VARIABLE

COSTING AND
BREAKEVEN
ANALYSIS
Ch 3 of Atrill (2018)
Producing and selling multigrain cereal
Units sold: 10,000

Selling price £3
Less: material, labour and other variable costs -£2
Less: fixed costs (£5,000/10000) -£0.50
Profit £0.50
Total profit (£0.50 x 10,000) £5,000
Variable costing is also known as marginal
costing or cost–volume–profit (CVP) analysis.
Simple but powerful financial model concerning INTRODUC
the relationship between profit and the level of
activity.
TION
Very useful for business planning.
DEFINITIONS

Variable costs: Costs which vary proportionately

with output (e.g. raw materials).

Fixed costs: Costs which do not change when output

changes (e.g. business rates).

Semi-variable costs: Costs which are partly fixed and partly

variable (e.g. land-line telephone).
COST BEHAVIOUR
CONTRIBUTION

Contribution is the excess of sales revenue

over the variable costs.

Note: It can be thought of as the contribution

towards paying for the fixed costs. Once the fixed
costs have been covered, the rest of the
contribution is net profit.
CONTRIBUTION
RELATIONSHIPS
CONTRIBUTION
ILLUSTRATION
A product has a selling price of £5 and a variable cost of £2.
If 18,000 items are sold, what is the contribution earned?
If fixed costs are £40,000 in total, what is the net profit?

**************
£
Sales revenue = 90,000
Variable costs = 36,000
Contribution = 54,000

Fixed costs = 40,000

Net profit = 14,000
BREAKEVEN POINT

The breakeven point (BEP) is the level of activity at

which the business makes neither a profit nor a loss.

Starting from zero, as the activity level increases, more

and more of the fixed costs are covered by the total
contribution earned. Thus,

BEP occurs when Total contribution = Total fixed costs.

Traditional Breakeven Chart
Margin of Safety
OPERATIONAL
GEARING
PROFIT–VOLUME CHART
LIMITATIONS OF CVP
ANALYSIS
• The relationship between sales income and activity
(quantity sold) may not be linear (see next slide).

• The relationship between total costs and activity (quantity

produced) may not be linear (see next slide).

• It is dangerous to use CVP analysis outside the relevant

range
(see next-but-one slide).
ECONOMIST’S COST–VOLUME
GRAPH
RELEVANT RANGE

Activity
0 A B
Relevant range
SHORT-TERM
DECISIONS USING
CVP
FOUR TYPES OF
DECISION
Close down certain products/activities?

What to produce when resources are scarce?

Whether or not to accept one-off contracts?

Produce or buy component materials?

Possible cessation of activities
The underlying basic assumption is that
fixed costs cannot be eliminated in the
short term.

It would be wrong to cease an activity that

was making an accounting loss DECISIO
provided it was making a positive contribution.
N TYPE A
Cessation would mean that less of the fixed
costs were covered and the loss would be
greater than before – in the short
term.
Scarce resource and choice of activities
This situation usually arises due to the
scarcity
of a raw material or type of skilled labour.

Determine which activity has the greatest

contribution per unit of scarce resource and DECISIO
concentrate on this activity.
N TYPE B
This will maximize the amount of
contribution
(and profit) from the activities able to be
performed before the scarce resource is used
up.
Acceptability of one-off, short-term
contracts

For example, the opportunity to accept an

export contract for a home-market product
(possibly with some modification) but at a DECISIO
reduced price.
N TYPE C
Determine whether the contract will
produce a positive contribution. If so,
recommend going ahead with the contract.
If not, reject the offer.
Make or buy decisions
For example, it may be possible
to buy in from outside some components you
make and use in your products.

The basic technique is to compare the DECISIO

variable cost of manufacturing with the cost
of buying the item from an outside supplier. N TYPE D
Other considerations include reliability of
supply, quality of manufacturing, future
price changes, etc.