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# Marginal costing & breakeven analysis

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### Marginal costing & breakeven analysis

1. 1. 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 1
2. 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) Business Accounting 2
3. 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 Business Accounting 3
4. 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 Accounting (Collis and Hussey, Business activity’ 4
5. 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 Business Accounting 5
6. 6. Solution 1 Variable and fixed costs Cost Direct Indirect  Mineral water (in bulk)  Bottles, lids and labels  Rent and rates  Electricity (lighting, heating and power) ?  Wages (for the bottling operative) ?  Depreciation of machinery Note • Electricity and wages may have variable elements • If we compare this with our classification into direct and indirect costs, we can conclude that product direct costs are always variable costs and, in the short term, indirect costs are likely to be fixed costs Business Accounting 6
7. 7.  Calculatingcosts are charged to the contribution Only the variable 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  Business Accounting 7
8. 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. 9. Pro forma Cotswold Coolers Marginal cost statement 1 unit £ Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss) 0.30 0.75 ( £ 3.20 )? ? Business Accounting 1,000 units £ ? ? ( £ ? )? ? (850) ? 9
10. 10. Solution 2 Cotswold Coolers Marginal cost statement Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss) 1 unit £ £ 3.20 0.30 0.75 (1.05) 2.15 1,000 units £ £ 3,200 300 750 (1,050) 2,150 (850) 1,300 Notes • The contribution per unit will be £2.15 • Total contribution from selling 1,000 units will be £2,150, which will cover the fixed costs of £850 and provide a net profit of £1,300 10
11. 11. Techniques based on marginal costing  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 Business Accounting 11
12. 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 Business Accounting 12
13. 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 Business Accounting 13
14. 14. Solution 3 Breakeven point in units Formula Workings Fixed costs £850 = 395.34883 Contribution per unit £2.15 or 395 units • Interpretation - Cotswold Coolers will break even when 395 units are sold - This is the minimum level of activity, where the business covers the total cost but makes neither a profit nor a loss NB Round to the nearest whole number (no split bottles!) This is not an exact science and the results must be interpreted in the knowledge that the figures are based on budgeted/planned figures, which are estimates Business Accounting 14
15. 15. Breakeven point in sales value or % of capacity Once you’ve found the breakeven point (BEP) in units, you can use it to find the BEP in sales value or % of capacity Formula Workings BEP in units × Selling price 395 × £3.20 = £1,264 sales value BEP in units × 100 Capacity in units 395 × 100 1,000 = 39.5% or 40% of capacity • Interpretation - Cotswold Coolers will break even when sales revenue reaches £1,264, which is 40% of their production capacity Business Accounting 15
16. 16. Exercise 4 Level of activity to achieve a target profit  Same information from the marginal cost statement    Total fixed costs will be Rs 850 per week Contribution will be Rs 2.15 per unit Required  Calculate the level of activity required to achieve a target profit of Rs 500 using the formula: Fixed costs + Target profit Contribution per unit
17. 17. Solution 4 Level of activity to achieve a target profit Formula Workings Total fixed costs + Target profit Rs 850 + Rs 500 = 627.9 Rs 2.15 Contribution per unit or 628 units • Interpretation - Bisleri will achieve a profit of Rs 500 when the business has sold 628 units - The contribution made by the sale of 628 units will exceed the total fixed costs by Rs 500, which is profit Business Accounting 17
18. 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 Rs 500, so inserting the figures: 628 – 395 = 233 units  Interpretation   Bisleri 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. 19. Breakeven graph Costs/Sales (Rs) Sales revenue PROFIT Rs1,350 Rs1,264 Rs 850 0 Profit Rs 500 Breakeven point LOSS Variable costs Fixed costs ←→ Margin of safety 233 units 395 628 Activity level (units)
20. 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 Business Accounting 20