Business Accounting 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

Business Accounting 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

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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

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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 costingVariable costs + Fixed costs = Total cost

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Exercise 1Variable 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

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Solution 1Variable 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

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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)

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Exercise 2Marginal 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

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Pro forma Cotswold Coolers Marginal cost statement

1 unit 1,000 units £ £ £ £

Sales 3.20 ? Variable costs Mineral water 0.30 ? Bottle, lid and label 0.75 ( )? ? ( )? Contribution ? ? Fixed costs (850) Net profit/(loss) ?

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Solution 2 Cotswold Coolers Marginal cost statement

1 unit 1,000 units £ £ £ £

Sales 3.20 3,200 Variable costs Mineral water 0.30 300 Bottle, lid and label 0.75 (1.05) 750 (1,050) Contribution 2.15 2,150 Fixed costs (850) Net profit/(loss) 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

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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

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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

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Exercise 3Breakeven 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

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Solution 3Breakeven 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

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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 100 395 100 = 39.5% Capacity in units 1,000 or 40% of capacity

Interpretation - Cotswold Coolers will break even when sales revenue

reaches £1,264, which is 40% of their production capacity

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Exercise 4Level 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

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Solution 4Level of activity to achieve a target profit

Formula Workings Total fixed costs + Target profit Contribution per unit

£850 + £500 £2.15

= 627.9 or 628 units

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

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Margin of safety

The formula for the margin of safety isSelected 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 ...

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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 pointVariable costs

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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)