduction in sales, even to a small extent


may affect the profit position very adversely and larger reduction of sales value may evenresult in losses. Thus,

margin of safety serves as an indicator to the strength of the business.

In order to rectify the unsatisfactory margin of safety, the management can take the following steps:

(i) Selling prices may be increased, but it should not affect the demand adversely otherwise the net sales

revenue shall stand reduced.

(ii) Fixed or the variable cost may be reduced.

(iii) Production may be enhanced, but it should be at a lower cost.

(iv) Unprofitable products may be substituted by profitable ones.

1.15ANGLE OF INCIDENCE

The angle of incidence is the angle between the sales line and the total cost line formed at the break-even-point

where the sales line and the total cost line intersect each other. The angle of incidence indicates profit earning

capacity of the business. A large angle of incidence indicates a high rate of profit and on the other hand, a

small angle of incidence indicates a low rate of profit. Usually the angle of incidence and margin of safety are

considered together to indicate the soundness of a business. A large angle of incidence with a high margin of

safety indicates the most favourable position of a business.

1.16DIFFERENTIAL COSTS AND INCREMENTAL COSTS

Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels.

The concept is used to reach decisions about which alternatives to pursue, and which to drop. The concept can

be particularly useful in step costing situations, where producing one additional unit of output may require a

substantial additional cost

Incremental cost measures the addition to unit cost which results from an addition to output.It is generally expressed as a cost per unit.

Characteristics of Differential costing

1. In order to ascertain the differential costs, only total cost is needed and not cost per unit.

2. Existing level is taken to be the base for comparison with some future or forecasted level.

3. Differential cost is the economists concept of marginal cost. 4. It may be referred to as incremental cost when the difference in cost is due to increase in the level of

production and decremental costs when difference in cost is due to decrease in the level of production.

5. It does not form part of the accounting records, but may be incorporated in budgets.

6. It is not necessary to adopt marginal cost technique for differential cost analysis because it can be worked

out on the method of absorption costing or standing costing.

7. What is said of the differential cost above, applies to differential revenue also.


1.17AREAS OF DECISION MAKING

Areas of decision-making:

(i) Stock management and inventory control decisions

(ii) Plant location decisions

(iii) Machinery replacement / capital budgeting decisions

(iv) Further processing decisions

(v) Product decisions Dropping or adding a product line (vi) Marketing decisions

(vii) Submitting tenders and quotations for new jobs based on relevant cost analysis

(viii) Acceptance of incremental orders in different situations like spare capacity, full capacity etc.

(ix) Make or buy decisions

(x) Product pricing decisions

(xi) Intra-Company transfer pricing decisions

(xii) Purchasing vs. lease financing decisions

The above areas involve the use of marginal costs, relevant cost and different cost approaches.

I. Inventory Decisions

Need

risk of obsolescence. Hence the optimum inventory levels, which lies somewhere between the maximum and

minimum levels, should be determined.

(a) Sales department would like to have maximum stock of all varieties of finished goods so as to meet all its

customer demand immediately.

(b) Production department may wish to produce large batches of a new products so that production runs are

long and costs are low.

(c) Financial control department would prefer low stock in order to reduce the capital tied up in stock.

So decisions regarding stock levels are usually concerned with seeking the best economic compromise between

conflicting objectives.

II. Plant Location Decisions:

The following are the basic aspects of plant location decisions:

(a) Selection of territory the state or territory in which the factory is to be located and (b) Selection of site the exact site where the factory is to be put up. Selection of territory. This aspect is influenced by:

(a) Entrepreneurs choice; (b) Tax benefit available; and

(c) Laws of the State, which may be suitable for setting up of the industrial units.

Selection of site: The advantages associated with each probable site may be analysed into the following

categories:

Natural Advantages Derived Advantages


-in certain areas cheap and unskilled labour is available in plenty, in certain areas

skilled labour will be available.

actors of distribution such as transport facilities, freight rate concessions, etc.

Analysis of alternatives: If a number of alternative sites are available, decisions can be taken by reference to

the following aspects:

1. Relative advantages of one site over others

2. Capital expenditure of alternative site locations

3. Break-even analysis of the project at various site locations

4. Incremental rate of return

5. Intangible factors

III. Cost factors and non-cost-factors in an asset replacement decision Cost Factors:

Comparison of operating costs of the existing plant with that of alternative plant.

Figures of comparative profitability, return on capital employed and interest on capital.

Assessment of opportunity costs to determine whether the funds proposed to be invested in purchase of the

new asset in replacement could be more gainfully deployed elsewhere.

Effect of disposal of the existing plant.

Additional capital expenditure of an obligatory nature to be incurred, if any, on related or allied projects such

as those for welfare.

Effect on tax liability due to profit or loss on the sale of plant/machinery to be replaced.

Non Cost Factors:

1. Market standing of the product: If the product is likely to become obsolete or go out of fashion in the near

future, it will not be worthwhile to go in for plant replacement.

2. Nature of the market capability of absorbing the product manufactured by the new plant in its entirety at the anticipated price.

3. Constraints on the resources required for the new plant.

4. Possibility of any bottleneck or imbalances in subsequent operations or process, in the new plant and if so,

whether these can be removed.

5. Possibility of any substitute product coming up which make the replaced plant redundant.

6. Likely effects of any change in the policy of the Government with regard to import of raw materials, export

of products, levy of duties etc.

Areas of Decision Making

IV. Further Processing Decisions

The following steps are involved in decision making on further processing of joint products:

(a) Compute Additional Revenue = Sale Value after Further Processing Sales Value at split off (b) Compute Additional Costs = Further Processing costs + S & D OH if any

(c) Compute Additional Profit = Additional Revenue Additional Costs (d) If Additional Profit is positive, process further, else sell at split off point.Joint costs i.e. costs upto split-off

stage is irrelevant


V. Product Development Decisions

1. Product development embraces new development, major modifications of existing products, manufacture of

products which are similar to those of competitors, product line acquisition, etc.

2. The six stages of innovation process, in the product development decisions are:

(a) Idea generation: Ideas are continually being generated through technology, competitors, firms scientists and salesmen & customer feedback. They also emanate from conferences and discussions, at meetings.

(b) Screening: Screening seeks to eliminate from further consideration those product ideas, which are not in

conformity with the Companys (a) objectives; or (b) resources. The objective may be maximum profit, sales stability and sales growth or company image. If the product idea is compatible with these objectives, it will be

examined in the light of availability of resources, viz. capital, know-how, production facilities to be used for

the manufacture, etc. Product ideas that pass these tests will move on to the next stage.

(c) Business analysis: This involves estimation of future sales, profits and rate of return for the proposed new

product and also to determine whether these are in conformity with the objectives of the company. The various

methods for carrying out business analysis are (a) Break-even analysis; (b) Discounted Cash Flow or NPV

method (c) Marketing mix method (d) Bayesian Decision method; (e) Standard Deviation method; and (f)

Critical Path method.(d) Developing the product in a concrete form: This involves the following four stages:

Engineering - preparation of prototype that is designed free of trouble for economical manufacture and

appealing to customer.Consumer preference testing to seek the distribution or strength of consumer preferences; Brand name to enable easy identification for the product; andPacking to ensure product protection, economy and also to serve as a sales promotional by using attractivepackaging designs.

(e) Test Marketing: Here, the entire product and marketing programme is tried out for the first time in a small

number of well-chosen and authentic sales environments. This primary motive of test marketing is to improve

knowledge of potential sales. It can also choose an alternative marketing plan after ascertaining market

position.(f) Commercialisation: After passing all the aforesaid stages of development, the project becomes ripe

for commercial production. By this time, the company gains confidence in the products future.

VI. Product Policy Decisions

A product policy decision involves the following:

a. Product modification decision

b. Product elimination decision; and

c. Product mix decision

(a) Product modification strategies

quality of product or to

compete successfully with the other manufacturers who supply product of good quality.

efficiency or versatility. It serves as an effective means of building a firms progressiveness and leadership.

strategy aims at improving the aesthetic appeal of the product in contrast to its

functional appeal. Changes in style of motor vehicles are examples of this strategy.

(b) Product elimination decision:

The cost of sustaining a weak product is as under: Un-recovered overheads; Loss of profit; Short production

runs and expensive set up times, and More attention of advertising and sales force time.

-meal basis: Where the loss becomes conspicuous and

hence necessary to eliminate the product.

inventories, or rising costs.


(C) Product Mix Decision:

Product mix means a composite of product offered for sale by a firm. The firms final choice of a product strategy is based on its long run objective, viz. profits, sales, stability and sales growth. To achieve these

objectives the firm chooses an optimal product mix, considering the following factors:

The objective function, which is normally maximization of profits or minimization of cost;

The constraints within which the objective function is to be achieved. These may be machine capacity, raw

materials availability, labour time, sales potential, etc.

VII. Product distribution decision:

The objective of distribution is getting the right goods to the places at the right time for the optimal cost.

The basic output of a distribution system is the level of customer service, which can be defined as the number

of day of delivery. In other words it is the percentage of customers who should get their orders in so many

number of days. This level of service depends upon an analysis of probable-customers, competitors and

response to alternative levels of service available.

The provision of a certain level of customer service involves warehousing, transportation costs etc. These are

considered to be the inputs of a distribution system.

The system can be considered efficient if it maintains a particular level of service at minimum cost. This means

freight charges, warehousing cost, inventory carrying cost etc. should be minimum.

Decision-making tools used for this purpose are (a) Linear programming (Transportation Model); and (b)

Inventory models.

VIII. Dropping or adding a product line:

Since the objective of any business organization is to maximize its profits, the firm can consider the economies

of dropping the unprofitable products, and adding a more remunerative product(s).

In such cases, the firm may have two alternatives as under:

(a) To drop the unprofitable product and to leave the capacity unutilised.

(b) To drop the unprofitable product and to utilize the capacity for the manufacture of a more remunerative

product.

For this purpose, the contribution approach is adopted, taking the following factors into account:

1. Contribution from unprofitable product (i.e. Sale Revenue Less Variable Costs)

2. Specific fixed costs of the unprofitable product, which can now be avoided or reduced.

3. Contribution from the other profitable product, which is proposed to be produced with the balance capacity.

IX. Make or Buy Decisions:

Make or buy decisions may be required to be taken in respect of component / raw material parts. In such cases,

the marginal costing and opportunity costing approaches shall be adopted in decision making. The decisions

will be based on the following computation:

(a) Compute Cost of Manufacturing = Variable Costs

+ Specific Fixed Cost (if any)

+ Opportunity Cost (in case of full capacity operations)

(b) Compute Cost of Buying = Direct Purchase Costs

+ Indirect Costs like buying commission


+ Opportunity Cost if any (e.g. Purchase of different quality raw material, leading to reduction in selling price

of finished product).

(c) Decisions will be as under:

If cost of manufacturing < Cost of Buying, the firm should go for manufacturing

If cost of manufacturing < Cost of Buying, then the firm is indifferent

If cost of manufacturing < Cost of Buying, the firm should go for buying

Cost&Management Accounting Unit-2.PDF (1)

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