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# Marginal costing

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### Marginal costing

1. 1. TOPICS 1. Marginal costing 2. Marginal cost 3. Relationship b/w marginal costing and economies of scale 4. Relevance of marginal private and social costs in marginal cost theory 5. Features of marginal costing system 6. Advantages of marginal costing system 7. Disadvantages of marginal costing system 8. Marginal costing as a management accounting tool 9. Elements of decision making 10.Relevant costs of decision making 11.Basic decision making indicators in marginal costing o Profit volume ratio o Cash volume profit analysis o Break-even analysis o Margin of safety o Shut down point 12.Cash position and forecast 13.Profit and loss forecast 14.Profit planning oMARGINAL COSTING AS A COSTING SYSTEM
2. 2. Marginal Costing is a type of flexible standard costing thatseparates fixed costs from proportional costs in relation to theoutput quantity of the objects. In particular, Marginal Costing is acomprehensive and sophisticated method of planning andmonitoring costs based on resource drivers. Selecting the resourcedrivers and separating the costs into fixed and proportionalcomponents ensures that cost fluctuations caused by changes inoperating levels, as defined by marginal analysis, are accuratelypredicted as changes in authorized costs and incorporated intovariance analysis.This form of internal management accounting has become widelyaccepted in business practice over the last 50 years. During thistime, however, the demands placed on costing systems by costmanagement requirements have changed radically.MARGINAL COSTIn economics and finance, marginal cost is the change in total costthat arises when the quantity produced changes by one unit. It isthe cost of producing one more unit of a good.[1] Mathematically, themarginal cost (MC) function is expressed as the first derivative ofthe total cost (TC) function with respect to quantity (Q). Note thatthe marginal cost may change with volume, and so at each level ofproduction, the marginal cost is the cost of the next unit produced.A typical Marginal Cost Curve
3. 3. In general terms, marginal cost at each level of production includesany additional costs required to produce the next unit. If producingadditional vehicles requires, for example, building a new factory, themarginal cost of those extra vehicles includes the cost of the newfactory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At eachlevel of production and time period being considered, marginal costsinclude all costs which vary with the level of production, and othercosts are considered fixed costs.A number of other factors can affect marginal cost and itsapplicability to real world problems. Some of these may beconsidered market failures. These may include informationasymmetries, the presence of negative or positive externalities,transaction costs, price discrimination and others.RELATION BETWEEN MARGINAL COST AND ECONOMIES OFSCALE • Production may be subject to economies of scale (or diseconomies of scale). Increasing returns to scale are said to exist if additional units can be produced for less than the previous unit, that is, average cost is falling. • This can only occur if average cost at any given level of production is higher than the marginal cost. • Conversely, there may be levels of production where marginal cost is higher than average cost, and average cost will rise for each unit of production after that point. This type of production function is generally known as diminishing marginal productivity: at low levels of production, productivity gains are easy and marginal costs falling, but productivity gains become smaller as production increases; eventually, marginal costs rise because increasing output (with existing capital, labour or organization) becomes more expensive. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the two curves intersect); this point will not be at the minimum for marginal cost if fixed costs are greater than zero.  Short and long run marginal costs and economies of scaleThe former takes as unchanged, for example, the capital equipmentand overhead of the producer, any change in its productioninvolving only changes in the inputs of labour, materials and energy.
4. 4. The latter allows all inputs, including capital items (plant,equipment, buildings) to vary.A long-run cost function describes the cost of production as afunction of output assuming that all inputs are obtained at currentprices, that current technology is employed, and everything is beingbuilt new from scratch. In view of the durability of many capitalitems this textbook concept is less useful than one which allows forsome scrapping of existing capital items or the acquisition of newcapital items to be used with the existing stock of capital itemsacquired in the past. Long-run marginal cost then means theadditional cost or the cost saving per unit of additional or reducedproduction, including the expenditure on additional capital goods orany saving from disposing of existing capital goods. Note thatmarginal cost upwards and marginal cost downwards may differ, incontrast with marginal cost according to the less useful textbookconcept.Economies of scale are said to exist when marginal cost accordingto the textbook concept falls as a function of output and is less thanthe average cost per unit. This means that the average cost ofproduction from a larger new built-from-scratch installation fallsbelow that from a smaller new built-from-scratch installation. Underthe more useful concept, with an existing capital stock, it isnecessary to distinguish those costs which vary with output fromaccounting costs which will also include the interest anddepreciation on that existing capital stock, which may be of adifferent type from what can currently be acquired in past years atpast prices. The concept of economies of scale then does not apply.  ExternalitiesExternalities are costs (or benefits) that are not borne by the partiesto the economic transaction. A producer may, for example, pollutethe environment, and others may bear those costs. A consumer mayconsume a good which produces benefits for society, such aseducation; because the individual does not receive all of thebenefits, he may consume less than efficiency would suggest.Alternatively, an individual may be a smoker or alcoholic andimpose costs on others. In these cases, production or consumptionof the good in question may differ from the optimum level.
5. 5.  Negative externalities of productionNegative Externalities of ProductionMuch of the time, private and social costs do not diverge from oneanother, but at times social costs may be either greater or less thanprivate costs. When marginal social costs of production are greaterthan that of the private cost function, we see the occurrence of anegative externality of production. Productive processes that resultin pollution are a textbook example of production that createsnegative externalities.Such externalities are a result of firms externalizing their costs ontoa third party in order to reduce their own total cost. As a result ofexternalizing such costs we see that members of society will benegatively affected by such behavior of the firm. In this case, wesee that an increased cost of production on society creates a socialcost curve that depicts a greater cost than the private cost curve.In an equilibrium state we see that markets creating negativeexternalities of production will overproduce that good. As a result,the socially optimal production level would be lower than thatobserved.Positive externalities of productionPositive Externalities of ProductionWhen marginal social costs of production are less than that of theprivate cost function, we see the occurrence of a positive externalityof production. Production of public goods are a textbook example ofproduction that create positive externalities. An example of such a
6. 6. public good, which creates a divergence in social and private costs,includes the production of education. It is often seen that educationis a positive for any whole society, as well as a positive for thosedirectly involved in the market.Examining the relevant diagram we see that such productioncreates a social cost curve that is less than that of the private curve.In an equilibrium state we see that markets creating positiveexternalities of production will under produce that good. As a result,the socially optimal production level would be greater than thatobserved.Social costsOf great importance in the theory of marginal cost is the distinctionbetween the marginal private and social costs. The marginal privatecost shows the cost associated to the firm in question. It is themarginal private cost that is used by business decision makers intheir profit maximization goals, and by individuals in theirpurchasing and consumption choices. Marginal social cost is similarto private cost in that it includes the cost functions of privateenterprise but also that of society as a whole, including parties thathave no direct association with the private costs of production. Itincorporates all negative and positive externalities, of bothproduction and consumption.Hence, when deciding whether or how much to buy, buyers takeaccount of the cost to society of their actions if private and socialmarginal cost coincide. The equality of price with social marginalcost, by aligning the interest of the buyer with the interest of thecommunity as a whole is a necessary condition for economicallyefficient resource allocation.Other cost definitions in marginal costing • Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable. • Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the level of output, for example, labour, fuel, power and cost of raw material. • Social costs of production are costs incurred by society, as a whole, resulting from private production. • Average total cost is the total cost divided by the quantity of output. • Average fixed cost is the fixed cost divided by the quantity of output.
7. 7. • Average variable cost are variable costs divided by the quantity of output. What is Marginal Costing? It is a costing technique where only variable cost or direct cost will be charged to the cost unit produced. Marginal costing also shows the effect on profit of changes in volume/type of output by differentiating between fixed and variable costs. Salient Points: • Marginal costing involves ascertaining marginal costs. Since marginal costs are direct cost, this costing technique is also known as direct costing; • In marginal costing, fixed costs are never charged to production. They are treated as period charge and is written off to the profit and loss account in the period incurred; • Once marginal cost is ascertained contribution can be computed. Contribution is the excess of revenue over marginal costs. • The marginal cost statement is the basic document/format to capture the marginal costs.Features of Marginal Costing System: • It is a method of recording costs and reporting profits; • All operating costs are differentiated into fixed and variable costs; • Variable cost â€“charged to product and treated as a product cost whilst • Fixed cost treated as period cost and written off to the profit and loss account
8. 8. Disadvantages Of Marginal Costing • Marginal cost has its limitation since it makes use of historical data while decisions by management relates to future events; • It ignores fixed costs to products as if they are not important to production; • Stock valuation under this type of costing is not accepted by the Inland Revenue as itâ€™s ignore the fixed cost element; • It fails to recognize that in the long run, fixed costs may become variable; • Its oversimplified costs into fixed and variable as if it is so simply to demarcate them; • Itâ€™s not a good costing technique in the long run for pricing decision as it ignores fixed cost. In the long run, management must consider the total costs not only the variable portion; • Difficulty to classify properly variable and fixed cost perfectly, hence stock valuation can be distorted if fixed cost is classify as variable. MARGINAL COSTING AS A MANAGEMENT ACCOUNTINGTOOL1. Marginal Costing is clearly the core aspect of traditionalmanagement accounting. Some of the classical applications ofmanagement accounting, however, have begun to lose theirsignificance. The question thus arises: What is the current role ofMarginal Costing in modern management accounting?2. Businesses today frequently voice their disapproval of thetraditional cost accounting approaches. At the beginning of the1990s, these criticisms were taken up by researchers involved withthe applications of cost accounting concepts. The main thrust of the dissatisfaction with conventional costaccounting methods is that they are too highly developed and too
9. 9. complex, and furthermore are no longer needed in their currentform since other tools are now available. Calls for increased use ofcost management tools, investment analyses, and value-based toolconcepts are frequently associated with criticism of the functionalityof current cost accounting approaches as management tools. Thisline of criticism sees little relevance in traditional cost accountingtasks such as monitoring the economic production process orassigning the costs of internal activities. At their current level ofdetail, such tasks are neither necessary nor does their perceivedpseudo accuracy further the goals of management. The viewpoint of the present author is that cost accounting has byno means lost its right to exist, for it is an easily overlooked fact thatthe data structure required by the new tools is already present intraditional cost accounting.3. To assess the present-day value of Marginal Costing, the changesoccurring in the business world must be analyzed more closely. Weneed first to look at how the purposes of cost accounting areshifting before we can determine its significance. (i) cost planning takes precedence over cost control. Theeffort involved in planning and monitoring costs is increasinglybeing seen as excessive. The charge levied against traditional costaccounting--that its complex cost allocations merely generate a kindof pseudo precision--lends further credence to this assessment. Analternative increasingly being called for is to control costs throughdirect activity/process information (quantities, times, quality) forcost management at local, decentralized levels instead of relying ondelayed and distorted cost data. In particular, empirical U.S.research on appropriate variables for performance measurement, inthe context of continuous improvement and modern managerialconcepts, is based on this view. The need for exact cost planningfor profitability management is thus touched on ex ante. (ii) cost accounting must be employed as a tool for costcontrol at an early stage. The relative significance of traditional costaccounting as a management accounting tool will decline as it isapplied mainly to fields where costs cannot be heavily influenced.More significant than influencing the current costs of production withcost center controlling and authorized-actual comparisons of thecost of goods manufactured is timely and market-based authorizedcost management. The greatest scope for influencing costs is at the
10. 10. early product development phase and when setting up theproduction processes. At the same time, this is the stage where costinformation is most urgently needed since the time and quantitystandards as defined by Bills of Materials (BOMs) and productionroutings are still lacking. This requires different methods of costplanning than those normally provided by Marginal Costing. (iii) the behavioural effect of cost information is starting tobe recognized. There is a strong current of accounting research inthe U.S. that takes human psychological factors into consideration.This is resulting in an extension of cost theory beyond its puremicroeconomic basis. Results of theoretical and empirical researchbased, for example, on the principal-agent theory indicate thatknowledge of the "relevant" costs does not always lead to theoptimization of overall enterprise profitability. Hence, theperspective that formed the basis for the absorption costing issuehas changed. Theories according to which cost allocations cancontain information and increase the efficiency of the use ofavailable capacity, or where future allocations can influence ex-antedecisions, require empirical research.4. The shift in the purposes of cost accounting is beingaccompanied by a shift in the main applications of standard costing.Costing solutions for market-oriented profitability management andlife-cycle-based planning and monitoring should be developedfurther. They should be implemented both in indirect areas and atthe corporate level. In addition, cost accounting must be integratedinto performance measurement.Competitive dynamics are giving rise to an increasing differentiationof market-based profitability controlling. This applies to themanagement of the profitability of products and product lines, aswell as distribution channels and increasingly customers, customergroups, and markets. The information required for this purpose canonly be supplied by multilevel and multidimensional marketingsegment accounting based on contribution margin accounting.Long-term cost planning based on the idea of lifecycle costing isgaining in prominence compared with short-term standard costing.Product decisions are increasingly based on more than just the costof goods manufactured and sales costs and now tend to include pre-production costs (such as development costs) and phasing-out costs(such as disposal costs). Product decisions are viewed strategically.
11. 11. Whether or not a product is successful is determined by theamortization of its overall cost. Furthermore, the cost and revenuetrend forecasts should be more dynamic to support the lifecyclepricing policy. This shift in cost and revenue planning is moving costand revenue accounting in the direction of investment-relatedcalculations.As management accounting is increasingly applied to the growingshare of the costs of indirect areas, the tool requirements increase.After J. G. Millers and T. E. Vollmanns discovery of the "hiddenfactory" as an area whose costs are neglected by conventionalproduction costing in the U.S., it was only a small step to theidentification of the lost relevance of conventional cost accountingby H. T. Johnson and R. S. Kaplan and their call to developaccounting systems separated into "process control, productcosting, and financial reporting," which eventually led to activity-based costing. Improving the cost transparency of indirect activityareas through Marginal Costing requires a thorough understandingof the output processes. Analysis frequently shows that even manysupport activities have a wide range of repetitive processes forwhich planning and cost allocation using drivers is worthwhile,providing the cost-volume is large enough. For this purpose, thedifferent operations in the cost centers must be identified, for whichresource consumption is then planned and tracked. The number ofthese operations is used as the driver. This process of costingoperations using proportional costs competes with the attempt toachieve better cost transparency in indirect areas with processcosting tools to also improve the planning and control of costs thatwere previously budgeted only as a lump sum.Industrial production and marketing are increasingly being handledby groups of affiliated companies. To plan and monitor the costs ofthese activities calls for the establishment of independent groupcost accounting. This necessity results mainly from therequirements of inventory valuation, the costing basis of transferprices, and to further the consistency of corporate cost accounting.Group cost accounting leads to the definition of independent groupcost categories. Marginal Costing and its tools have been developedfor individual companies and are the suitable platform for thisexpansion.Performance measures are gaining increasing prominence indecentralized management accounting. Standard U.S. management
12. 12. books devote a great deal of space to performance measurement inthe broad sense of the word. The concept is broad for the reasonthat performance measurement is accompanied by the provision ofdecision-support information, the management of business units,and the use of incentive systems. Using modelling and empiricalresearch, the exponents of this area are developing the idea thatmonetary factors are not the only possible components ofperformance measurement.Since the 1980s there has been a growing consciousness of thesignificance of continuously improving the performance capabilitiesof the company, resulting in the increased importance ofnonmonetary indicators. The recent literature on performancemeasurement has focused on problems in the following areas:* The usability of performance information for managers,* The assessment of teamwork,* The motivational effects of performance measurement,* The strategic dimension.The tenor of the recent investigations into performancemeasurement reflects the general criticism of managementaccounting voiced by Johnson and Kaplan in Relevance Lost. It wasrecognized that short-term accounting information is insufficient toevaluate and control company activities effectively. In particular, itwas acknowledged that the use of standard costs does notadequately take performance improvements into consideration.Moreover, the conventional allocation approach based on theoperating rate encourages high utilization of capacity at any cost,underestimates the problem of increasing numbers of variants, usesthe wrong overhead allocation base, and fails to appreciateinterdepartmental interrelationships.While top management benefits most from financial successindicators that it examines in monthly or longer intervals and thatcan consist of multidimensional aggregate figures, lowermanagement must necessarily be concerned mainly withnonfinancial, operational, and very short-term data at the day orshift level. In concrete terms, measures in the categories of time,quantity, and quality--such as equipment downtime, lead time,
13. 13. response time, degree of utilization (ratio of actual output quantityto planned output quantity), sales orders, and error rate--arebecoming increasingly significant for controlling business processes.In the strategic dimension, the Balanced Scorecard developed byKaplan and Norton--which links financial and nonfinancial indicatorsfrom different strategically relevant perspectives including cause-effect chains--is the main proposal under consideration forperformance measurement. The Balanced Scorecard links strategiccontingencies to financial measures, incorporates success factors ofthe future, and explicitly includes monetary and nonmonetaryparameters. The Balanced Scorecard therefore provides aframework for systematic mapping and control of the criticalsuccess factors for an enterprise. A Balanced Scorecard is a systemthat defines objectives, measures, targets, and initiatives for each ofthe four perspectives of financial, customer, internal businessprocess, and learning and growth. Further analyses and experiencein measuring performance can enable identification and assessmentof cause-effect relationships within the four perspectives (such asthe effect of delivery time on customer satisfaction) and betweenthe perspectives (such as the effect of customer satisfaction onprofitability). The knowledge so gained may eventually lead to areformulation of strategy.In the context of comprehensive performance measurement, evenshort-term costs and financial results can serve as controlinstruments for strategic enterprise management, such as a lowerauthorized cost of goods manufactured as a benchmark. Concreteplanned costs and planned results must be rigorously derived fromhigher-level target factors so that specific requirements can bederived in turn when they are broken down into smallerorganizational units for the time and quantity standards.Information for decision making The need for a decision arises inbusiness because a manager is faced with a problem and alternativecourses of action are available. In deciding which option to choosehe will need all the information which is relevant to his decision; andhe must have some criterion on the basis of which he can choosethe best alternative. Some of the factors affecting the decision maynot be expressed in monetary value. Hence, the manager will haveto make qualitative judgements, e.g. in deciding which of twopersonnel should be promoted to a managerial position. Aquantitative decision, on the other hand, is possible when thevarious factors, and relationships between them, are measurable.This chapter will concentrate on quantitative decisions based on
14. 14. data expressed in monetary value and relating to costs andrevenues as measured by the management accountant.Elements of a decisionA quantitative decision problem involves six parts:a) An objective that can be quantified Sometimes referred to aschoice criterion or objective function, e.g. maximisation of profitor minimisation of total costs.b) Constraints Many decision problems have one or moreconstraints, e.g. limited raw materials, labour, etc. It is thereforecommon to find an objective that will maximise profits subject todefined constraints.c) A range of alternative courses of action under consideration.For example, in order to minimise costs of a manufacturingoperation, the available alternatives may be:i) to continue manufacturing as at presentii) to change the manufacturing methodiii) to sub-contract the work to a third party.d) Forecasting of the incremental costs and benefits of eachalternative course of action.e) Application of the decision criteria or objective function, e.g. thecalculation of expected profit or contribution, and the ranking ofalternatives.f) Choice of preferred alternatives.Relevant costs for decision makingThe costs which should be used for decision making are oftenreferred to as "relevant costs". CIMA defines relevant costs as costsappropriate to aiding the making of specific management decisions.To affect a decision a cost must be:a) Future: Past costs are irrelevant, as we cannot affect them bycurrent decisions and they are common to all alternatives that wemay choose.b) Incremental: Meaning, expenditure which will be incurred oravoided as a result of making a decision. Any costs which would beincurred whether or not the decision is made are not said to beincremental to the decision.
15. 15. c) Cash flow: Expenses such as depreciation are not cash flowsand are therefore not relevant. Similarly, the book value of existingequipment is irrelevant, but the disposal value is relevant.Other terms:d) Common costs: Costs which will be identical for all alternativesare irrelevant, e.g. rent or rates on a factory would be incurredwhatever products are produced.e) Sunk costs: Another name for past costs, which are alwaysirrelevant, e.g. dedicated fixed assets, development costs alreadyincurred.f) Committed costs: A future cash outflow that will be incurredanyway, whatever decision is taken now, e.g. contracts alreadyentered into which cannot be altered.Opportunity costRelevant costs may also be expressed as opportunity costs. Anopportunity cost is the benefit foregone by choosing one opportunityinstead of the next best alternative.ExampleA company is considering publishing a limited edition book bound ina special leather. It has in stock the leather bought some years agofor \$1,000. To buy an equivalent quantity now would cost \$2,000.The company has no plans to use the leather for other purposes,although it has considered the possibilities:a) of using it to cover desk furnishings, in replacement for othermaterial which could cost \$900b) of selling it if a buyer could be found (the proceeds are unlikely toexceed \$800).In calculating the likely profit from the proposed book beforedeciding to go ahead with the project, the leather would not becosted at \$1,000. The cost was incurred in the past for some reasonwhich is no longer relevant. The leather exists and could be used onthe book without incurring any specific cost in doing so. In using theleather on the book, however, the company will lose theopportunities of either disposing of it for \$800 or of using it to savean outlay of \$900 on desk furnishings.The better of these alternatives, from the point of view of benefitingfrom the leather, is the latter. "Lost opportunity" cost of \$900 will
16. 16. therefore be included in the cost of the book for decision makingpurposes.The relevant costs for decision purposes will be the sum of:i) avoidable outlay costs, i.e. those costs which will be incurred onlyif the book project is approved, and will be avoided if it is notii) the opportunity cost of the leather (not represented by any outlaycost in connection to the project).This total is a true representation of economic cost.Now attempt exercise 5.1.The assumptions in relevant costingSome of the assumptions made in relevant costing are as follows:a) Cost behaviour patterns are known, e.g. if a department closesdown, the attributable fixed cost savings would be known.b) The amount of fixed costs, unit variable costs, sales price andsales demand are known with certainty.c) The objective of decision making in the short run is to maximisesatisfaction, which is often known as short-term profit.d) The information on which a decision is based is complete andreliable.THE BASIC DECISION MAKING INDICATORS INMARGINAL COSTING • PROFIT VOLUME RATIO • BREAK- EVEN POINT • CASH VOLUME PROFIT ANALYSIS • MARGIN OF SAFETY • INDIFFERENCE POINT
17. 17. • SHUT – DOWN POINTPROFIT VOLUME RATIO (P V RATIO )The profit volume ratio is the relationship between the Contributionand Sales value.It is also termed as Contribution to Sales RatioFormula : P V Ratio = Contribution X 100 SalesSignificance of PV Ratio • It is considered to be the basic indicator of profitability of business. • The higher the PV Ratio, the better it is for the business. In the case of the firm enjoying steady business conditions over a period of years, the PV Ratio will also remain stable and steady. • If PV Ratio is improved, it will result in better profits.Improvement of PV Ratio • By reducing the variable costs. • By increasing the selling price • By increasing the share of products with higher PV Ratio in the overall sales mix. (where a firm produces a number of products)Use of PV Ratio • To compute the variable costs for any volume of sales • To measure the efficiency or to choose a most profitable line. The overall profitability of the firm can be improved by
18. 18. increasing the sales/output of product giving a higher PV Ratio. • To determine the Break – Even Point and the level of output required to earn a desired profit. • To decide the most profitable sales – mix.BREAK – EVEN ANALYSIS • Break-Even Analysis is a mathematical technique for analyzing the relationship between sales and fixed and variable costs. Break-even analysis is also a profit-planning tool for calculating the point at which sales will equal total costs. • The break-even point is the intersection of the total sales and the total cost lines. This point determines the number of units produced to achieve breakeven. • The analysis generally assumes linearity (100% variable or 100% fixed) of costs. If a firm’s costs were all variable, the firm could be profitable from the start. If the firm is to avoid losses, its sales must cover all costs that vary directly with production and all costs that do not change with production levels. • Fixed costs are those expenses associated with the project that you would have to pay whether you sold one unit or 10,000 units. Examples include general office expenses, rent, depreciation, interest, salaries, research and development, and utilities. Variable costs vary directly with the number of units that you sell. Examples include materials, direct labour, postage, packaging, and advertising. Some costs are difficult to classify. As a general guideline, if there is a direct relationship between cost and number of units sold, consider the cost variable. If there is no relationship, then consider the cost fixed. • A break-even chart is constructed with a horizontal axis representing units produced and a vertical axis representing sales and costs. Represent fixed costs by a horizontal line since they do not change with the number of units produced. Represent variable costs and sales by upward sloping lines since they vary with the number of units produced and sold. The break-even point is the intersection of the total sales and the total cost lines. Above that point, the firm begins to make a profit, but below that point, it suffers a loss. Here is a sample break-even chart:
19. 19. The algebraic equation for break-even analysis consists of four factors. If you know any three of the four, you can solve for the fourth factor. You calculate the break-even amount with the following equation: Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable Costs per Unit * Quantity Sold] For example, assume you have total fixed monthly costs of \$1200 and total variable costs of \$6 per unit. If you could sell the units for \$10 each, the equation indicates that you need to sell 300 units to break even. If you knew you could sell 400 units, the equation would indicate that the sales price would need to be \$9 per unit to break even.• When managing inventory, you should aim for the Economic Order Quantity (EOQ). This is the level of inventory that balances two kinds of inventory costs: holding (or carrying) costs, which increase with the amount of inventory ordered, and order costs, which decrease with the amount ordered.• The largest components of holding costs for most companies are the cost of space to store the inventory and the cost of tying up capital in inventory. Other components include the labour costs associated with inventory maintenance and insurance costs. Also include deterioration, spoilage, and obsolescence costs. The costs of more frequent orders include lost discounts for larger quantity purchases and labour and supply costs of writing the orders. Additional costs include paying the bills and processing the paperwork, associated telephone and mail costs, and the labour costs of processing and inspecting incoming inventory.
20. 20. • EOQ is the size of order that minimizes the total of holding and ordering costs. The algebraic expression of EOQ is as follows: EOQ = square root of [2*U*O divided by H] where U is the number of units used annually, O is the order cost per order, and H is the holding cost per unit. For example, assume you use 40,000 units annually, it costs \$50 to place an order, and it costs \$20 to hold the raw materials for one unit. The equation yields an amount of 447, which is the number of units you need to order at one time to minimize total costs. The reorder point, or Economic Order Point (EOP), tells you when to place an order. Calculating the reorder point requires you to know the lead time from placing to receiving an order. You compute it as follows: EOP = Lead time * Average usage per unit of timeFor example, assume you need 6400 units evenly throughout theyear, there is a lead time of one week, and there are 50 workingweeks in the year. You calculate the reorder point to be 128 units asfollows.1 week * [6400 units / 50 weeks] = 128 unitsYou might also consider “Just In Time” inventory management, ifavailable and appropriate. “Just In Time” allows you to keep minimalinventory in stock. You only order when you make a sale. Carefullyanalyze the time lag. You must be able to satisfy the customer aswell as keep your inventory investment minimized.Use of BEP Analysis In capital budgetingBreak even analysis is a special application of sensitivity analysis. Itaims at finding the value of individual variables which the project’sNPV is zero. In common with sensitivity analysis, variables selectedfor the break even analysis can be tested only one at a time.The break even analysis results can be used to decide abandon ofthe project if forecasts show that below break even values are likelyto occur.In using break even analysis, it is important to remember theproblem associated with sensitivity analysis as well as someextension specific to the method: • Variables are often interdependent, which makes examining them each individually unrealistic.
21. 21. • Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future. • Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid. • Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis.Limitations Of BEP Analysis • Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. • It assumes that fixed costs (FC) are constant • It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) • It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). • In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).COST VOLUME PROFIT ANALYSIS • Analysis that deals with how profits and costs change with a change in volume. More specifically, it looks at the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and mix of products sold. • CVP analysis involves the analysis of how total costs, total revenues and total profits are related to sales volume, and is therefore concerned with predicting the effects of changes in
22. 22. costs and sales volume on profit. It is also known as breakeven analysis.• By studying the relationships of costs, sales, and net income, management is better able to cope with many planning decisions. For example, CVP analysis attempts to answer the following questions: (1) What sales volume is required to break even? (2) What sales volume is necessary in order to earn a desired (target) profit? (3) What profit can be expected on a given sales volume? (4) How would changes in selling price, variable costs, fixed costs, and output affect profits? (5) How would a change in the mix of products sold affect the break-even and target volume and profit potential?• Cost-volume-profit analysis (CVP), or break-even analysis, is used to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be "breaking even." The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.• Total variable costs are considered to be those costs that vary as the production volume changes. In a factory, production volume is considered to be the number of units produced, but in a governmental organization with no assembly process, the units produced might refer, for example, to the number of welfare cases processed.• There are a number of costs that vary or change, but if the variation is not due to volume changes, it is not considered to be a variable cost. Examples of variable costs are direct materials and direct labour. Total fixed costs do not vary as volume levels change within the relevant range. Examples of fixed costs are straight-line depreciation and annual insurance charges.
23. 23. • All the lines in the chart are straight lines: Linearity is an underlying assumption of CVP analysis. Although no one can be certain that costs are linear over the entire range of output or production, this is an assumption of CVP. • To help alleviate the limitations of this assumption, it is also assumed that the linear relationships hold only within the relevant range of production. The relevant range is represented by the high and low output points that have been previously reached with past production. CVP analysis is best viewed within the relevant range, that is, within our previous actual experience. Outside of that range, costs may vary in a nonlinear manner. The straight-line equation for total cost is: Total cost = total fixed cost + total variable cost Total variable cost is calculated by multiplying the cost of a unit, which remains constant on a per-unit basis, by the number of units produced. Therefore the total cost equation could be expanded as: Total cost = total fixed cost + (variable cost per unit numberof units) Total fixed costs do not change. A final version of the equation is: Y = a + bx where a is the fixed cost, b is the variable cost per unit, x is the level of activity, and Y is the total cost. Assume that the fixed costs are \$5,000, the volume of units produced is 1,000, and the per-unit variable cost is \$2. In that case the total cost would be computed as follows: Y = \$5,000 + (\$2 1,000) Y = \$7,000 It can be seen that it is important to separate variable and fixed costs. Another reason it is important to separate these costs is because variable costs are used to determine the contribution margin, and the contribution margin is used to determine the break-even point. The contribution margin is the difference between the per-unit variable cost and the selling price per unit. For example, if the per-unit variable cost is \$15 and selling price per unit is \$20, then the contribution margin is equal to \$5. The contribution margin may provide a
24. 24. \$5 contribution toward the reduction of fixed costs or a \$5 contribution to profits. If the business is operating at a volume above the break-even point volume (above point F), then the \$5 is a contribution (on a per-unit basis) to additional profits. If the business is operating at a volume below the break-even point (below point F), then the \$5 provides for a reduction in fixed costs and continues to do so until the break-even point is passed. • Once the contribution margin is determined, it can be used to calculate the break-even point in volume of units or in total sales dollars. When a per-unit contribution margin occurs below a firms break-even point, it is a contribution to the reduction of fixed costs. Therefore, it is logical to divide fixed costs by the contribution margin to determine how many units must be produced to reach the break-even point: • The financial information required for CVP analysis is for internal use and is usually available only to managers inside the firm; information about variable and fixed costs is not available to the general public. CVP analysis is good as a general guide for one product within the relevant range. If the company has more than one product, then the contribution margins from all products must be averaged together. But, any cost-averaging process reduces the level of accuracy as compared to working with cost data from a single product. Furthermore, some organizations, such as nonprofits organizations, do not incur a significant level of variable costs. In these cases, standard CVP assumptions can lead to misleading results and decisions.USES OF CVP ANALYSISa) Budget planning. The volume of sales required to make a profit(breakeven point) and the safety margin for profits in the budgetcan be measured.b) Pricing and sales volume decisions.c) Sales mix decisions, to determine in what proportions eachproduct should be sold.d) Decisions that will affect the cost structure andproduction capacity of the company.
25. 25. THE BASIC PRINCIPLES OF CVP ANALYSISCVP analysis is based on the assumption of a linear total costfunction (constant unit variable cost and constant fixed costs) andso is an application of marginal costing principles.The principles of marginal costing can be summarised as follows: a) Period fixed costs are a constant amount, therefore if one extra unit of product is made and sold, total costs will only rise by the variable cost (the marginal cost) of production and sales for that unit. b) Also, total costs will fall by the variable cost per unit for each reduction by one unit in the level of activity. c) The additional profit earned by making and selling one extra unit is the extra revenue from its sales minus its variable costs, i.e. the contribution per unit. d) As the volume of activity increases, there will be an increase in total profits (or a reduction in losses) equal to the total revenue minus the total extra variable costs. This is the extra contribution from the extra output and sales. e) The total profit in a period is the total revenue minus the total variable cost of goods sold, minus the fixed costs of the period.MARGIN OF SAFETYMargin of safety represents the strength of the business. It enablesa business to know that what is the exact amount he/ she hasgained or loss over or below break even point).Margin of safety = (( sales - break-even sales) / sales) x 100% If P/Vratio is given then sales/pv ratioIn unit salesIf the product can be sold in a larger quantity that occurs at thebreakeven point, then the firm will make a profit; below this point, aloss. Break-even quantity is calculated by: Total fixed costs / (selling price - average variable costs). Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution
26. 26. margin of each unit that is sold. This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. Therefore, Profit = (selling price * quantity) - (average variable costs * quantity + total fixed costs). Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).Firms may still decide not to sell low-profit products, for examplethose not fitting well into their sales mix. Firms may also sellproducts that lose money - as a loss leader, to offer a complete lineof products, etc. But if a product does not break even, or a potentialproduct looks like it clearly will not sell better than the breakevenpoint, then the firm will not sell, or will stop selling, that product.An example: • Assume we are selling a product for \$2 each. • Assume that the variable cost associated with producing and selling the product is 60 cents. • Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is \$1000. • In this example, the firm would have to sell (1000 / (2.00 - 0.60) = 715) 715 units to break even. in that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining loss.Break Even = FC / (SP − VC)where FC is Fixed Cost, SP is selling Price and VC is Variable CostSignificance: • Up to the BEP, the contribution is earned is sufficient only to recover the fixed costs. However the beyond the BEP, the contribution is called the profit • Profit is nothing but the contribution earned out of margin of safety of sales. • The size of the margin of safety shows the strength of the business. • A low margin of safety indicates the firm has a large fixed expenses and is moiré vulnerable to changes. • A high margin of safety implies that a slight fall in sales may not the business very much.
27. 27. Improvements in margin of safety:The possible steps for improve the margin of safety. • Increase in selling price, provided the demand is inelastic so as to absorb the increased prices. • Reduction in fixed expenses • Reduction in variable expenses • Increasing the sales volume provided capacity is available. • Substitution or introduction of a product mix such that more profitable lines are introduced.SHUT DOWN PROBLEMSShut down point indicates the level of operation(sales), below whichit is not justifiable to pursue production. For this purpose fixedexpenses of a business are classified as (i) avoidable ordiscretionary fixed costs (ii) unavoidable or committed fixed costs.The focus of shut down point calculation is to recover the avoidablefixed costs in the first place. By suspending the operations, the firmmay save as also incur some additional expenditure. The decision isbased on whether contribution is more than the difference betweenthe fixed expenses incurred in normal operation and the fixedexpense incurred when the plant is shut down.A firm has to close down if its contribution is insufficient to recovereven the avoidable fixed costs.Shutdown problems involve the following types of decisions:a) Whether or not to close down a factory, department, product lineor other activity, either because it is making losses or because it istoo expensive to run.b) If the decision is to shut down, whether the closure should bepermanent or temporary. Shutdown decisions often involve longterm considerations, and capital expenditures and revenues.c) A shutdown should result in savings in annual operating costs fora number of years in the future.d) Closure results in release of some fixed assets for sale. Someassets might have a small scrap value, but others, e.g. property,might have a substantial sale value.
28. 28. e) Employees affected by the closure must be made redundant orrelocated, perhaps even offered early retirement. There will be lumpsums payments involved which must be taken into consideration.For example, suppose closure of a regional office results in annualsavings of \$100,000, fixed assets sold off for \$2 million, butredundancy payments would be \$3 million. The shutdown decisionwould involve an assessment of the net capital cost of closure (\$1million) against the annual benefits (\$100,000 per annum).It is possible for shutdown problems to be simplified into short rundecisions, by making one of the following assumptionsa) Fixed asset sales and redundancy costs would be negligible.b) Income from fixed asset sales would match redundancy costs andso these items would be self-cancelling.In these circumstances the financial aspects of shutdown decisionswould be based on short run relevant costs.CASH POSITION AND FORECAST • The Cash position and forecast enquiry is usually used by the Treasurer or whoever is responsible for ensuring that the company has adequate funds for expected outgoings. • The Cash Position input data is the known balances: • Postings in cash and bank accounts (any account relevant to cash management),the unreconciled entries in the bank clearing accounts (uncashed cheques etc), and • any memo records which may have been manually entered (planning advices) as relevant to a cash position • cash flows from transactions managed in Treasury Management Examples are: • -bank balances
29. 29. • -outgoing checks posted to the bank clearing account • -outgoing transfers posted to the bank clearing account • -maturing deposits and loans • -notified incoming payments posted to the bank account • -incoming payments with a value date •GUIDELINES FOR RUNNING THE CASHPOSITION OR FORECAST ENQUIRY1. Understanding the Business RequirementsDescribes the information that you should gather about yourcompanys operations in this area to adequately configure it.2. Dates and the Cash ForecastThe Cash position and forecast is all about amounts and dates. Thesection explains how the dates are determined for the variousinputs.3. Cash Forecast TerminologyExplains the key terms that are encountered in the configuration.Must be read before embarking on the configuration section.4. Cash Forecast ConfigurationGuidelines on configuring the Cash Position and Forecast - presentedin two sections - essential and then advanced configuration.5. Related Configuration / Processing areasDescribes some of the related configuration and processing areasthat impact or feed data to the cash forecast.6. Preparing test dataPresents some hints on preparing test data directly without havingto run the feeder programs.PROFIT AND LOSS FORECAST