For manufacturing businesses, there may be times of the year when there is more capacity than required, and this means that goods can be sold at a lower price than normal.
To see how much profit can be made from doing this, it is necessary to consider the contribution to be made from sales as a whole, rather than per product. This is done by switching from absorption costing to special order marginal costing, which is often used for short term financial decision-making.
Let’s look at an example. A company that manufactures printers produces 200 printers each week, and sells them for £350 each.
The weekly costs of producing each printer are as follows:
- Direct materials at £55 per product = £11,000
- Direct labour at £70 per product = £14,000
- Fixed production overheads at £30,000 in total
Therefore, the total cost of producing 200 printers is £55,000. If we divide this by the number of units produced (200), then we get the absorption cost of £275 per unit.
We can now work out the profit the company makes from selling its products.
The selling price of each product (£350) multiplied by the number of products sold (200) = £70,000. We then need to subtract production costs, as worked out above.
£70,000 minus production costs of £55,000 brings us to a final weekly profit of £15,000.
Marginal costing: special order pricing
We have been asked to increase production by 50 units, and sell them at £200. Using absorption costing, we would not be able to produce the additional 50 units and sell them at £200, as this is £75 less than the cost.
To work out how much profit can be made from this, special price marginal costing is used. We need to see, once the regular sales have covered the break- even point, how much contribution the special price goods can make.
- 200 printers at £350 = 70,000
- 50 printers at £200 = 10,000
- Total revenue = £80,000
Now let’s subtract the production costs:
- Direct materials for 250 products, at £55 per product = £13,750
- Direct labour for 250 products at £70 per product = £17,500
- Production overheads = £30,000
Total costs = £61,250
£80,000 minus £61,250 makes a profit of £18,750. So, using marginal costing we have increased the profit by £3,750, rather than losing £75 per unit.
A knowledge of marginal costing and special order pricing is required for most accounting roles, both financial and management. You can develop your knowledge of the topic, and gain a professional qualification, by studying for the AAT Level 3 Advanced Diploma in Accounting. Special order marginal costing is covered in depth within the Costs and Revenues unit. Find out more by enquiring below.