17a marginal costing & breakeven analysis

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  • 1. Chapter 17 continued 17a: Marginal costing and breakeven analysis
    • After completing this topic you should be able to
      • Describe the main purposes of marginal costing
      • Construct a marginal cost statement and associated profit statement
      • Conduct breakeven analysis
    • Independent study
      • Study Chapter 17
      • Progress test and practice question(s) as set
  • 2. The story so far ...
    • Cost accounting is the process of collecting, processing and presenting financial and quantitative data within an entity to ascertain the cost of the cost centres and cost units’ (Collis and Hussey, 2007, p. 213)
    • Revenue expenditure can be divided into direct costs (eg direct materials) and indirect costs (eg production overheads) and the information is used to prepare a total cost statement
    • Product direct costs + Indirect costs = Total cost
  • 3. Marginal costing
    • One problem with methods of total costing is that the classification of revenue expenditure into direct costs and indirect costs ignores their different behaviours when production or sales activity varies
    • An alternative is to use marginal costing, where the main purpose is to provide detailed cost information for planning and short-term decisions in a business where activity levels fluctuate
    • Actual or budgeted/planned figures can be used
  • 4. Classifying costs by behaviour
    • Costs and expenses are classified according to their behaviour when activity levels fluctuate
      • A variable cost is ‘an item of revenue expenditure that varies directly with changes in the level of production or sales activity’ (Collis and Hussey, 2007, p. 292)
      • A fixed cost is ‘an item of revenue expenditure that is unaffected by changes in the level of production or sales activity’ (Collis and Hussey, 2007, p. 292)
    • In marginal costing
      • Variable costs + Fixed costs = Total cost
  • 5. Exercise 1 Variable and fixed costs
    • Ros expects the production costs will be as follows
      • Mineral water (in bulk)
      • Bottles, lids and labels
      • Rent and rates
      • Electricity (lighting, heating and power)
      • Wages (for the bottling operative)
      • Depreciation on the bottling machine
    • Required
      • Indicate whether the above costs are variable costs or fixed costs
  • 6. Solution 1 Variable and fixed costs
  • 7. Calculating contribution
    • Only the variable costs are charged to the cost units
      • The variable cost per unit is known as the marginal cost
    • The difference between the sales value and the variable costs is known as the contribution and is based on the assumption that the sales value and variable costs will be constant
      • Sales value – Variable costs = Contribution
    • Contribution represents the contribution towards covering the fixed costs
      • Total contribution – Fixed costs = Net profit/(loss)
  • 8. Exercise 2 Marginal cost statement
    • A marginal cost statement allows you to calculate the contribution per unit and net profit or loss over the accounting period
    • Cotswold Coolers plans to produce and sell 1,000 units of mineral water per week
      • The selling price will be £3.20 per unit and variable costs per unit will be mineral water £0.30; bottle, lid and label £0.75. Fixed costs will be £850 per week.
    • Required
      • Complete the marginal cost statement for 1 unit and the associated weekly profit statement based on 1,000 units
  • 9. Pro forma Cotswold Coolers Marginal cost statement
  • 10. Solution 2 Cotswold Coolers Marginal cost statement
  • 11.
    • The information in a marginal cost statement forms the basis of two widely used techniques for making short-term decisions
      • Breakeven analysis and contribution analysis
    • We are going to start with breakeven analysis, which can be used for
      • Setting the minimum selling price
      • Setting the minimum level of activity
      • Planning the level of activity to generate a required profit
      • Calculating the margin of safety at a given level of activity
    Techniques based on marginal costing
  • 12. Breakeven analysis
    • The purpose of breakeven analysis is to identify the breakeven point (BEP), which is ‘the level of activity at which there is neither a profit nor a loss, as measured by volume of production or sales, percentage of production capacity or level of sales revenue’ (Collis and Hussey, 2007, p. 296)
    • In other words, the breakeven point is where
      • Total contribution = total fixed costs or
      • Total revenue = total costs
  • 13. Exercise 3 Breakeven point in units
    • Ros expects the total fixed costs for 1 week will be £850 and we know from the marginal cost statement that the contribution per unit will be £2.15
    • Required
      • Calculate the breakeven point in units using the formula:
      • Fixed costs
      • Contribution per unit
  • 14. Solution 3 Breakeven point in units
  • 15. Breakeven point in sales value or % of capacity
  • 16. Exercise 4 Level of activity to achieve a target profit
    • Same information from the marginal cost statement
      • Total fixed costs will be £850 per week
      • Contribution will be £2.15 per unit
    • Required
      • Calculate the level of activity required to achieve a target profit of £500 using the formula:
      • Fixed costs + Target profit
      • Contribution per unit
  • 17. Solution 4 Level of activity to achieve a target profit
  • 18. Margin of safety
    • The formula for the margin of safety is
      • Selected level of activity – Breakeven point
    • Our selected level of activity is where the business will make a profit of £500, so inserting the figures:
      • 628 – 395 = 233 units
    • Interpretation
      • Cotswold Coolers could miss the sales target of 628 units by as many as 233 units before the level of activity drops below the breakeven point of 395 units and the business starts making a loss
    • All this information can be shown graphically ...
  • 19. Breakeven graph Costs/Sales (£) £1,350 Profit £500 £1,264 £850 Fixed costs ←-> Margin of safety 233 units 0 395 628 Activity level (units) Sales revenue PROFIT LOSS Breakeven point Variable costs
  • 20. Conclusions
    • Breakeven analysis is based on marginal costing and provides detailed cost information in a business where production and/or sales levels fluctuate
    • It is based on the assumption that sales value and variable costs are constant and that variable costs vary with changes in the level of activity whilst fixed costs do not, but in the longer term
      • Variable costs may vary for other reasons (eg direct labour may be less efficient at higher levels of activity)
      • Fixed costs may increase in steps (eg more machines or larger premises needed at higher levels of activity)