BL 6 study pack(English)-part-5

C H A P T E R

INTRODUCTION

This chapter looks at calculating mark-up and margin to arrive at the amount in rupees for given mark-up/margin percentages in different scenario.

The costing method that we shall be looking at is Cost plus Pricing. We will see how mark-up and margin % are used to determine the profit from either selling price or unit cost.

 129

CHAPTER CONTENTS

1. Concepts of mark-up and margin
2. Principles of marginal costing
3. Cost-plus pricing
4. Full cost-plus pricing
5. Marginal cost-plus pricing

LEARNING OUTCOME

1.5.1

1.5.1

1.5.1

1.5.1

1.5.1

1 Concepts of mark-up and margin

You may be required in your assessment to calculate profit, selling price or cost of sale of an item or number of items from certain information. To do this you need to remember the following crucial formula.

%

Profit may be expressed either as a percentage of cost of sales (such as 25% (25/100) mark-up) or as a percentage of sales (such as 20% (25/125) margin).

When you have this information, you can then use it in 2 different ways:

Cost Mark Up – this is where you know the cost of an introductory product so you can add the element of profit required to the cost to calculate the selling price.

Or

Profit Margin – which is what you would use for an established product and the market price can be used to calculate the profit element to give you a target cost.

Profit margins

If profit is expressed as a percentage of sales (margin) the following formula is also useful.

%

Selling price 100

Profit 20

Cost of sales 80

It is best to think of the selling price as 100% if profit is expressed as a margin (percentage of sales). On the other hand, if profit is expressed as a percentage of cost of sales (mark-up) it is best to think of the cost of sales as being 100%. The following examples should help to clarify this point.

Example: Margin

Delilah's Dresses sells a dress at a 10% margin. The dress cost the shop Rs. 1,000.

Required

Calculate the profit made by Delilah's Dresses.

Solution

The margin is 10% (ie 10/100)

 Let selling price = 100%

 Profit = 10%

 Cost = 90% = Rs. 1,000

 1% = Rs.1,000

90

 10% = profit =

Rs. 1,000 = Rs. 111.11 (and the selling price is Rs. 1,000 + 90  10

Rs. 111.11 = Rs. 1,111.11)

Example: mark-up

Trevor's Trousers sells a pair of trousers for Rs. 800 at a 15% mark-up.

Required

Calculate the profit made by Trevor's Trousers.

Solution

The mark-up is 15%.

 Let cost of sales = 100%

 Profit = 15%

 Selling price = 115% = Rs. 800

 1% = Rs. 800

115

 15% = profit = Rs. 800

115 15

= Rs. 104.35

QUESTION Profits

A skirt which cost the retailer Rs. 750 is sold at a profit of 25% on the selling price.

Required Calculate the profit.

A Rs. 187.50 B Rs. 200.00 C Rs. 250.00 D Rs. 300.00

ANSWER

Let selling price = 100% Profit = 25% of selling price

 Cost = 75% of selling price Cost = Rs. 750 = 75%

 1% = Rs. 750

75

 25% = profit =

Rs. 750 75 25

= Rs. 250.00

 The correct answer is C.

2 Principles of marginal costing

Introduction

The marginal costing philosophy is that profit measurement should be based on an analysis of total contribution; that is, sales value less the variable cost of sales.

Supporters of marginal costing argue that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.

The principles of marginal costing (also known as variable costing) are as follows:

1. Period fixed costs are the same for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen:

1. Revenue will increase by the sales value of the item sold
2. Costs will increase by the variable cost per unit
3. Profit will increase by the amount of contribution earned from the extra item
   2. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.
   3. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs.
   4. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

Before reviewing marginal costing principles any further, it will be helpful to remind yourself of the basics by looking at a numerical example.

Example

Water and Sons makes a product, the Splash, which has a variable production cost of Rs. 60 per unit and a sales price of Rs 100 per unit. At the beginning of September 20X0, there were no opening inventories and production during the month was 20,000 units. Fixed costs for the month were Rs. 300,000 for production and Rs. 150,000 for administration, sales and distribution. There were no variable marketing costs.

Required

Calculate the contribution and profit for September, using marginal costing principles, if sales were as follows:

1. 10,000 Splashes
2. 15,000 Splashes
3. 20,000 Splashes

The first stage in the profit calculation must be to identify the variable costs, and then the contribution. Fixed costs are deducted from the total contribution to derive the profit. All closing inventories are valued at marginal production cost (Rs. 60 per unit). Production during the month in all 3 cases is 20,000 units.

10,000 Splashes 15,000 Splashes 20,000 Splashes

The conclusions that may be drawn from this example are as follows:

1. The profit per unit varies at differing levels of sales, because the average fixed overhead cost per unit changes with the volume of output and sales.
2. The contribution per unit is constant at all levels of output and sales. Total contribution, which is the contribution per unit multiplied by the number of units sold, increases in direct proportion to the volume of sales.
3. Since the contribution per unit does not change, the most effective way of calculating the expected profit at any level of output and sales would be as follows:

1. Calculate the total contribution
2. Deduct fixed costs as a period charge in order to find the profit
   4. In our example, the expected profit from the sale of 17,000 Splashes would be as follows:

Rs’000

The marginal costing philosophy is that profit measurement should be based on an analysis of total contribution; that is, sales value less the variable cost of sales.

3 Cost-plus pricing

The usual method of establishing prices in a jobbing concern is cost-plus pricing.

Cost-plus pricing means that a desired profit margin is added to total costs to arrive at the selling price.

The estimated profit will depend on the particular circumstance of the job and organisation in question. In competitive situations the profit may be small, but if the organisation is sure of securing the job the margin may be greater. In general terms, the profit earned on each job should conform to the requirements of the organisation's overall business plan.

The final price quoted will, of course, be affected by what competitors charge and what the customer will be willing to pay.

Example: Selling price and unit cost

Product CT's unit cost is Rs. 150. A selling price is set based on a margin of 20%.

Required

Calculate the selling price.

Solution

Therefore selling price = Rs. 150 ÷ 80% = Rs. 187.50

• Example: Selling price and unit cost (2) Product HM's unit cost is Rs. 650. The mark up is 20%. Required

Calculate the selling price.

Solution

Therefore selling price = Rs. 650 × 120% = Rs. 780

Example: Selling price and unit cost (3)

Product JT's selling price is Rs. 935. The mark up is 10%.

Required

Calculate the unit cost.

Solution

Therefore unit cost = Rs. 935 ÷ 110% = Rs. 850

4 Full cost-plus pricing

In full cost-plus pricing the sales price is determined by calculating the full cost of the product and then adding a percentage mark-up for profit. The most important criticism of full cost-plus pricing is that it fails to recognise that since sales demand may be determined by the sales price, there will be a profit maximising combination of price and demand.

Full cost-plus pricing is a method of determining the sales price by calculating the full cost of the product and adding a percentage mark-up for profit.

Setting full cost-plus prices

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 rigid and 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.

QUESTION Full Cost-plus pricing

A business has begun to produce a new product, product X, for which the following cost estimates have been made.

Rs

Direct materials 270

Direct labour: 4 hours at Rs. 50 per hour 200

Variable production overheads: machining, ½ hr at Rs. 60 per hour 30

500

Production fixed overheads are budgeted at Rs. 3,000,000 per month and, because of the shortage of available machining capacity, the company will be restricted to 10,000 hours of machine time per month. The absorption rate will be a direct labour rate, however, and budgeted direct labour hours are 25,000 per month. It is estimated that the company could obtain a minimum contribution of Rs. 100 per machine hour on producing items other than product X.

The direct cost estimates are not certain as to material usage rates and direct labour productivity, and it is recognised that the estimates of direct materials and direct labour costs may be subject to an error of  15%. Machine time estimates are similarly subject to an error of  10%.

The company wishes to make a profit of 20% on full production cost from product X.

Required

Ascertain the full cost-plus based price.

Even for a relatively 'simple' cost-plus pricing estimate, some problems can arise, and certain assumptions must be made and stated. In this example, we can identify two problems:

1. Should the opportunity cost of machine time be included in cost or not?
2. What allowance, if any, should be made for the possible errors in cost estimates?

Different assumptions could be made.

ANSWER

Exclude machine time opportunity costs: ignore possible costing errors

Rs

Direct materials 270

Direct labour (4 hours) 200

Variable production overheads 30

Fixed production overheads

(at Rs. 3,000,000

25,000

= Rs.120 per direct labour hour)

480

Full production cost 980

Profit mark-up (20%) 196

Selling price per unit of product X 1,176

Include machine time opportunity costs: ignore possible costing errors

Rs

Full production cost as in (a) 980

Opportunity cost of machine time: contribution forgone (½ hr

 Rs.100) 50

Adjusted full cost 1,030

Profit mark-up (20%) 206

Selling price per unit of product X 1,236

Exclude machine time opportunity costs but make full allowance for possible underestimates of cost

1. Include machine time opportunity costs and make a full allowance for possible underestimates of cost

Rs

Potential full production cost as in (c) 1,125.5 Opportunity cost of machine time:

potential contribution forgone (½ hour  Rs. 100  110%) 55.0 Adjusted potential full cost 1,180.5

Profit mark-up (20%) 236.1

Selling price per unit of product X 1,416.6

Using different assumptions, we could arrive at any of four different unit prices in the range Rs 1,176.0 to Rs 1,416.6.

Problems with and advantages of full cost-plus pricing

There are several serious problems with relying on a full cost approach to pricing.

1. It fails to recognise that since demand may be determining price, there will be a profit-maximising combination of price and demand.
2. There may be a need to adjust prices to market and demand conditions.
3. Budgeted output volume needs to be established. Output volume is a key factor in the overhead absorption rate.
4. A suitable basis for overhead absorption must be selected, especially where a business produces more than one product.

However, it is a quick, simple and cheap method of pricing which can be delegated to junior managers (which is particularly important with jobbing work where many prices must be decided and quoted each day) and, since the size of the profit margin can be varied, a decision based on a price in excess of full cost should ensure that a company working at normal capacity will cover all of its fixed costs and make a profit.

5 Marginal cost-plus pricing

Marginal cost-plus pricing involves adding a profit margin to the marginal cost of production/sales. A marginal costing approach is more likely to help with identifying a profit-maximising price.

Marginal cost-plus pricing/mark-up pricing is a method of determining the sales price by adding a profit margin onto either marginal cost of production or marginal cost of sales.

QUESTION Marginal cost-plus pricing

A product has the following costs:

Rs

Fixed overheads are Rs. 100,000 per month. Budgeted sales per month are 400 units to allow the product to break even.

Required

Fill in the blank in the sentence below.

The mark-up which needs to be added to marginal cost to allow the product to break even is %.

ANSWER

The correct answer is 166 2/3%.

Breakeven point is when total contribution equals fixed costs. At breakeven point, Rs.100,000 = 400 (price – Rs. 150)

 Rs. 250 = price – Rs. 150

 Rs 400 = price

 Mark-up = ((400 – 150) /150)  100% = 166 2/3%

5.1 The advantages and disadvantages of a marginal cost-plus approach to pricing

The main advantages are as follows:

1. It is a simple and easy method to use.
2. The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect demand conditions.
3. It draws management attention to contribution, and the effects of higher or lower sales volumes on profit. In this way, it helps to create a better awareness of the concepts and implications of marginal costing and cost- volume-profit analysis. For example, if a product costs Rs.100 per unit and a mark-up of 150% is added to reach a price of Rs. 250 per unit, management should be clearly aware that every additional Rs. 10 of sales revenue would add Rs. 6 to contribution and profit.
4. In practice, mark-up pricing is used in businesses 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 adding a mark-up (20% or 33.3%, say) to the purchase cost.

There are, of course, drawbacks to marginal cost-plus pricing.

1. 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, competitors' prices and profit maximisation.
2. It ignores fixed overheads in the pricing decision, but the sales price must be sufficiently high to ensure that a profit is made after covering fixed costs.

CHAPTER ROUNDUP

⮎ The usual method of fixing prices within a jobbing concern is cost-plus pricing.

⮎ In full cost-plus pricing the sales price is determined by calculating the full cost of the product and then adding a percentage mark-up for profit. The most important criticism of full cost-plus pricing is that it fails to recognise that since sales demand may be determined by the sales price, there will be a profit- maximising combination of price and demand.

⮎ Marginal cost-plus pricing involves adding a profit margin to the marginal cost of production/sales. A marginal costing approach is more likely to help with identifying a profit-maximising price.

⮎ The marginal costing philosophy is that profit measurement should be based on an analysis of total contribution; that is, sales value less the variable cost of sales.

Supporters of marginal costing argue that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.

1. The cost of a job is Rs. 100,000

PROGRESS TEST

• If profit is 25% of the job cost, the price of the job = Rs………………
  • If there is a 25% margin, the price of the job = Rs…………………

1. Fill in the blanks.

1. One of the problems with relying on a full cost-plus approach to pricing is that it fails to recognise that since price may be determining demand, there will be a …………………….. combination of …………. and …………….
2. An advantage of the full cost-plus approach is that, because the size of the profit margin can be varied, a decision based on a price in excess of full cost should ensure that a company working at …………….. capacity will cover

…………….… and make a ………………..

1. Pricing based on mark-up per unit of limiting factor is particularly useful if an organisation is not working to full capacity.

True False

1 (a) Rs. 100,000 + (25%  Rs. 100,000) = Rs. 100,000 + Rs. 25,000 = Rs. 125,000

ANSWERS TO PROGRESS TEST

(b) Let price of job = x

 Profit = 25%  x (selling price)

If profit = 0.25x

x – 0.25x = cost of job

0.75x = Rs. 100,000

x = Rs. 100,000 0.75

= Rs. 133,333

1. (a) profit-maximising combination of price and demand

(b) working at normal capacity will cover all of its fixed costs and make a profit

1. False. It is useful if the organisation is working at full capacity.