BUDGETS AND BUDGETORY CONTROL

Budgeting is an integral part of management to achieve organizational objectives.. A budget is a plan of action and is prepared to facilitate the  planning and control process.

Definition of Budget:

 ‘A budget is a financial and/or quantitative statement, prepared prior to a defined period of time, of the policy to be pursued during the period for the purpose of attaining a given objective’. (The Chartered Institute of Management Accountants, London)

Elements of Budget:

The basic elements of a budget are as follows:-

1. It is a comprehensive and coordinated plan of action.

2. It is a plan for the firm’s operations and resources.

3. It is based on objectives to be attained.

4. It is related to specific future period.

5. It is expressed in financial and/or physical units.

Budgetary Control:

CIMA, London defines budgetary control as, “the establishment of the budgets relating to the responsibility of executives to the requirements of a policy and the continuous comparison of actual with budgeted result either to secure by individual action the objectives of that policy or to provide a firm basis for its revision”

‘Budgetary Control is a planning in advance of the various functions of a business so that the business as a whole is controlled’. (Wheldon)  

Elements of budgetary control:

1. Establishment of budgets for each function and division of the organization.

2. Regular comparison of the actual performance with the budget to know the variations from budget and placing the responsibility of executives to achieve the desire result as estimated in the budget.

3. Taking necessary remedial action to achieve the desired objectives, if there is a variation of the actual performance from the budgeted performance.

4. Revision of budgets when the circumstances change.

5. Elimination of wastes and increasing the profitability.

Objectives of Budgetary Control

Budgetary Control assists the management in the allocation of responsibilities and is a useful device to estimate and plan the future course of action. The general objectives of budgetary control are as follows:

1. Planning:

(a) A budget is an action plan as it is prepared after a careful study and research.

(b) A budget operates as a mechanism through which objectives and policies are carried out.

(c) It is a communication channel among various levels of management.

(d) It is helpful in selecting a most profitable alternative.

(e) It is a complete formulation of the policy of the concern to be pursued for attaining given objectives.

2. Co-ordination:

It coordinates various activities of the business to achieve its common objectives. It induces the executives to think and operate as a group.

3. Control:

Control is necessary to judge that the performance of the organization confirms to the plans of business. It compares the actual performance with that of the budgeted performance, ascertains the deviations, if any, and takes corrective action at once.

Installation of Budgetary Control:

There are certain steps necessary to install a good budgetary control system in an organization. They are as follows:

1. Determination of the Objectives

2. Organization for Budgeting

3. Budget Centre

4. Budget Officer

5. Budget Manual

6. Budget Committee

7. Budget Period

8. Determination of Key Factor

1. Determination of Objectives:

It is very clear that the installation of a budgetary control system presupposes the determination of objectives sought to be achieved by the organization in clear terms.

2. Organization for Budgeting:

Having determined the objectives clearly, proper organization is essential for the successful preparation, maintenance and administration of budgets. The responsibility of each executive must be clearly defined. There should be no uncertainty regarding the jurisdiction of executives.

3. Budget Centre:

It is that part of the organization for which the budget is prepared. It may be a department or any other part of the department. It is essential for the appraisal of performance of different departments so as to make them responsible for their budgets.

4. Budget Officer:

A Budget Officer is a convener of the budget committee. He coordinates the budgets of various departments. The managers of different departments are made responsible for their department’s performance.

5. Budget Manual:

It is a document which defines the objectives of budgetary control system. It spells out the duties and responsibilities of budget officers regarding the preparation and execution of budgets. It also specifies the relations among various functionaries.

6. Budget Committee:

The heads of all important departments are made members of this committee. It is responsible for preparation and execution of budgets. The members of this committee may sometimes take collective decisions, if necessary. In small concerns, the accountant is made responsible for the same work.

7. Budget Period:

It is the period for which a budget is prepared. It depends upon a number of factors. It may be different for different concerns/functions. The following are the factors that may be taken into consideration while determining budget period:

a. The type of budget,

b. The nature of demand for the products,

c. The availability of finance,

d. The economic situation of the cycle and

e. The length of trade cycle

8. Determination of Key Factor:

Generally, the budgets are prepared for all functional areas of the business. They are inter related and inter dependent. Therefore, a proper coordination is necessary. There may be many factors that influence the preparation of a budget. For example, plant capacity, demand position, availability of raw materials, etc. Some factors may have an impact on other budgets also. A factor which influences all other budgets is known as Key factor. The key factor may not remain the same. Therefore, the organization must pay due attention on the key factor in the preparation and execution of budgets.

Types of Budgeting:

Budget can be classified into three categories from different points of view. They are:

1. According to Function

2. According to Flexibility

I. According to Function:

(a) Sales Budget:

The budget which estimates total sales in terms of items, quantity, value, periods, areas, etc is called Sales Budget.

(b) Production Budget:

It estimates quantity of production in terms of items, periods, areas, etc. It is prepared on the basis of Sales Budget.

(c) Cost of Production Budget:

This budget forecasts the cost of production. Separate budgets may also be prepared for each element of costs such as direct materials budgets, direct labour budget, factory materials budgets, office overheads budget, selling and distribution overheads budget, etc.

(d) Purchase Budget:

This budget forecasts the quantity and value of purchase required for production. It gives quantity wise, money wise and period wise particulars about the materials to be purchased.

(e) Personnel Budget:

The budget that anticipates the quantity of personnel required during a period for production activity is known as Personnel Budget.

(f) Research Budget:

The budget relates to the research work to be done for improvement in quality of the products or research for new products.

(g) Capital Expenditure Budget:

The budget provides a guidance regarding the amount of capital that may be required for procurement of capital assets during the budget period.

(h) Cash Budget:

This budget is a forecast of the cash position by time period for a specific duration of time. It states the estimated amount of cash receipts and estimation of cash payments and the likely balance of cash in hand at the end of different periods.

(i) Master Budget:

It is a summary budget incorporating all functional budgets. It also includes the preparation of a Projected Income Statement and a  Projected Balance Sheet. Sometimes control ratios like projected Net Profi ratio, Earnings Per Share, Return on Investment

II. According to Flexibility:

On the basis of flexibility, budgets can be divided into two categories:

1. Fixed Budget

2. Flexible Budget

1. Fixed Budget:

Fixed Budget is one which is prepared on the basis of a standard or a fixed level of activity. It does not change with the change in the level of activity.

2. Flexible Budget:

A budget prepared to give the budgeted cost of any level of activity is termed as a flexible budget. According to CIMA, London, a Flexible Budget is, ‘a budget designed to change in accordance with level of activity attained’. It is prepared by taking into account the fixed and variable elements of cost.

PREPARATION OF BUDGETS:

I. SALES BUDGET:

Sales budget is the basis for the preparation of all other budgets. It is the forecast of sales to be achieved in a budget period. The sales manager is directly responsible for the preparation of this budget. Sales budget is prepared after considering a number of factors such as past sales figures and trend, Market demand, . Nature of competition, Plant capacity, Seasonal fluctuations etc.

II. PRODUCTION BUDGET:

Production = Sales + Closing Stock – Opening Stock

Example:

3. The sales of a concern for the next year are estimated at 50,000 units. Each unit of the product requires 2 units of Material ‘A’ and 3 units of Material ‘B’. The estimated opening balances at the commencement of the next year are:

Finished Product : 10,000 units

Raw Material ‘A’ : 12,000 units

Raw Material ‘B’ : 15,000 units

The desirable closing balances at the end of the next year are:

Finished Product : 14,000 units

Raw Material ‘A’ : 13,000 units

Raw Material ‘B’ : 16,000 units

Prepare the materials purchase budget for the next year.

Answer:

Production Budget

Estimated Sales                                           50,000 units

Add: Estimated Closing Finished Goods         14,000 ,,

64,000 ,,

Less: Estimated Opening Finished Goods      10,000 ,,

          Production                                          54,000

Materials Purchase Budget

Material ‘A’           Material ‘B’

Material Consumption                1,08,000 units       1,62,000 units

Add: Closing stock of materials    13,000 ,,                  16,000 ,,

                                                  1,21,000 ,,                1,78,000 ,,

Less: Opening stock of materials 12,000 ,,                    15,000 ,,

Materials to be purchased        1,09,000 ,,                 1,63,000 ,,

Workings:

Materials consumption: Material ‘A’ Material ‘B’

Material required per unit of production 2 units 3 units

For production of 54,000 units 1,08,000 1,62,000

III. CASH BUDGET:

It is an estimate of cash receipts and disbursements during a specified future period of time. “The Cash Budget is an analysis of flow of cash in a business over a future, short or long period of time. It is a forecast of expected cash intake and outlay” (Soleman, Ezra – Handbook of Business administration).

Procedure for preparation of Cash Budget:

1. First take into account the opening cash balance, if any, for the beginning of the period for which the cash budget is to be prepared.

2. Then Cash receipts from various sources are estimated. It may be from cash sales, cash collections from debtors/bills receivables, dividends, interest on investments, sale of assets, etc.

3. The Cash payments for various disbursements are also estimated. It may be for cash purchases, payment to creditors/bills payables, payment to revenue and capital expenditure, creditors for expenses, etc.

4. The estimated cash receipts are added to the opening cash balance, if any.

5. The estimated cash payments are deducted from the above proceeds.

6. The balance, if any, is the closing cash balance of the month concerned.

7. The closing cash balance is taken as the opening cash balance of the following month.

8. Then the process is repeatedly performed.

9. If the closing balance of any month is negative i.e the estimated cash payments exceed estimated cash receipts, then overdraft facility may also be arranged suitably.

FIXED AND FLEXIBLE BUDGETS:

Fixed Budget

A Fixed Budget is defined as a budget which is designed to remain constant at all levels of activities. The level of activity is anticipated first,  and only  a single budget is prepared at this level. Actual performance is measured and compared with the budget.

Flexible Budget

A Flexible Budget is defined as, ‘a budget designed to change in accordance with level of activity attained’, CIMA, London.

Under flexible budgeting a series of budgets are prepared at different levels of activities. Therefore, it facilitates meaningful comparison  of actual performance with  appropriate budget figures.

It is prepared according to marginal costing principles:

1. Cost can be classified into fixed and variable cost. Semi-variable cost is to be segregated fixed and variable elements.

2. Total fixed cost remains constant at all  levels of activities.

3. Total Variable cost varies in the same proportion withy  the level of activity actually achieved.

 It is based on the following equation:

Total Cost = Fixed Cost + (output x Varaible Cost per unit)

MARGINAL COSTING

INTRODUCTION

Marginal costing is a technique of costing. It is widely used by management in profit planning, cost control and decision making.

Marginal Cost

Marginal cost is the change in total cost when the output is increased by one unit. The ICMA, England defines marginal cost as, “the amount of any given volume of output by which the aggregate costs are changed if the volume of output is increased or decreased by one unit”.

Thus marginal cost of Nth unit = Total Cost of Nth unit – Total Cost of N -1 unit.

Since Fixed costs remain constant at different levels of output, the change in total cost when the output is increased by unit is the variable cost of producing that additional unit. Therefore, marginal cost is the variable cost of production of one unit of output. It comprises of prime cost and variable overheads.

MC = Dir. Material + Direct Labour + Other Variable Costs

Marginal costing

Marginal costing is defined by the ICWA, India as “the ascertainment of marginal costs and of the effect on profit of changes in volume or type of output by differentiating between fixed costs, and variable costs”

Features of Marginal Costing/ Assumptions of Marginal Costing

The following are the special features of Marginal Costing:

1. All elements of costs can be divided into fixed and variable. Semi – Variable costs are also separated into fixed and variable elements.
2. Variable cost per unit remains constant irrespective of level of output and fluctuates directly in proportion to changes in the volume of output.
3. Fixed costs remains constant irrespective of the level of activity.
4. Only variable costs are considered as the cost of the product and are charged to products, processes or outputs. Fixed costs are treated as  ‘period costs’ and  they are charged to profit and loss account during the period in which they are  incurred.
5. The work – in – progress and finished stocks are valued at marginal cost only.
6. The relative profitability of the products or departments is based on the  “contribution” they give. Contribution is the difference between sales and marginal cost.
7. The selling  price  per unit remains the same at all levels of output.

Advantages of Marginal Costing

The following are the advantages of marginal costing technique:

1. Simplicity

The concept of marginal costing can be easily understood  as it breaks up the cost as variable and fixed.

2. Stock Valuation

Stock valuation cab be easily done and understood as it includes only the variable cost.

3. Meaningful Reporting

Marginal costing serves as a good basis for reporting to management. The profits are analyzed from the point of view of sales rather than production.

4. Effect on Fixed Cost

The fixed costs are treated as period costs and are charged to Profit and Loss Account directly. Thus, they have practically no effect on decision making.

5. Profit Planning

The Cost – Volume Profit relationship is perfectly analysed to reveal efficiency of products, processes, and departments. Break – even Point and Margin of Safety are the two important concepts helpful in profit planning.

6. Cost Control and Cost Reduction

Marginal costing technique is helpful in preparation of flexible budgets as the costs are classified into fixed and variable. The emphasis is laid on variable cost for control. The constant focus is on cost and volume and their effect on profit pave the way for cost reduction.

7. Pricing Policy

Marginal costing is immensely helpful in determination of selling prices under different situations like recession, depression, introduction of new product, etc. Correct pricing can be developed under the marginal costs technique with the help of the cost information revealed therein.

8. Helpful to Management

Marginal costing is helpful to the management in exercising decisions regarding make or buy, exporting, key factor and numerous other aspects of business operations.

Limitations of Marginal Costing

Marginal costing has the following limitations:

1.Difficulty in Classification: In marginal costing, costs are segregated into fixed and variable. In actual practice, this classification scheme proves to be superfluous in that, certain costs may be partly fixed and partly variable and certain other costs may have no relation to volume of output or even with the time. In short, the categorisation of costs into fixed and variable elements is a difficult and tedious job.

2.Difficulty in Application: The marginal costing technique cannot be applied in industries where large stocks in the form of work-in-progress (job and contracting firms) are maintained.

3.Defective Inventory Valuation: Under marginal costing, fixed costs are not included in the value of finished goods and work in progress. By eliminating fixed costs from finished stock and work-in-progress, marginal costing techniques present stocks at less than their true value. 2. Profits will be lower than that shown under absorption costing and hence may be objected to by tax authorities.

4. Misleading Financial Statements: The balance sheet may not present a true and fair view of the state of financial affairs of the business.

5. Wrong Basis for Pricing: In marginal costing, sales prices are arrived at on the basis of contribution alone. This is not appropriate especially in the long run.

5. Limited Scope: Marginal costing is useful in the  short-run profit planning and decision-making.

Marginal Costing and Absorption Costing

Absorption costing charges all the costs i.e., both the fixed and variable fixed to the products, jobs, processes, and operations. Marginal costing technique charges variable cost. Absorption costing is not any specific method of costing. It is common name for all the methods where the total cost is charged to the output.

Absorption Costing is defined by I.C.M.A, England as “the practice of charging all costs, both fixed and variable to operations, processes, or products” From this definition it is inferred that absorption costing is full costing. The full cost includes prime cost, factory overheads, administration overheads, selling and distribution overheads.

Distinction between Absorption Costing and Marginal Costing

Absorption Costing	Marginal Costing
1. Total cost technique is the practice of charging all cost, both variable and fixed to operations, process or products.	1. Marginal costing charges only variable cost to products, process, or operations and excludes fixed cost entirely.
2. It values stock at the cost which includes fixed cost also.	2. It values stock at total variable cost only. This results in higher value of excess of sales over the total costs in solving managerial problems
3. It is guided by profit which is the	3. It focuses its attention on Contribution which is excess of sales over variable cost.
4. In total cost technique, there is a problem of apportionment of fixed costs which may result in under or over recovery of expenses.	4.It excludes fixed cost. Therefore, there is no question of arbitrary apportionment.

The difference between marginal costing and absorption costing is shown with the help of the following examples.

Contribution

The difference between selling price and variable cost (or marginal cost) is known as `Contribution’ or `Gross Margin’. It may be considered as some sort of fund from out of which all fixed costs are met. The difference between contribution and fixed cost represents either profit or loss, as the case may be. Contribution is calculated thus:

Contribution = Selling price – Variable cost, = Fixed Cost + Profit or – Loss

Marginal Cost Equation

Marginal Cost Equation can be expressed thus:

S – V = C, C = F + P and in case of loss  C = F – L

Profit Volume Ratio (P/V Ratio)

The profitability of business operations can be found out by calculating the P/V Ratio. It shows the relationship between contribution and sales and is usually expressed in percentage. It is also known as `marginal-income ratio’, `contribution-sales ratio’ or `variable-profit ratio’. P/V Ratio thus is the ratio of contribution to sales, and is calculated thus:

P/V Ratio = Contribution / Sales

The ratio can also be shown by comparing the change in contribution to change in sales, or change in profit to change in sales. Any increase in contribution, obviously, would mean increase in profit, as fixed expenses are assumed to be constant at all levels of production.

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

The importance of P/V Ratio lies in its use for evaluating the profitability of alternative products, proposals or schemes. A higher ratio shows greater profitability. Management should, therefore, try to increase P/V ratio by widening the gap between the selling price and the variable costs. This can be achieved by increasing sale price, reducing variable costs or switching over to more profitable products.

Marginal Cost Statement

In marginal costing, a statement of marginal cost and contribution is prepared to ascertain contribution and profit. In this statement, contribution is separately calculated for each of the product or department. These contributions are totaled up to arrive at the total contribution. Fixed cost is deducted from the total contribution to arrive at the profit figure. No attempt is made to apportion fixed cost to various products or departments.

Marginal Cost Statement                         Rs.

Sales                                              xxxxx

Less: Variable Cost                              (xxxx)

                                                    -----

Contribution                                      xxxxx

Less: Fixed Cost                                 (xxxx)

                                                    -----

Profit / Loss                                      xxxx

                                                    -----

Differential Costing

The concept of differential cost is a relevant cost concept in those decision situations which involve alternative choices. It is the difference in the total costs of two alternatives. This helps in decision making. It can be determined by subtracting the cost of one alternative from the cost of another alternative. Differential costing is the change in the total cost which results from the adoption of an alternative course of action. The alternative may arise on account of sales, volume, price change in sales mix, etc decisions. Differential cost analysis leads to more correct decisions than more marginal costing analysis. In this technique the total costs are considered and not the cost per unit. Differential costs do not form part of the accounting system while marginal costing can be adapted to the routine accounting itself. However, when decisions involve huge amount of money differential cost analysis proves to be useful.

Differential cost is generally confused with marginal cost. Of course, these two techniques are similar in some aspects but these also differ in certain other respects.

Similarities

(i) Both the differential cost analysis and marginal cost analysis are based on the classification of cost into fixed and variable. When fixed costs do not change, both differential and marginal costs are same.

 (ii) Both are the techniques of cost analysis and presentation and are used by the management in formulating policies and decision making.

Dissimilarities

(i) Marginal cost may be incorporated in the accounting system where as differential cost are worked out for reporting to the management for taking certain decisions.

(ii) Entire fixed cost are excluded from costing where as some of the relevant fixed costs may be included in the differential cost analysis.

(iii) In marginal costing, contribution and p/v ratio are the main yardstick for evaluating performance and decision making. In differential cost analysis emphasis is made between differential cost and incremental or decremental revenue for making policy decisions.

(iv) Differential cost analysis may be used in absorption costing and marginal costing.

Break-even analysis

Break-even analysis is a specific method of presenting and studying the inter relationship between costs, volume and profits. (Hence, the name C-V-P Analysis). It is an important tool of financial analysis whereby the impact on profit of the changes in volume, price, costs and mix can be found out with a certain amount of accuracy. A business is said to break even when its total sales are equal to its total costs. It is a point of no profit or no loss. At this point contribution is equal to fixed costs.

                                                   Fixed Costs

Break-Even Point (in units) = ------------------------

                                              Contribution per unit

                                               

                                                 Fixed Costs

Break-Even Point (in Rupees) =  -------------                                 (OR)

                                                P/V Ratio

                                              Fixed Costs x Sales

Break-Even Point (in Rupees) = ------------- ----------

                                               Contribution Margin

BREAK-EVEN CHART

The break-even point can also be shown graphically through the break-even chart. The break-even chart `shows the profitability or otherwise of an undertaking at various levels of activity and as a result indicates the point at which neither profit nor loss is made’. It shows the relationship, through a graph, between cost, volume and profit. The break-even point lies at the point of intersection between the total cost line and the total sales line in the chart.

Angle of Incidence

This is the angle of intersection between the sales line and the total cost line. The larger the angle the greater is the profit or loss, as the case may be.

Margin of Safety

This is the difference between the actual sales level and the break even sales. It represents the “cushion” for the company. The larger the distance between the break even sales volume and the actual sales volume, the company can afford to allow the fall in sales without the danger of incurring losses. If the margin of safety is low, even a small fall in the sales volume will drive the company into the loss area. It should be noted that beyond the break even point all contribution (Sales – Marginal Cost) will directly increase the profits.

Margin of safety = Actual Sales - Break-even Sales

The effect of a price reduction will always reduce the P / V ratio, raise the break – even point shorten the margin of safety.

CONSTRUCTION OF BREAK-EVEN CHART

The following steps are required to be taken while constructing the break-even chart:

1. Sales volume is plotted on the X-axis. Sales volume can be shown in  the form of rupees, units or as a percentage of capacity. A horizontal line is drawn spacing equal distances showing sales at various activity levels.

2. Y axis represents revenues, fixed and variable costs. A vertical line is also spaced in equal parts.

3. Draw the sales line from point O onwards. Cost lines may be drawn in two ways (i) Fixed cost line is drawn parallel to X axis and above it variable cost line is drawn from zero point of fixed cost line. This line is called the Total cost line (ii) In the second method the variable cost line is drawn from point O and above this, fixed cost line is depicted running parallel to the variable cost line. This line may be called Total cost line.

4. The point at which the total cost cuts across the sales line is the break-even point and volume at this point is break-even volume.

5. The angle of incidence is the angle between sales and the total cost line. It is formed at the intersection of the sales and the total cost line, indicating the profit earning capacity of a firm. The wider the angle the greater is the profit and vice versa. Usually, the angle of incidence and the margin of safety are considered together to show that a wider angle of incidence coupled with a high margin of safety would indicate the most suitable conditions.

Cash Break-Even Chart

It is the level of output or sales where the cash inflow will be equivalent to

cash needed to meet immediate cash liabilities. Fixed expenses are to be classified as those involving cash payments and those not involving cash payments like depreciation. Cash break-even point can be calculated thus:

Cash Break-even Point (of output)

                         Cash fixed costs

                  = -----------------------------

                    Cash contribution per unit

Illustration 10: The following information is available in respect of Graphics Ltd. Ghaziabad, for the budget period.

Sales- 10,000 units at Rs.10 per unit.

Variable costs Rs.4 per unit.

Fixed costs Rs.25,000 including depreciation of Rs.5,000

Preference Dividend to be paid Rs.5,000

Taxes to be paid Rs.5,000

 Prepare a cash break-even chart.

Composite Break-even Point

Where a firm is dealing with several products, a composite breakeven point can be calculated using the following formula:

Composite Break-even point (Sales)

                   Cash fixed costs

        = ----------------------------------

               Composite P/V Ratio

            Total Fixed Costs x Total Sales

 or = --------------------------------------

                     Total Contribution

         Total Contribution

or = ------------------------- x 100

                Total Sales

PROFIT VOLUME GRAPH

Profit volume graph is a pictorial representation of the profit volume relationship. It shows profit and loss account at different volumes of sales. In this graph X axis represents sales. However, the sales line bisects the graph horizontally to form two areas. The ordinate above the zero sales line, shows the profit area, and the ordinate below the zero sales line indicates the loss or the fixed cost area. The profit-volume-ratio line is drawn from the fixed cost point through the break-even point to the point of maximum profit. In order to construct this graph, therefore, data on profit at a given level of activity, the break-even point and the fixed costs are required.

COST-VOLUME-PROFIT (CVP) ANALYSIS

The relationship between cost, volume and profit is explained in CVP analysis. Break even analysis is alternatively called as CVP analysis also. But it is said that the study up to the state of equilibrium is called as break even analysis and beyond that point we term it as CVP analysis. Cost – Volume Profit analysis helps the management in profit planning or deciding the volume of sales required to earn a particular level of profit.

APPLICATION OF MARGINAL COSTING

The following are some of the managerial decisions which are taken with the help of marginal costing decisions:

1. Fixation of selling price under different market conditions.
2. Profit planning
3. whether to accept a special offer or not
4. whether to accept an export offer or not
5. Make or buy decision
6. Selection of a suitable product mix or sales mix.
7. decision making under a Key factor
8. Alternative methods of production.
9. Suspending activities or  closing down of a department
10. replace a product by another one
11. merger of plant capacities
12. shut down vs. statusquo
13. whether to sell or further process

1. Profit Planning

Profit planning is the planning of the future operations to attain maximum profit or to maintain level of profit. Whenever there is a change in sale price, variable costs and product mix, the required volume of sales for maintaining or attaining a desired amount of profit may be ascertained with the help of P / V ratio.

                            Fixed Cost + Profit

Expected Sales = -------------------------

                                  P / V Ratio

2. Introduction of a New Product

Sometimes, a product may be added to the existing lines of products with a view to utilise idle facilities, to capture a new market or for any other purpose. The profitability of this new product has to be found out initially. Usually, the new product will be manufactured if it is capable of contributing something toward fixed costs and profit after meeting its variable costs.

3. Level of Activity Planning

Marginal costing is of great help while planning the level of activity. Maximum contribution at a particular level of activity will show the position of maximum profitability.

4. Key Factor

A concern would produce and sell only those products which offer maximum profit. This is based on the assumption that it is possible to produce any quantity without any difficulty and sell likewise. However, in actual practice, this seems to be unrealistic as several constraints come in the way of manufacturing as well as selling. Such constraints that come in the way of management’s efforts to produce and sell in unlimited quantities are called `key factors’ or `limiting factors’. The limiting factors may be materials, labour, plant capacity, or demand. Management must ascertain the extent of the influence of the key factor for ensuring maximisation of profit. Normally, when contribution and key factors are known, the relative profitability of different products or processes can be measured with the help of the following formula:

                         Profitability = Contribution/ Key Factor                 

5. Make of Buy Decisions

A company might be having unused capacity which may be utilized for making component parts or similar items instead of buying them from the market. In arriving at such a decision, the cost of manufacturing component parts should be compared with price quoted in the market. If the variable costs are lower than the purchase price, the component parts should be manufactured in the factory itself. Fixed costs are excluded on the assumption that they have been already incurred, and the manufacturing of components involves only variable cost. However, if there is an increase in fixed costs and any limiting factor is operating while producing a component, that should also be taken into account.  In case a firm decides to get a product manufactured from outside, besides savings in cost, it must also take into account the following factors:

(a) Whether the outside supplier would be in a position to maintain the quality of the product?

(b) Whether the supplier would be regular in his supplies?

(c) Whether the supplier is reliable? In other words is the financially and technically sound?

7. Fixation of selling price

Although prices are determined by market conditions and other factors, marginal costing technique assists the management in the fixation of selling prices under various circumstances which is as follows.

a) Pricing under normal conditions.

b) Pricing during stiff competition.

c) Pricing during trade depression.

d) Accepting special bulk orders.

e) Accepting additional orders to utilize idle capacity.

8. Accepting Export Order

Marginal costing technique can also be used to take a decision as to whether to accept a foreign offer or not. The speciality of this situation is that normally foreign order is requiring the manufacturer to supply the product at a price lower than the inland selling price. Here the decision is taken by comparing the marginal cost of the product with the foreign price offered. If the foreign order offers a price higher than the marginal cost then the offer can be accepted subject to availability of sufficient installed production capacity. The following illustration highlights this decision:

9. Closing down of department

When a firm is operating for loss sometime, the management has to decide upon its shut down.

a) Complete shut down: The firm may be permanently closed any intention to revive it. Such a decision is warranted.

i) When the selling price does not even cover the variable cost: or

ii) The demand for the output is very low and the future prospects are bleak.

Complete shut down saves the management from the fixed of running the factory or division or firm.

b) Partial or temporary shut down: Here the intention is to close down for sometime and reopen the firm when circumstances favour it. Some fixed cost will continue in the form of irreducible minimum, like Skelton staff to maintain the factory, some managerial remuneration, salaries, irreplaceable technical experts, etc. The saving from the partial shut down should be compared with the position if the firm continues. If there is substantial savings, shut down may be preferable. Minor savings in expenditure does not warrant shut down because reviving a firm is a cumbersome process.