Professional Documents
Culture Documents
17a Marginal Costing & Breakeven Analysis
17a Marginal Costing & Breakeven Analysis
Independent study
Study Chapter 17 Progress test and practice question(s) as set
Business Accounting
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
Business Accounting 2
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
Business Accounting
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
Business Accounting
Required
Indicate whether the above costs are variable costs or fixed costs
Business Accounting 5
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
Calculating contribution
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
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
Business Accounting 8
Pro forma
Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss)
0.30 0.75 (
)? ?
? ? (
)? ? (850) ?
Business Accounting
Solution 2
Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss)
(1.05) 2.15
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
Business Accounting 10
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
Business Accounting 11
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
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
Business Accounting
Workings
395 100 1,000 = 39.5% or 40% of capacity
Business Accounting
15
Required
Calculate the level of activity required to achieve a target profit of 500 using the formula:
Business Accounting
16
Interpretation - Cotswold Coolers will achieve a profit of 500 when the business has sold 628 units - The contribution made by the sale of 628 units will exceed the total fixed costs by 500, which is profit
Business Accounting
17
Margin of safety
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
Breakeven graph
Costs/Sales ()
Sales revenue
PROFIT
Variable costs
Fixed costs
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)
Business Accounting 20