CIMA - C1 Fundamentals of Management Accounting
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90
4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
(b) The marginal costing profit in each period and in total would be:
(i) Period 1 $
(ii) Period 2 $
(iii) Total $
Answer
(a) (i) Period 1 $
700
(ii) Period 2 $
1,300
(iii) Total $
2,000
Workings
The absorption rate for fixed production overhead is
units 1,500
$1,500
= $1 per unit
Period 1
Period 2
Total
$
$
$
$
$
$
Sales
7,200
10,800
18,000
Production costs
Variable
6,000
6,000
12,000
Fixed
1,500
1,500
3,000
7,500
7,500
15,000
Add opening inventory b/f
–
1,500
7,500
9,000
15,000
Less closing inventory c/f
(1,500
)
–
–
Production cost of sales
6,000
9,000
15,000
(Under-)/over-absorbed
overhead
–
–
–
Total production costs
6,000
9,000
15,000
Gross profit
1,200
1,800
3,000
Other costs
500
500
1,000
Net profit
700
1,300
2,000
(b) (i) Period 1 $
400
(ii) Period 2 $
1,600
(iii) Total $
2,000
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
91
Workings
Period 1
Period 2
Total
$
$
$
$
$
$
Sales
7,200
10,800
18,000
Variable production cost
6,000
6,000
12,000
Add opening inventory b/f
–
1,200
–
6,000
7,200
12,000
Less closing inventory c/f
(1,200
)
–
–
Variable production cost
of sales
4,800
7,200
12,000
Contribution
2,400
3,600
6,000
Fixed costs
2,000
2,000
4,000
Profit
400
1,600
2,000
Question
Two approaches to dealing with overheads
X Co commenced business on 1 March making one product only. The standard cost of one unit is as follows.
$
Direct labour
5
Direct material
8
Variable production overhead
2
Fixed production overhead
5
Standard production cost
20
The fixed production overhead figure has been calculated on the basis of a budgeted normal output of 36,000 units per
annum.
You are to assume that all the budgeted fixed expenses are incurred evenly over the year. March and April are to be taken
as equal period months.
Selling, distribution and administration expenses are as follows.
Fixed $120,000 per annum
Variable 15% of the sales value
The selling price per unit is $35 and the number of units produced and sold was as follows.
March April
Units Units
Production 2,000 3,200
Sales 1,500 3,000
(a) If a marginal costing system is in operation:
(i) The value of the closing inventory for each month will be:
March $
April $
(ii) The loss reported for March will be $
(iii) The profit reported for April will be $
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92
4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
(b) If an absorption costing system is in operation:
(i) The value of the closing inventory for each month will be:
March $
April $
(ii) The production overhead for March will be
absorbed by $
(iii) The production overhead for April will be
absorbed by $
(iv) The loss reported for March will be $
(v) The profit reported for April will be $
Answer
(a) (i) March $
7,500
(500 units × $15)
April $
10,500
(700 units × $15)
(ii) The loss reported for March will be $
2,875
Workings
Contribution per unit:
$ per unit
Selling price
35.00
Variable production cost
(15.00)
Variable selling expenses ($35 × 15%)
(5.25
)
Contribution per unit
14.75
Loss for March:
$
Contribution (1,500 × $14.75)
22,125
Fixed production overhead ($5 × 36,000 × 1/12)
(15,000)
Fixed selling expenses
(10,000
)
Loss
(2,875
)
(iii) The profit reported for April will be $
19,250
Workings
$
Contribution (3,000 × $14.75)
44,250
Fixed production overhead
(15,000)
Fixed selling expenses
(10,000
)
19,250
(b) (i) March $
10,000
(500 units × $20)
April $
14,000
(700 units × $20)
(ii) The production overhead for March will be
under
absorbed by $
5,000
(iii) The production overhead for April will be
over
absorbed by $
1,000
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
93
Workings
March
April
$
$
Overhead absorbed
(2,000 × $5)
10,000
(3,200 × $5)
16,000
Overhead incurred
($5 × 36,000 × 1/12)
15,000
15,000
Under/(over) absorbed
5,000
(1,000
)
(iv) The loss reported for March will be $
375
(v) The profit reported for April will be $
20,250
Workings
March
April
$
$
Marginal costing (loss)/profit
(2,875)
19,250
Plus increase in inventory @ $5 fixed overhead per unit:
500 units × $5
2,500
200 units × $5
1,000
Absorption costing (loss)/profit
(375)
20,250
An assessment question may, for example, give you a marginal costing profit figure and ask you to use inventory figures
and the overhead absorption rate to calculate the absorption costing profit. If inventory levels increase, absorption
costing will report a higher profit than marginal costing. If inventory levels decrease, absorption costing will report the
lower profit.
Question
Profit reconciliation
The following information is available for H Co.
20X9
Opening inventory 900 units
Closing inventory 300 units
Marginal costing profit $100,000
Using an overhead absorption rate of $20 per unit, calculate what the profit would be if absorption costing were used.
Answer
Units
Opening inventory
900
Closing inventory
300
Decrease
600 x $20 = $12,000 lower
Marginal profit
$100,000
$12,000
Absorption profit
$88,000
Assessment
focus point
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94
4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
3 Pricing decisions
3.1 Full cost plus pricing
A price determined using full cost plus pricing is based on full cost plus a percentage mark-up for profit.
A traditional approach to pricing products is full cost plus pricing, whereby the sales price is determined by calculating
the full cost of the product and adding a percentage mark-up for profit.
In full cost plus pricing, the full cost may be a fully absorbed production cost only, or it may include some absorbed
administration, selling and distribution overhead.
A business might have an idea of the percentage profit margin it would like to earn and so might decide on an average
profit mark-up as a general guideline for pricing decisions. This would be particularly useful for businesses that carry
out a large amount of contract work or jobbing work, for which individual job or contract prices must be quoted
regularly to prospective customers.
However, the percentage profit mark-up does not have to be fixed, but can be varied to suit the circumstances. In
particular, the percentage mark-up can be varied to suit demand conditions in the market.
3.1.1 Problems with full cost plus pricing
(a) Prices must be adjusted to market and demand conditions, the decision cannot simply be made on a cost
basis only. A company may need to match the prices of rival firms when these take a price-cutting
initiative.
(b) A full cost plus basis for a pricing decision is a means of ensuring that, in the long run, a company
succeeds in covering all its fixed costs and making a profit out of revenue earned. However, in the short
term it is inflexible.
(1) A firm tendering for a contract may quote a cost plus price that results in the contract going
elsewhere, although a lower price would have been sufficient to cover all incremental costs and
opportunity costs.
(2) In the short term, rapidly-changing environmental factors might dictate the need for lower (or
higher) prices than long-term considerations would indicate.
(c) Where more than one product is sold by a company, the price decided by a cost plus formula depends on
the method of apportioning fixed costs between the products.
3.1.2 Example: full cost plus pricing with more than one product
GL Company is attempting to decide sales prices for two products, Lyons and Tygers. The products are both made by
the same workforce and in the same department. 30,000 direct labour hours are budgeted for the year. The budgeted
fixed costs are $30,000 and it is expected that the department will operate at full capacity. Variable costs per unit are as
follows.
Lyons
Tygers
$
$
Materials
4
4
Labour
(2 hours)
6
(3 hours)
9
Expenses
(1 machine hour)
2
(1 machine hour)
2
12
15
Expected demand is 7,500 Lyons and 5,000 Tygers.
FA
S
T F
O
RWAR
D
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
95
Required
Calculate the unit prices which give a profit of 20% on full cost if overheads are absorbed on the following bases.
(a) On a direct labour hour basis
(b) On a machine hour basis
Solution
(a) A direct labour hour basis
Budgeted fixed costs
Budgeted labour costs
=
()
$30,000
15,000 +15,000
= $1
Absorption rate $1 per direct labour hour
Lyons
Tygers
$
$
Variable costs
12.00
15.00
Overhead absorbed
2.00
3.00
14.00
18.00
Profit (20%)
2.80
3.60
Price
16.80
21.60
The total budgeted profit would be $(2.80 × 7,500) + ($3.60 × 5,000) = $39,000
(b) A machine hour basis
Budgeted fixed costs
Budgeted machine hours
=
()
$30,000
7,500 +5,000
=
$30,000
12,500
= $2.40
Absorption rate $2.40 per machine hour
Lyons
Tygers
$
$
Variable costs
12.00
15.00
Overhead absorbed
2.40
2.40
Full cost
14.40
17.40
Profit (20%)
2.88
3.48
Price
17.28
20.88
The total budgeted profit would be $(2.88 × 7,500) + ($3.48 × 5,000) = $39,000
(c) The different bases for charging overheads result in different prices for both Lyons (difference of 48c per unit)
and Tygers (difference of 72c per unit).
It is unlikely that the expected sales demand for the products would be the same at both sales prices. It is questionable
whether one (or either) product might achieve expected sales demand at the higher price. In other words, although the
budgeted profit is $39,000 whichever overhead absorption method is used, this assumes that budgeted sales would be
achieved regardless of the unit price of each product. This is an unrealistic basis on which to make a decision.
3.1.3 Advantages of full cost plus pricing
(a) Since the size of the profit margin can be varied at management's discretion, a decision based on a price
in excess of full cost should ensure that a company working at normal capacity will cover all its fixed costs
and make a profit. Companies may benefit from cost plus pricing in the following circumstances.
(i) When they carry out large contracts which must make a sufficient profit margin to cover a fair
share of fixed costs
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96
4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
(ii) If they must justify their prices to potential customers (for example for government contracts)
(iii) If they find it difficult to estimate expected demand at different sales prices
(b) It is a simple, quick and cheap method of pricing which can be delegated to junior managers. This may
be particularly important with jobbing work where many prices must be decided and quoted each day.
Question
Mark up
A company's product's full cost is $4.75 and it is sold at full cost plus 70%. A competitor has just launched a similar
product selling for $7.99. The company needs to change the price of its product to match that of the competitor.
The margin of the first product should change to
%.
Answer
The margin should change to
68.2
%
Workings
Margin in $ = $(7.99 – 4.75) = $3.24.
Margin as % of full cost = (3.24/4.75) × 100% = 68.2%.
3.1.4 Generating a return on sales or investment
Full cost plus pricing is a form of target pricing, which means setting a price so as to achieve a target return on sales or
investment.
Let's start with looking at a target return on sales.
Suppose LM Company wishes to make a 20% return on sales. The full cost of product K is $100. The price that LM
Company needs to set is therefore calculated as follows.
Let the selling price = P
P– full cost = 20% of P= 0.2P
Therefore P – 0.2P = full cost
Therefore 0.8P = full cost = $100
Therefore P = $100/0.8 = $125
Now let's look at a target return on investment.
Suppose sales of product Z for the coming year are expected to be 500 units. A return of 15% in the coming year is
required on the annual investment of $250,000 in product Z. The full cost of product Z is $175. The required selling price
is calculated as follows.
Required return = 15% × $250,000 = $37,500
Expected cost = 500 × $175 = $87,500
Required revenue – expected cost = required return
Therefore expected revenue = $(37,500 + 87,500) = $125,000
Therefore selling price = $125,000/500 = $250
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
97
Question
Pricing to generate a return on investment
MM Company requires a 30% return on investment from its products. It will invest $800,000 in product B in the coming
year, when it expects to sell 50,000 units.
If the full cost of product B is $100, the required selling price is $
.
Answer
The required selling price is $
104.80
Workings
Required return = 30% × $800,000 = $240,000
Expected cost = 50,000 × $100 = $5,000,000
Required revenue = $(5,000,000 + 240,000) = $5,240,000
Selling price = $5,240,000/50,000 = $104.80
Watch out for OT questions in the assessment on this area in particular.
3.2 Marginal cost plus pricing
Marginal cost plus prices are based on the marginal cost of production or the marginal cost of sales, plus a profit
margin.
Instead of pricing products or services by adding a profit margin on to full cost, a business might add a profit margin on to
marginal cost (either the marginal cost of production or else the marginal cost of sales).
For example, if a company budgets to make 10,000 units of a product for which the variable cost of production is $3 a
unit and the fixed production cost $60,000 a year, it might decide to fix a price by adding, say, 33
1
/
3
% to full production
cost to give a price of $9 × 1
1
/
3
= $12 a unit. Alternatively, it might decide to add a profit margin of, say, 250% on to the
variable production cost, to give a price of $3 × 350% = $10.50.
3.2.1 Advantages of a marginal cost plus approach
(a) It is a simple and easy method to use.
(b) The mark-up can be varied, and so provided that a rigid mark-up is not used, mark-up pricing can be
adjusted to reflect demand conditions.
(c) It draws management attention to contribution and the effects of higher or lower sales volumes on profit.
This helps to create a better awareness of the concepts and implications of marginal costing and
breakeven analysis (topics we cover in Chapters 4 and 6). For example, if a product costs $10 a unit and
a mark-up of 150% is added to reach a price of $25 a unit, management should be clearly aware that every
additional $1 of sales revenue would add 60c to contribution and profit.
(d) Mark-up pricing is convenient where there is a readily identifiable basic variable cost. Retail industries
are the most obvious example, and it is quite common for the prices of goods in shops to be fixed by
Assessment
focus point
FA
S
T F
O
RWAR
D
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4: Marginal costing and pricing decisions ⏐ Part A Cost determination and behaviour
adding a mark-up (20% or 33
1
/
3
%, say) to the purchase cost. For example, a department store might buy
in items of pottery at $3 each, add a mark-up of one third and resell the items at $4.
3.2.2 Drawbacks to marginal cost plus pricing
(a) Although the size of the mark-up can be varied in accordance with demand conditions, it does not ensure
that sufficient attention is paid to demand conditions and competitors' prices.
(b) It ignores fixed overheads in the pricing decision, but the price must be high enough to ensure that a profit
is made after covering fixed costs. Pricing decisions cannot ignore fixed costs altogether.
Question
Profit margin
A product has the following costs.
$
Direct materials 5
Direct labour 3
Variable overhead 7
Fixed overheads are $10,000 per month. Budgeted sales for the month are 400 units.
The profit margin that needs to be added to marginal cost to break even is
%
Answer
The profit margin is
167
%
Workings
Total costs for the month = variable costs + fixed costs
= ($15 × 400) + $10,000 = $16,000
∴ Sales revenue must equal $16,000
∴ Selling price per unit = $16,000/400 = $40
∴ Mark-up = $(40 – 15) = $25
Mark-up % = (25/15) × 100% = 167%
3.2.3 Margins and mark-ups
Consider the following cost/profit/sales structure.
%
Cost
80
Profit
20
Sales
100
The profit added to the full cost or marginal cost of a product may be expressed in one of two ways.
• Percentage of cost of sales, such as 25% (
20
/
80
) mark-up
• Percentage of sales, such as 20% (
20
/
100
) margin
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Part A Cost determination and behaviour ⏐ 4: Marginal costing and pricing decisions
99
Alternatively, the cost/profit/sales structure could be:
%
Cost
100
Profit
20
Sales
120
• Mark-up =
20
/
100
= 20%
• Margin =
20
/
120
= 16.7%
Question
Selling price and unit cost
(a) Product B's unit cost is $50. A selling price is set based on a margin of 15%. The selling price is $
(b) Product L sells for $750. The mark-up is 10%. The unit cost of product L is $
Answer
(a) The selling price is $
58.82
Workings
$
%
Cost
50
85
Profit
?
15
Selling price
?
100
∴ Selling price = $50/0.85 = $58.82
(b) The unit cost is $
681.82
Workings
$
%
Cost
?
100
Profit
?
10
Selling price
750
110
Cost = $750/1.1 = $681.82
Question
Mark-up
CTF Co uses a mark-up of 15% on full cost to price its product X. The indirect costs are 20% of the direct costs. What
mark-up should be applied to direct costs to give the same selling price for product X?
A 138%
B 18%
C 38%
D 118%
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