Marginal Costing And Cost Analysis: Capacity Utilization

Capacity Utilisation

Marginal costing is used in planning the capacity to be utilised to arrive at the maximum contribution.

Illustration:

A company can produce 150,000 units of a product each month. The report of sales department is as follows:

Volume of production 60% 70% 80% 90% 100%

Selling Price per unit (`) 0.85 0.9 0.7 0.65 0.6

Variable manufacturing costs at these levels is ` 0.20 per unit. Fixed costs are ` 50000. Determine the level of production which gives maximum profit.

Statement showing the contribution at various levels

Capacity 60% 70% 80% 90% 100%

Units 90000 105000 120000 135000 150000 ` ` ` ` `

Sales 76500 94500 84000 87750 90000

Less: Variable Cost 18000 21000 24000 27000 30000

Contribution 58500 73500 60000 60750 60000

But there are many factors that limit the volume of output of a firm, such as market demand for the product, non-availability of a specific raw material, availability of labour hours and machine hours etc. These limiting factors are called ‘Key Factor’. In such situation it is not enough to compute the contribution but contribution for each unit of key factor is required to be calculated. The total contribution for the limiting factor must recover the fixed cost. Further contribution per limiting factor helps in the product-mix decision. In order to maximise profits that product which gives highest contribution per limiting factor should be produced to the maximum possible level keeping in mind the market demand and firm’s capacity to produce. The quantity of production of other products should be determined in the same

The directors propose that product C should be given up because the contribution of this product is the lowest.

Let us check this logic by applying the principles of marginal costing and come to a conclusion.

The fixed expense under the present arrangement is `61,000, and it is calculated as follows:

For A 10,000 units at ` 3 per unit = ` 30,000

For B 5,000 units at ` 3 per unit = ` 15,000

For C 8,000 units at ` 2 per unit = ` 16,000

Total = ` 61,000

Fixed expenses will remain same even though the production arrangement might change. We know that:

Contribution per unit = selling price - marginal cost

Contribution per unit of product A = ` 32 - ` 20 = ` 12

Contribution per unit of product B = ` 30 - ` 20 = ` 10

Contribution per unit of product C= ` 26 - ` 18 = ` 8

In this case, there can be three production arrangements:

1) If the production of product A is stopped, the production of B and C will increase by 50%

B's output 5,000 + 5/100 x 5000 = 7,500 units

C's output 8,000 + 50/100 x 8000 = 12,000 units

B's contribution on 7,500 units at ` 10 = `