topic 31 marginal costing contribution

• Short-run decision making

  Long-term survival means a firm's revenue must cover all costs, but in the short run fixed costs can be ignored, and decisions should be based on contribution rather than profit
• Marginal costs


  The costs incurred when one extra unit is produced above the planned level
• Marginal revenues


  The revenues earned by the sale of one extra unit
• Short-term decision making based on contribution

  • Break even analysis
  • Accepting or rejecting a special order
• Factors to consider for accepting a special order

  • Has the firm got spare capacity to cope with the order?
  • Are fixed costs already covered by existing production, and will there be no additional fixed costs?
• Non-financial considerations for accepting a special order

  • There must be separation from existing customers who must be unaware of the special low price, otherwise there would be a loss of goodwill and existing customers
  • The new customer must not be able to 'sell on' the product for less than the normal price
  • Competitors may react by cutting their prices, leading to a damaging price war
  • If the order comes from overseas, there will be added complications - delays in payment/credit control: currency/exchange rate problems; language barriers or the need to employ a special agent
• Reasons for accepting an order with a negative contribution

  • A special order may lead to future orders and greater long term profits. The 'one-off order is acting as a 'loss leader'
  • If a business is facing a downturn in sales accepting loss making orders will keep their workforce in employment, providing social benefits and ensuring the workers do not become de-skilled, and will keep machinery in use if failure to use the machinery would result in deterioration
  • Social accounting means that firms do not simply aim to make profits and may provide products below cost to disadvantaged groups. This can be for purely altruistic reasons or to provide good PR
• Make or buy decisions

  • If a firm currently makes its own product but an outside supplier can supply them at a lower price than the manufactured cost per unit, on financial grounds the firm should buy in rather than make
  • How reliable is the new supplier in terms of delivery times and quality assurance?
  • Problems of overseas orders - transport, currency, returns out, language
  • Possible redundancies if work is contracted out - implications for employee motivation, industrial relations, image and social responsibility
  • Is the price quoted long-term and realistic, or is it a special promotional price which might be increased in the future?
• Being socially irresponsible may damage a firm's long term profitability

  
  

  -if the workforce is unhappy productivity will suffer

  -there may be high labour turnover

  -new or temporary staff may need to be hired increasing training costs

  -poor reputation may make it harder to find new staff

  -larger firms may receive extensive media coverage making business looking bad

  -damages a firm's corporate image, could reduce demand for their products and maybe consumer boycott
• Disadvantages of social accounting

  • High costs - for example of installing safety equipment or filters to prevent pollution
  • Many firms compete on a global scale and different countries have different health and safety and environmental standards
  • It is difficult to place a monetary value on non-financial aspects and assess whether the benefits of social responsibility outweigh the costs
  • Conflicting stakeholder group interests- there can be conflict between groups and within groups. Which group should the firm be aiming to satisfy the most?
• Limiting factor


  A resource needed to make products that is limited in supply, so production of the product will not be able to match demand
• Deciding which products to prioritise when a limiting factor exists

  1. First calculate the contribution per unit for each product

  2. Then divide this by the scarce resource (limiting factor) used by each product

  3. Rank the products in order of preference

  4. Allocate the scarce resources in full to the best product, then to the second best etc. Any remainder will go to the worst product
• Full cost pricing


  Applies the concept of Absorption costing and adds a percentage mark up to Total costs
• Marginal cost pricing


  Adds a mark up to variable costs, usually involving a larger percentage mark-up than full cost pricing
• A firm is able to sell more of its product if it lowers the price


  But it is making a smaller contribution per unit and profit margin on each item sold
• If the increase in units sold is greater than the reduction in the profit margin, then price reductions are advisable (price elastic demand)
• Even with elastic demand there must be some profit margin, as fixed costs would have to be paid whatever the level of demand/activity
• The basic rule is: does the decision make a positive contribution (d

  oes the MR cover the extra MCs) or are there any non financial considerations
• If there is not spare capacity a special order should not be accepted as it displaces production with the normal selling price resulting in a loss of contribution