Objectives of Financial Analysis
- Pricing Decision
- Profit Planning and Maintaining the Desired Level of Profit.
- Make or Buy Decisions.
- Problems of key or Limiting Factors,
- Selection of a suitable or Profitable sale Mix.
- Effect of changes in sales price.
- Alternative Methods of Production.
- Determination of the optimum level of activity.
- Evaluation of performance.
- Capital Investment decision.
1) Pricing Decision: Fixing selling prices is one of the most critical functions of management. Although processes are generally determined by market conditions and other economic factors yet marginal costing technique assists the control in the fixation of selling prices under various circumstances as:
- Pricing under normal conditions
- During stiff competition during the trade depression
- During trade depression
- For accepting special bulk orders
- For accepting additional orders utilizing idle capacity.
- Accept export orders and investigate new markets.
2) Profit Planning and Maintaining the Desired Level of Profit: Marginal costing techniques can be applied for profit planning as well. Planning future activities to maximize profits or maintain a target level of profits is known as profit planning. The profitability of a business is impacted by changes in sales price, variable costs, and product mix. Because fixed costs are included in the overall cost in absorption costing, the impact of such changes on a company’s earnings is not revealed. The required value of sales for sustaining or achieving a desired level of profit can be calculated using marginal costing as follows:
3) Make or Buy Decisions: Sometimes a business must choose whether to manufacture a specific product or component on-site (using idle manufacturing facilities) or to purchase it from a company that specializes in it. When faced with such a “make or buy” choice, marginal costing is a highly helpful method. When selecting whether to “make or buy,” it is important to distinguish between fixed and variable costs. The variable manufacturing cost should then be contrasted with the cost at which this component or product can be purchased from a third party. If the variable (marginal) cost of the good or component is less than the purchase price, it is better to create it rather than buy it. But if the purchase price is lower than the marginal cost, it would be better to buy than to make it. However, this decision is based upon the assumption that fixed expenses do not increase and production facilities cannot be employed for more profitability. A concern might also be forced to make rather than buy due to irregular outside supply, the revelation of trade secrets, a lack of surplus capacity, and other factors.
4) Problems of Key or Limiting Factors: A limiting factor is a factor that restricts or limits sales or production, which eliminates the worry of generating endless profits. Any production aspect, including the availability of raw materials, labor, capital, plant capacity, and even sales, maybe the limiting factor. If a company has two or more product lines and a key or limiting element, it may become difficult to decide which product should be produced more to best use the limiting factor and increase earnings. When the limiting factor is in operation. The criterion to evaluate a product’s profitability should be contribution per unit of limiting factor. The product gives the highest contribution per unit of limiting factor. When two or more limiting factors are in play, all of them must be taken into account.
5) Selection of a suitable or Profitable sale Mix: When a concern manufactures more than one product, a problem often arises regarding the product mix or the sales mix that will yield the maximum profits. The products that contribute the most should be retained, and their production should be enhanced when determining the ideal or lucrative sales mix. Products that contribute relatively less should have their manufacturing scaled back or stopped altogether. The combination of products that generates the highest contribution is the ideal sales mix. If there is a limiting factor, its contribution per unit should be taken into account when determining a product’s profitability.
6) Effect of changes in sales price: Management is generally confronted with the problem of analyzing the effect of changes in sales price upon the profitability of the concern. It may be required to reduce the prices on account of the competition, depression, and expansion programs of government regulations. The effect of changes in sales prices can be easily analyzed with the help of the contribution technique.
7) Alternative Methods of Production: The management may occasionally have to decide between different production methods, such as handwork or machine work. The management may have to choose between producing the identical product using Machine No. 1 or Machine No. 2, which presents a choice challenge. In these situations, the marginal costing methodology can be used, and the method that contributes the most can be chosen while keeping the limiting factor in mind of course.
8) Determination of the optimum level of activity: Marginal costing is a technique that aids management in choosing the right amount of work. It is possible to find contributions at various activity levels to help with this decision, and the level of activity that provides the most significant contribution will be the ideal level. Up until the marginal cost does not exceed the selling price, the production story can be raised.
9) Evaluation of performance: The marginal costing technique can also be used to assess the effectiveness of various departments, product lines, or markets. To increase earnings, management may occasionally have to decide to stop producing certain items or operating certain departments. It is conceivable to evaluate the contributions of different products, sales divisions, or departments in these circumstances, and the one that makes the smallest relative contribution to sales—the one with the lowest P/V ratio, therefore, ought to be dropped. The application of the marginal costing technique to assess the effectiveness of various goods or departments is demonstrated in the example that follows.
10) Capital Investment decision: The technique of marginal costing also helps the management in taking capital investment decisions. Such decisions are very crucial for management and the topic of capital investment decisions has been separately discussed here. However, a simple example is given below to illustrate how marginal costing techniques can be used while making such decisions.