Question

The Managing Director asks you for your help. You are required to write a report (1500 words) covering the costing and pricing issues set out above. In particular, you should address the following;

1. Is the Managing Directors' friend right in suggesting that marginal costing is an appropriate way to control costs and set a      selling price? You should illustrate your answer with relevant calculations.

2. What other methods of cost might be appropriate? Your answer should be supported by appropriate theory.

3. You are asked to suggest a selling price for both the current year and next year. You should justify your price on the basis of costing and pricing theory. You are also required to produce a break-even analysis to support your suggested selling price.

The Shetland Wool Company is a small family-owned company that produces very high-quality hand-knitted wool sweaters. It uses a relatively small number of casual employees who produce the garments in their own homes. These are then sold in small numbers to exclusive outlets. The current performance of the business is not good and the Directors have looked in some detail at the cost base. They have established the following information;

• The average cost of the wool used in a garment is      £28.50

• The labor involved in producing a sweater is on      average 30 hours

• Casual labor currently costs £5.50 per hour; however,      the Directors feel that in order to maintain staff they will have to      increase this next year by at least 5%

• The transportation costs involved in producing the sweaters together with the cost of delivery amount to £4.50 per sweater.

 

In addition to the above costs, the company also runs a Head Office which costs £100,000 per year. The Directors require total salaries of £125,000 and each year they award themselves a 5% pay increase. The level of advertising is an issue on which the Directors do not agree. This year's advertising spend is £115,000. Next year the Sales Director would like to advertise in airline magazines, he believes that this would increase sales from this year’s forecast of 2,000 sweaters. He estimates that if the advertising budget is increased to £285,000 then sales would increase to 5,000 sweaters. The Finance Director feels that this is not realistic and at the last Board meeting said "whatever we spend on that advertising thing we will never ever sell more than 3,000 sweaters". The Sales Director replied by saying "if we sold sweaters at £200 each, I could make annual sales of 10,000".

 

It is difficult to make a direct comparison of competing products. However high-quality knitted sweaters sell for between £200 and £400. The Shetland Wool Company has always assumed that the market is not particularly price-sensitive and their reputation is for very high-quality garments.

 

The company's current pricing policy is not very clear, in the past, they have aimed for 200% of budgeted manufacturing costs at normal volumes. However, a friend of the Managing Director recently told her that this was not necessary. The friend said that all the company needed to concentrate on was its marginal costs. If it could keep these low and made sure that the selling price was a little bit higher the rest would all work out. 

 

Answer 1

1. Marginal cost means the incremental cost of production which arises due to one unit increase in the production quantity. Marginal costing is the system of costing in which the products and services are valued at variable cost only. It does not take into consideration of fixed costs. It takes into account only direct costs. Costs are classified on the basis of the behavior of cost i,e, fixed or variable. Marginal costing is an appropriate method to control cost and set a selling price due to following reasons:

1. Simplified Pricing Policy: The marginal cost remains constant per unit of output whereas the fixed cost remains constant in total. Since marginal cost per unit is constant from period to period within a short span of time, firm decisions on pricing policy can be taken. If fixed cost is included, the unit cost will change from day to day depending upon the volume of output. This will make decision-making tasks difficult.

2. Proper recovery of Overheads: Overheads are recovered in costing on the basis of pre-determined rates. If fixed overheads are included on the basis of pre-determined rates, there will be an under-recovery of overheads if production is less or if overheads are more. There will be over-recovery of overheads if production is more than the budget or actual expenses are less than the estimate. This creates the problem of treatment of such under or over-recovery of overheads. Marginal costing avoids such under or over recovery of overheads.

3. Shows Realistic Profit: Advocates of marginal costing argues that under the marginal costing technique, the stock of finished goods and work-in-progress are carried on a marginal cost basis and the fixed expenses are written off to profit and loss account as period cost. This shows the true profit of the period.

4. How much to produce: Marginal costing helps in the preparation of break-even analysis which shows the effect of increasing or decreasing production activity on the profitability of the company.

5. More control over expenditure: Segregation of expenses as fixed and variable helps the management to exercise control over expenditure.

6. Helps in Decision Making: Marginal costing helps the management in taking a number of business decisions like make or buy, discontinuance of a particular product, replacement of machines, etc.

In the given case, the marginal cost of wollen garments is:

Cost of wool : 28.50

Labour cost : 173.25 (5.5 x 1.05 x 30)

Transport cost : 4.5

Total marginal cost : 206.25

From above calculations, it is clear that even if advertisement expenditure is not increased, the marginal cost of each wollen garment is 206.25 which exceeds the proposed selling price of 200 by the Sales director. Hence keeping the sales price at 200 is not at all advisable even if it results in an increase in annual sales to 10000 units.

However, if advertisement expenditure is increased to 285000 in next year the sales would increase to 5000 units.

This means that by incurring additional advertisement of 170000 (285000 - 115000) additional sales of 3000 would be made. Hence per unit advertisement cost in additional units sold is 56.67 (170000 / 3000)

The marginal cost per unit, in this case, will be = 206.25 + 56.67

= 262.92

The selling price should not be lesser than this.

2. Another method of costing that may be appropriate would be absorption costing. Absorption Costing is the practice of charging all costs, both variable and fixed to operations, processes, or products.

In absorption costing the classification of expenses is based on a functional basis whereas in marginal costing it is based on the nature of expenses. In absorption costing, the fixed expenses are distributed over products on an absorption costing basis that is, based on a pre-determined level of output. Since fixed expenses are constant, such a method of recovery will lead to over or under-recovery of expenses depending on the actual output being greater or lesser than the estimate used for recovery. Since absorption costing considers all costs, the actual profit or loss can be determined.

In the given case, the company is incurring various fixed costs such as the director's salary, head office expenditure, and advertisement cost. All these costs are also required to be considered while determining the cost per unit and selling price so that the company is at a profit after considering overall sales. A company should not only recover its marginal costs but its fixed costs as well in the long run if it has to survive.

3. Selling price on the basis of absorption costing:

Particulars	Current year	Next year
Units sold	2000	5000
Wool per unit	28.5	28.5
Labour per unit	165 (5.5 x 30)	173.25
Transport cost	4.50	4.50
Total variable cost per unit	198	206.25
Total variable cost	396000 (198 x 2000)	1031250 (206.25 x 5000)
Head office expenditure	100000	100000
Director's salary	125000	131250
Advertisement	115000	285000
Total cost	736000	1547500
Cost per unit	368	309.50

The selling prices in both years should be more than the cost per unit. the selling price will fall within the given range of 200 - 400. Therefore the highest possible selling price is 400.

Contribution from this selling price:

	Current year	Next year
Contribution per unit	202 (400-198)	193.75 (400 - 206.25)
Total contribution	404000	968750
Total fixed cost	340000 (736000 - 396000)	516250 (1547500 - 1031250)
Break even (F.C. / Contribution)	340000 / 202 = 1683 units	516250 / 193.75 = 2665 units

Thus the breakeven units fall within the sales range of 2000 units and 5000 units