10 Marginal Analysis Flashcards
Marginal REVENUE
Marginal PRODUCT
Marginal COST
MR
INCREMENTAL revenue by generating ONE MORE unit of OUTPUT
MP
Incremental OUTPUT obtained by adding ONE MORE UNIT of INPUT
MC
Marginal cost = incremental cost for one more unit of output. TYPICALLY DECREASE as process becomes MORE EFFICIENT (up to a point when it increases)
Profit is MAXIMIZED at the point where
Marginal Revenue = Marginal Cost
To make MARGINAL ANALYSIS meaningful, TOTAL COST broken down to FIXED and VARIABLE costs
See 10-4 Graph
**AVERAGE Fixed Costs DECLINE per unit as more output.
Total FIXED is DIVIDED BY more and more units
Average Fixed Cost decline with output
Average Total Costs decline then increase (pushed up by point where Average Variable INCREASES
ATC = AFC + AFC
Accounting v Economic COSTS
Accounting = Explicit Costs: ACTUAL cash outlays or commitment (eg Cash, Payables, DEPRECIATION RECOGNIZED)
Economic Costs: Includes BOTH Explicit and Implicit Costs.
Implicit Costs: Contribution to INCOME that is FORGONE by not using limited resource for NEXT BEST USE.
EXPLICIT versus IMPLICIT COSTS
Explicit: actual cash disbursements
Implicit = OPPORTUNITY COSTS (used for a purpose and NOT NEXT BEST ALTERNATIVE)
***THE TRUE HURDLE FOR AN ECONOMIC DECISION IS WHETHER REVENUES COVER EXPLICIT AND IMPLICIT COSTS.
Accounting V Economic PROFITS
Accounting PROFITS: Book Income greater than Book Expenses
Economic PROFITS (PURE profit): Income exceeds Explicit and IMPLICIT
RELEVANT versus IRRELEVANT Factors
RELEVANT MUST: Occur in the Future AND will Differ among options.
RELEVANT: Revenues and Costs must be>
1. Made in the FUTURE. SUNK or COMMITTED COSTS have no bearing.
- DIFFER among possible courses of action
Only AVOIDABLE Costs are Relevant
- Avoidable Costs: may be saved by not adopting a particular action (eg variable RM, Direct Labor)
Unavoidable: can’t be AVOIDED if PARTICULAR ACTION IS TAKEN. ie Long Term Lease.
INCREMENTAL (MARGINAL OR DIFFERENTIAL) Costs: are inherent in the concept of Relevance.
- in the RELEVANT RANGE, The INCREMENTAL Cost of an additional unit is the same. Once a certain level is reached, Capacity is insufficient. New Shift (additional foreman, (fixed) more DL. Second shift is outside the relevant ranage.
Quantitative Analysis
- Focuses in INCREMENTAL revenues and costs (Not Totals) for an option.
Contribution Margin is used PER UNIT OF CONSTRAINT. (CM = Rev - Variable)
- The CONSTRAINT is any measure of activity (DL, Machine Hours that DRIVES THE COSTS)
***When a constraint is LIMITED or UNAVAILABABLE, direct resources to the HIGHEST CM per UNIT OF CONSTRAINT (OPTIMUM STRATEGY). Remaining units used for next highest Contribution Margin.
QUALITATIVE Factors to consider in Marginal Anslysis
RR, QES,DG
- Special price concessions trigger Robinson-Portman act of 1936
- Govt contract regulations apply
- Sales to special customer affect sales in regular market
- Regular customers learn of special price and demand same
- Disinvestment (dropping) product line, hurts sales in other product lines
- Outsourced product Quality is acceptable and Reliable
- EE morale; layoffs or too many hours
SPECIAL ORDERS
in general
BIDS should be made at Prices that MEET or EXCEED Incremental COST.
- Lower than incremental costs can lower profit; however lower bids are more competitive.
**If available capacity exists, fixed cost irrelevant
**Mgt must be assured acceptance of special order will not affects Sales at normal prices; reg customers demand same.
Special Orders: Available Capacity Exists
- NO Opportunity Cost Involved because FIXED COSTS already committed when capacity available. FIXED costs Irrelevant
***Accept order if Minimum PRICE = VARIABLE Costs. Profit = 0. This is LOWEST acceptable bid.
Special orders: No available Capacity
**Marginal (Incremental, Differential) costs must be considered.
**Variable AND Opportunity Costs must be considered. (Cost of redirecting resources)
**Fixed Costs are Committed BUT production of EXISTING is Reduced to fill special. So:
Revenue, Variable Costs, Fixed Cost related to Reduced production RELEVANT
**In addition: Revnue LOST, from reducing OTHER PRODUCTION is RELEVANT
MAKE or BUY (Outsource)
- Use available as efficiently as possible BEFORE outsourcing.
1. If Relevant COSTS are LESS than cost buy > Make in House
2.If Relevant Costs are MORE than cost to buy> Outsource
**Look at Relevant Costs: Not TOTAL Costs. > Variable + AVOIDABLE Fixed.
Ignore: Sunk, Costs that do not DIFFER between alternatives
**Qualitative: Product Quality, Reliability
RELEVANT COST: TOTAL of all AVOIDABLE (Var plus Avoidable part of Fixed)
SEE next for Make or Buy No Idle Capacity
MAKE or BUY (Outsource)
- Use available as efficiently as possible BEFORE outsourcing.
1. If Relevant COSTS are LESS than cost buy > Make in House
2.If Relevant Costs are MORE than cost to buy> Outsource
**Look at Relevant Costs: Not TOTAL Costs. > Variable + AVOIDABLE Fixed.
Ignore: Sunk, Costs that do not DIFFER between alternatives
**Qualitative: Product Quality, Reliability
RELEVANT COST: TOTAL of all AVOIDABLE (Var plus Avoidable part of Fixed)
SEE next for Make or Buy No Idle Capacity
Make or Buy: No Idle Capacity
**Opportunity Costs must be considered.
ie
1. make or buy with Var + Avoidable Fixed but also opportunity cost (income from new product which could be produced)
Sell “AS IS” or Process Further
Two Methods
Regaular
Incremental
**Sell at Split Off, “Joint Cost” (common costs) is IRRELEVANT (It is SUNK)
**Costs after Split-Off are Separable (Relevant).
After split (on two products)
- Direct to each individual Costs (further processing) and,
- Allocated between the two Joint costs after split off. using allocation formula of:
Sales Value of (X/X+Y) x $ joint cost to be allocated (repeat for Y)
Sales
- direct further processing
- allocated further processing
= Profit after further processing
compare to
Sales
- Allocated joint
= profit with No further processing
INCREMENTAL APPROACH
(Use Marginal Analysis)
1. Incremental Revenue > Incremental Cost = Process Further
2. Incremental Revenue
