Marginal and relevant costing techniques are used in:
Finding the best use of restricted resources
Make/buy decisions
Continuation/closure decisions
Pricing special contracts
We will start by brief revision of what revenues and costs might be relevant
2 Identifying marginal and relevant costs
Marginal revenue is usually an easy figure to find: it is just the additional revenue from selling one more unit or from taking on a contract.
Relevant costs are more difficult. They fall into two main groups:
Marginal costs – additional costs caused by the decision
Opportunity costs – revenue forgone as a result of the decision
The following costs are never relevant:
Re-apportioned current fixed overheads
Depreciation
Book costs
Sunk (past) costs.
If the decision changes the pattern of cash flows, then those cash flows are relevant
Use of scarce resources
Use as an index: Contribution/unit of scarce resource needed
The higher the index the better the earning rate of the resource.
Material available = 1200 kgs
Product A: contribution/unit = $24; uses 10 kg/unit; maximum demand = 80 units
Product B: contribution/unit = $15; uses 5 kg/unit; maximum demand = 200 units
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To make maximum demand of both products would take: 10 x 80 + 5 x 200 = 1,800 kg, so material is a scarce of restricting resource.
Contribution/unit of scarce resource needed:
Product A = $24/10 = $2.4; Product B = $15/5 = $3.0
Therefore make B in preference to A
200 units (maximum demand) of B will consume 1000kg and generate $3,000 contribution.
There are 200 kgs of material left, which is enough to allow 20 units. These will generate $480
Therefore, total maximum contribution = $3,480.
3 Make or buy decisions
When resources are limited, in order to meet full sales, it might be possible to buy in some products rather than manufacturing them. Which should be made and which bought?
The firm should first concentrate on making units where the difference between the make and buy price is greatest. But, as with the previous example, it is not absolute savings we need to look at but savings per unit of scarce resource.
Make all 200 units of B. This will consume 1000 kgs, leaving 200 kgs
Make 20 units of A (uses remaining material)
Buy 60 units of A (assuming a profit can be made when bought in)
3.1 Closure/continuation
When considering closure decisions compare costs saved (marginal costs plus any fixed costs avoided) to revenue lost.
It is worth closing if the costs saved exceed the revenue lost.
It is worth continuing if the revenue lost exceeds the costs saved
4 Special contracts
The minimum acceptable contract price = the relevant costs of the contract
Note carefully opportunity costs such as inventory. Say that 1000 kg of Material X was needed and that 700 kgs are in inventory. The 700 kgs cost $10/kg, could be sold now for $9/kg (the company has no other use for the material) and more could be bought for $11/kg.
What is the relevant cost of the material?
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Note that the historical cost of $10 is irrelevant: it’s a sunk cost.
If the contract were not taken up, 700 kgs of material would be sold for $9, so $9 x 700 = $6,300 is an opportunity cost.
The remaining 300 kgs will have to be bought for $11/kg = $3,300
Total relevant cost is therefore = $3,300 + $6,300 = $9,600
Activity based costing
A company manufactures two products with the following cost structures:
Product A
Product B
Expected sales volume
10,000 units
2,000 units
$
$
Marginal cost
20
50
Fixed costs
50
100
Total absorption cost
70
150
Selling price (50% mark-up)
105
225
Product B is more complex to manufacture than Product A, taking twice the amount of production time and requiring more expensive components. It sells in a much lower volume than Product A. Production is carried out in a highly automated factory. The annual fixed production costs of $700,000 have been absorbed on a simple production time basis.
However, whereas Product A is produced in batches of 1,000 units, Product B is produced in batches of only 100 units. Set-up is very complex and it is estimated that 30% of fixed costs are set-up costs incurred every time production of a batch has to be organised. The company is considering costing its products using an activity based costing approach for set-up costs.
Competing products from other manufacturers sell at $100 for Product A competitors, and $250 for product B competitors.
Required
Calculate each product’s cost and selling price using activity based costing and comment on any changes from the original results and any implications there might be for future production strategies.
Comment on the company’s current and future pricing policies.
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Activity based costing
(a) Under ABC, $210,000 of fixed costs will be driven by set-ups (30% x $700,000). The remaining 70% will be absorbed as present over 12,000 units.
For set-ups:
Total number of set-ups driving (causing) the set-up cost of $210,000 is:
10,000/1000 + 2,000/100 = 30
Cost/set-up = $210,000/30 = $7,000
The set-up cost in a production run of 1,000 units of A = $7,000/1000 = $7
The set-up cost in a production run of 100 units of B = $7,000/100 = $70.
The new cost structures under ABC would be:
Product A
Product B
$
$
Marginal cost
20
50
Set-up costs
7
70
Fixed costs (70% of original)
35
70
Total absorption cost
62
190
Selling price (50% mark-up)
93
285
ABC has therefore pushed more costs towards the less efficient production used for Product B. Under ABC, set-up costs absorbed into Product B cost 10 times those of Product A (previously these costs were apportioned 1:2 on the basis of time in production).
Product B is very inefficient to set-up and produce, and its costs would be radically decreased if batch sized could be increased. It is not clear why Product B is produced in such very small batches, but an obvious reason is that Product B is perishable. If it were produced in the same batch size as Product A, only two production runs per year would be needed, but that implies high, slow-moving inventory.
(b) Summary selling prices are:
Product A
Product B
$
$
Market prices of close competitors
100
250
Original cost + 50% mark-up
105
225
New cost + 50% mark-up
93
285
If the markets and products are very competitive, then market prices will have to be, or should be, charged. So, under the original approach Product A would not have sold well at $105 if competing products could be bought for $100. If the company were able to introduce a degree of differentiation into its products, then it has more options. Differentiation allows non-price competition to be used. For example, a strong brand name can allow companies to charge premium prices for otherwise identical products. So, if Product A is selling well at $105, it might be worthwhile exploring what would happen with even higher prices and more advertising.
The recalculation of the selling price under ABC shows that Product A is made more cheaply than originally thought and it would be worthwhile for the company to explore whether it was the cost leader. That would give access to a cost leadership strategy where the company can make very good profits whilst selling at the market price, or it could reduce its prices in the hope of pushing less efficient competitors from the market.
Under the conventional approach, the cost Product B, appears to have been understated and its selling price set too low – both with respect to a cost plus approach (which hopes to cover costs by a mark-up) and with reference to the market prices that seem to have been available. Under ABC, the company would like to charge $285. That might be possible if the product could be differentiated sufficiently. Even if a selling price of only $250 could be achieved, this is still in excess of the new total cost and well in excess of the marginal cost of production. Product B would be worth discontinuing only if the expected contribution at market price of:
2000 x (250 – 50) = 400,000
were compensated for by a reduction in fixed costs of that amount. Given that total fixed costs are $700,000 and most production effort is spent on Product A, it is unlikely that these savings could be achieved.
