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8/11/2019 Marginal Costing 1
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n general terms marginal cost at each level of prodction incldesany additional costs re0ired to prodce the net nit. f prodcingadditional vehicles re0ires for eample bilding a new factory themarginal cost of those extra vehicles incldes the cost of the newfactory. n practice the analysis is segregated into short and long-rn cases and over the longest rn all costs are marginal. "t eachlevel of prodction and time period being considered marginal costsinclde all costs which vary with the level of prodction and othercosts are considered fied costs.
" nmber of other factors can affect marginal cost and itsapplicability to real world problems. ome of these may be
considered mar(et failres. hese may inclde informationasymmetries the presence of negative or positive eternalitiestransaction costs price discrimination and others.
RELATION BETWEEN MARGINAL COST AND ECONOMIES OFSCALE
• +rodction may be sbect to economies of scale 8ordiseconomies of scale9. ncreasing retrns to scale are said toeist if additional nits can be prodced for less than theprevios nit that is average cost is falling.
• his can only occr if average cost at any given level ofprodction is higher than the marginal cost.
• ,onversely there may be levels of prodction where marginalcost is higher than average cost and average cost will rise foreach nit of prodction after that point. his type ofprodction fnction is generally (nown as diminishingmarginal prodctivity< at low levels of prodction prodctivity gains are easy and marginal costs falling bt prodctivitygains become smaller as prodction increases= eventallymarginal costs rise becase increasing otpt 8with eisting
capital labor or organiation9 becomes more epensive. Forthis generic case minimm average cost occrs at the pointwhere average cost and marginal cost are e0al 8whenplotted the two crves intersect9= this point will not be at theminimm for marginal cost if fied costs are greater than ero.
Short an long r!n marginal costs an "conomi"s o#
scal"
he former ta(es as nchanged for eample the capital e0ipmentand overhead of the prodcer any change in its prodctioninvolving only changes in the inpts of labor materials and energy.
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he latter allows all inpts inclding capital items 8plante0ipment bildings9 to vary.
" long-rn cost fnction describes the cost of prodction as afnction of otpt assming that all inpts are obtained at crrent
prices that crrent technology is employed and everything is beingbilt new from scratch. n view of the drability of many capitalitems this tetboo( concept is less sefl than one which allows forsome scrapping of eisting capital items or the ac0isition of newcapital items to be sed with the eisting stoc( of capital itemsac0ired in the past. >ong-rn marginal cost then means theadditional cost or the cost saving per nit of additional or redcedprodction inclding the ependitre on additional capital goods orany saving from disposing of eisting capital goods. ;ote thatmarginal cost pwards and marginal cost downwards may differ incontrast with marginal cost according to the less sefl tetboo(concept.
'conomies of scale are said to eist when marginal cost accordingto the tetboo( concept falls as a fnction of otpt and is less thanthe average cost per nit. his means that the average cost ofprodction from a larger new bilt-from-scratch installation fallsbelow that from a smaller new bilt-from-scratch installation. ?nderthe more sefl concept with an eisting capital stoc( it isnecessary to distingish those costs which vary with otpt fromacconting costs which will also inclde the interest and
depreciation on that eisting capital stoc( which may be of adifferent type from what can crrently be ac0ired in past years atpast prices. he concept of economies of scale then does not apply.
E$t"rnaliti"s
'ternalities are costs 8or benefits9 that are not borne by the partiesto the economic transaction. " prodcer may for eample pollte the environment and others may bear those costs. " consmer mayconsme a good which prodces benefits for society sch asedcation= becase the individal does not receive all of thebenefits he may consme less than efficiency wold sggest."lternatively an individal may be a smo(er or alcoholic andimpose costs on others. n these cases prodction or consmptionof the good in 0estion may differ from the optimm level.
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%"it& N"gati'" "$t"rnaliti"s o# (ro!ction
N"gati'" E$t"rnaliti"s o# Pro!ction
Mch of the time private and social costs do not diverge from oneanother bt at times social costs may be either greater or less thanprivate costs. @hen marginal social costs of prodction are greater
than that of the private cost fnction we see the occrrence of anegative eternality of prodction. +rodctive processes that resltin polltion are a tetboo( eample of prodction that createsnegative eternalities.
ch eternalities are a reslt of firms eternaliing their costs ontoa third party in order to redce their own total cost. "s a reslt ofeternaliing sch costs we see that members of society will benegatively affected by sch behavior of the firm. n this case wesee that an increased cost of prodction on society creates a social
cost crve that depicts a greater cost than the private cost crve.
n an e0ilibrim state we see that mar(ets creating negativeeternalities of prodction will overprodce that good. "s a resltthe socially optimal prodction level wold be lower than thatobserved.
Positi'" "$t"rnaliti"s o# (ro!ction
+ositive 'ternalities of +rodction
@hen marginal social costs of prodction are less than that of theprivate cost fnction we see the occrrence of a positive eternality
of prodction. +rodction of pblic goods are a tetboo( eample ofprodction that create positive eternalities. "n eample of sch a
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pblic good which creates a divergence in social and private costsincldes the prodction of edcation. t is often seen that edcationis a positive for any whole society as well as a positive for thosedirectly involved in the mar(et.
'amining the relevant diagram we see that sch prodctioncreates a social cost crve that is less than that of the private crve.n an e0ilibrim state we see that mar(ets creating positiveeternalities of prodction will nder prodce that good. "s a resltthe socially optimal prodction level wold be greater than thatobserved.
Social costs
Af great importance in the theory of marginal cost is the distinction
between the marginal private and social costs. he marginal privatecost shows the cost associated to the firm in 0estion. t is themarginal private cost that is sed by bsiness decision ma(ers intheir profit maimiation goals and by individals in theirprchasing and consmption choices. Marginal social cost is similarto private cost in that it incldes the cost fnctions of privateenterprise bt also that of society as a whole inclding parties thathave no direct association with the private costs of prodction. tincorporates all negative and positive eternalities of bothprodction and consmption.
Bence when deciding whether or how mch to by byers ta(eaccont of the cost to society of their actions if private and socialmarginal cost coincide. he e0ality of price with social marginalcost by aligning the interest of the byer with the interest of thecommnity as a whole is a necessary condition for economicallyefficient resorce allocation.
Oth"r cost "#initions in marginal costing
• Fi$" costs are costs which do not vary with otpt foreample rent. n the long rn all costs can be consideredvariable.
• )aria*l" cost also (nown as operating costs prime costs oncosts and direct costs are costs which vary directly with thelevel of otpt for eample labor fel power and cost ofraw material.
• Social costs o# (ro!ction are costs incrred by society asa whole reslting from private prodction.
• A'"rag" total cost is the total cost divided by the 0antityof otpt.
• A'"rag" #i$" cost is the fied cost divided by the 0antity
of otpt.
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• A'"rag" 'aria*l" cost are variable costs divided by the0antity of otpt.
What is Marginal Costing+
t is a costing techni0e where only variable cost or direct cost will becharged to the cost nit prodced.
Marginal costing also shows the effect on profit of changes in volme/type
of otpt by differentiating between fied and variable costs.
alient +oints<
• Marginal costing involves ascertaining marginal costs. incemarginal costs are direct cost this costing techni0e is also (nownas direct costing=
• n marginal costing fied costs are never charged to prodction. hey are treated as period charge and is written off to the profit and
loss accont in the period incrred=
• Ance marginal cost is ascertained contribtion can be compted.,ontribtion is the ecess of revene over marginal costs.
• he marginal cost statement is the basic docment/format tocaptre the marginal costs.
F"at!r"s o# Marginal Costing S,st"m-
• t is a method of recording costs and reporting profits=
• "ll operating costs are differentiated into fied and variable costs=
• Cariable cost DEcharged to prodct and treated as a prodct costwhilst
• Fied cost treated as period cost and written off to the profit and lossaccont
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Disa'antag"s O# Marginal Costing
• Marginal cost has its limitation since it ma(es se of historicaldata while decisions by management relates to ftre events=
• t ignores fied costs to prodcts as if they are not importantto prodction=
• toc( valation nder this type of costing is not accepted by
the nland Revene as itDEGs ignore the fied cost element=
• t fails to recognie that in the long rn fied costs maybecome variable=
• ts oversimplified costs into fied and variable as if it is sosimply to demarcate them=
• tDEGs not a good costing techni0e in the long rn for pricingdecision as it ignores fied cost. n the long rn managementmst consider the total costs not only the variable portion=
• $ifficlty to classify properly variable and fied cost perfectlyhence stoc( valation can be distorted if fied cost is classifyas variable.
MARGINAL COSTING AS A MANAGEMENT ACCO.NTING
TOOL
1. Marginal ,osting is clearly the core aspect of traditional
management acconting. ome of the classical applications of
management acconting however have begn to lose theirsignificance. he 0estion ths arises< @hat is the crrent role of
Marginal ,osting in modern management accontingH
2. *sinesses today fre0ently voice their disapproval of the
traditional cost acconting approaches. "t the beginning of the
1&&)s these criticisms were ta(en p by researchers involved with
the applications of cost acconting concepts.
he main thrst of the dissatisfaction with conventional cost
acconting methods is that they are too highly developed and too
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comple and frthermore are no longer needed in their crrent
form since other tools are now available. ,alls for increased se of
cost management tools investment analyses and vale-based tool
concepts are fre0ently associated with criticism of the fnctionality
of crrent cost acconting approaches as management tools. hisline of criticism sees little relevance in traditional cost acconting
tas(s sch as monitoring the economic prodction process or
assigning the costs of internal activities. "t their crrent level of
detail sch tas(s are neither necessary nor does their perceived
psedo accracy frther the goals of management.
he viewpoint of the present athor is that cost acconting has by
no means lost its right to eist for it is an easily overloo(ed fact that
the data strctre re0ired by the new tools is already present in
traditional cost acconting.
3. o assess the present-day vale of Marginal ,osting the changes
occrring in the bsiness world mst be analyed more closely. @e
need first to loo( at how the prposes of cost acconting are
shifting before we can determine its significance.
8i9 cost planning ta(es precedence over cost control. he
effort involved in planning and monitoring costs is increasingly
being seen as ecessive. he charge levied against traditional costacconting--that its comple cost allocations merely generate a (ind
of psedo precision--lends frther credence to this assessment. "n
alternative increasingly being called for is to control costs throgh
direct activity/process information 80antities times 0ality9 for
cost management at local decentralied levels instead of relying on
delayed and distorted cost data. n particlar empirical ?..
research on appropriate variables for performance measrement in
the contet of continos improvement and modern managerial
concepts is based on this view. he need for eact cost planningfor profitability management is ths toched on e ante.
8ii9 cost acconting mst be employed as a tool for cost
control at an early stage. he relative significance of traditional cost
acconting as a management acconting tool will decline as it is
applied mainly to fields where costs cannot be heavily inflenced.
More significant than inflencing the crrent costs of prodction with
cost center controlling and athoried-actal comparisons of the
cost of goods manfactred is timely and mar(et-based athoriedcost management. he greatest scope for inflencing costs is at the
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early prodct development phase and when setting p the
prodction processes. "t the same time this is the stage where cost
information is most rgently needed since the time and 0antity
standards as defined by *ills of Materials 8*AMs9 and prodction
rotings are still lac(ing. his re0ires different methods of costplanning than those normally provided by Marginal ,osting.
8iii9 the behavioral effect of cost information is starting to
be recognied. here is a strong crrent of acconting research in
the ?.. that ta(es hman psychological factors into consideration.
his is reslting in an etension of cost theory beyond its pre
microeconomic basis. Reslts of theoretical and empirical research
based for eample on the principal-agent theory indicate that
(nowledge of the IrelevantI costs does not always lead to the
optimiation of overall enterprise profitability. Bence the
perspective that formed the basis for the absorption costing isse
has changed. heories according to which cost allocations can
contain information and increase the efficiency of the se of
available capacity or where ftre allocations can inflence e-ante
decisions re0ire empirical research.
4. he shift in the prposes of cost acconting is being
accompanied by a shift in the main applications of standard costing.
,osting soltions for mar(et-oriented profitability management andlife-cycle-based planning and monitoring shold be developed
frther. hey shold be implemented both in indirect areas and at
the corporate level. n addition cost acconting mst be integrated
into performance measrement.
,ompetitive dynamics are giving rise to an increasing differentiation
of mar(et-based profitability controlling. his applies to the
management of the profitability of prodcts and prodct lines as
well as distribtion channels and increasingly cstomers cstomergrops and mar(ets. he information re0ired for this prpose can
only be spplied by mltilevel and mltidimensional mar(eting
segment acconting based on contribtion margin acconting.
>ong-term cost planning based on the idea of lifecycle costing is
gaining in prominence compared with short-term standard costing.
+rodct decisions are increasingly based on more than st the cost
of goods manfactred and sales costs and now tend to inclde pre-
prodction costs 8sch as development costs9 and phasing-ot costs8sch as disposal costs9. +rodct decisions are viewed strategically.
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@hether or not a prodct is sccessfl is determined by the
amortiation of its overall cost. Frthermore the cost and revene
trend forecasts shold be more dynamic to spport the lifecycle
pricing policy. his shift in cost and revene planning is moving cost
and revene acconting in the direction of investment-relatedcalclations.
"s management acconting is increasingly applied to the growing
share of the costs of indirect areas the tool re0irements increase.
"fter J. K. MillerLs and . '. CollmannLs discovery of the Ihidden
factoryI as an area whose costs are neglected by conventional
prodction costing in the ?.. it was only a small step to the
identification of the lost relevance of conventional cost acconting
by B. . Johnson and R. . aplan and their call to develop
acconting systems separated into Iprocess control prodct
costing and financial reportingI which eventally led to activity-
based costing. mproving the cost transparency of indirect activity
areas throgh Marginal ,osting re0ires a thorogh nderstanding
of the otpt processes. "nalysis fre0ently shows that even many
spport activities have a wide range of repetitive processes for
which planning and cost allocation sing drivers is worthwhile
providing the cost-volme is large enogh. For this prpose the
different operations in the cost centers mst be identified for which
resorce consmption is then planned and trac(ed. he nmber ofthese operations is sed as the driver. his process of costing
operations sing proportional costs competes with the attempt to
achieve better cost transparency in indirect areas with process
costing tools to also improve the planning and control of costs that
were previosly bdgeted only as a lmp sm.
ndstrial prodction and mar(eting are increasingly being handled
by grops of affiliated companies. o plan and monitor the costs of
these activities calls for the establishment of independent gropcost acconting. his necessity reslts mainly from the
re0irements of inventory valation the costing basis of transfer
prices and to frther the consistency of corporate cost acconting.
Krop cost acconting leads to the definition of independent grop
cost categories. Marginal ,osting and its tools have been developed
for individal companies and are the sitable platform for this
epansion.
+erformance measres are gaining increasing prominence indecentralied management acconting. tandard ?.. management
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boo(s devote a great deal of space to performance measrement in
the broad sense of the word. he concept is broad for the reason
that performance measrement is accompanied by the provision of
decision-spport information the management of bsiness nits
and the se of incentive systems. ?sing modelling and empiricalresearch the eponents of this area are developing the idea that
monetary factors are not the only possible components of
performance measrement.
ince the 1&%)s there has been a growing consciosness of the
significance of continosly improving the performance capabilities
of the company reslting in the increased importance of
nonmonetary indicators. he recent literatre on performance
measrement has focsed on problems in the following areas<
N he sability of performance information for managers
N he assessment of teamwor(
N he motivational effects of performance measrement
N he strategic dimension.
he tenor of the recent investigations into performancemeasrement reflects the general criticism of management
acconting voiced by Johnson and aplan in Relevance >ost. t was
recognied that short-term acconting information is insfficient to
evalate and control company activities effectively. n particlar it
was ac(nowledged that the se of standard costs does not
ade0ately ta(e performance improvements into consideration.
Moreover the conventional allocation approach based on the
operating rate encorages high tiliation of capacity at any cost
nderestimates the problem of increasing nmbers of variants sesthe wrong overhead allocation base and fails to appreciate
interdepartmental interrelationships.
@hile top management benefits most from financial sccess
indicators that it eamines in monthly or longer intervals and that
can consist of mltidimensional aggregate figres lower
management mst necessarily be concerned mainly with
nonfinancial operational and very short-term data at the day or
shift level. n concrete terms measres in the categories of time0antity and 0ality--sch as e0ipment downtime lead time
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response time degree of tiliation 8ratio of actal otpt 0antity
to planned otpt 0antity9 sales orders and error rate--are
becoming increasingly significant for controlling bsiness processes.
n the strategic dimension the *alanced corecard developed byaplan and ;orton--which lin(s financial and nonfinancial indicators
from different strategically relevant perspectives inclding case-
effect chains--is the main proposal nder consideration for
performance measrement. he *alanced corecard lin(s strategic
contingencies to financial measres incorporates sccess factors of
the ftre and eplicitly incldes monetary and nonmonetary
parameters. he *alanced corecard therefore provides a
framewor( for systematic mapping and control of the critical
sccess factors for an enterprise. " *alanced corecard is a system
that defines obectives measres targets and initiatives for each of
the for perspectives of financial cstomer internal bsiness
process and learning and growth. Frther analyses and eperience
in measring performance can enable identification and assessment
of case-effect relationships within the for perspectives 8sch as
the effect of delivery time on cstomer satisfaction9 and between
the perspectives 8sch as the effect of cstomer satisfaction on
profitability9. he (nowledge so gained may eventally lead to a
reformlation of strategy.
n the contet of comprehensive performance measrement even
short-term costs and financial reslts can serve as control
instrments for strategic enterprise management sch as a lower
athoried cost of goods manfactred as a benchmar(. ,oncrete
planned costs and planned reslts mst be rigorosly derived from
higher-level target factors so that specific re0irements can be
derived in trn when they are bro(en down into smaller
organiational nits for the time and 0antity standards.
nformation for decision ma(ing he need for a decision arises inbsiness becase a manager is faced with a problem and alternativecorses of action are available. n deciding which option to choosehe will need all the information which is relevant to his decision= andhe mst have some criterion on the basis of which he can choosethe best alternative. ome of the factors affecting the decision maynot be epressed in monetary vale. Bence the manager will haveto ma(e L0alitativeL dgements e.g. in deciding which of twopersonnel shold be promoted to a managerial position. "L0antitativeL decision on the other hand is possible when thevarios factors and relationships between them are measrable.
his chapter will concentrate on 0antitative decisions based on
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c2 Cash #lo3- 'penses sch as depreciation are not cash flowsand are therefore not relevant. imilarly the boo( vale of eistinge0ipment is irrelevant bt the disposal vale is relevant.
Ather terms<
2 Common costs< ,osts which will be identical for all alternativesare irrelevant e.g. rent or rates on a factory wold be incrredwhatever prodcts are prodced.
"2 S!n1 costs< "nother name for past costs which are alwaysirrelevant e.g. dedicated fied assets development costs alreadyincrred.
#2 Committ" costs- " ftre cash otflow that will be incrredanyway whatever decision is ta(en now e.g. contracts alreadyentered into which cannot be altered.
O((ort!nit, cost
Relevant costs may also be epressed as opportnity costs. "nopportnity cost is the benefit foregone by choosing one opportnityinstead of the net best alternative.
E$am(l"
" company is considering pblishing a limited edition boo( bond ina special leather. t has in stoc( the leather boght some years agofor O1))). o by an e0ivalent 0antity now wold cost O2))).
he company has no plans to se the leather for other prposesalthogh it has considered the possibilities<
a9 of sing it to cover des( frnishings in replacement for othermaterial which cold cost O&))b9 of selling it if a byer cold be fond 8the proceeds are nli(ely toeceed O%))9.
n calclating the li(ely profit from the proposed boo( beforedeciding to go ahead with the proect the leather wold not becosted at O1))). he cost was incrred in the past for some reasonwhich is no longer relevant. he leather eists and cold be sed onthe boo( withot incrring any specific cost in doing so. n sing theleather on the boo( however the company will lose theopportnities of either disposing of it for O%)) or of sing it to savean otlay of O&)) on des( frnishings.
he better of these alternatives from the point of view of benefiting
from the leather is the latter. I>ost opportnityI cost of O&)) will
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therefore be inclded in the cost of the boo( for decision ma(ingprposes.
he relevant costs for decision prposes will be the sm of<
i9 Lavoidable otlay costsL i.e. those costs which will be incrred onlyif the boo( proect is approved and will be avoided if it is not
ii9 the opportnity cost of the leather 8not represented by any otlaycost in connection to the proect9.
his total is a tre representation of Leconomic costL.
;ow attempt eercise 5.1.
Th" ass!m(tions in r"l"'ant costing
ome of the assmptions made in relevant costing are as follows<
a9 ,ost behavior patterns are (nown e.g. if a department closesdown the attribtable fied cost savings wold be (nown.
b9 he amont of fied costs nit variable costs sales price andsales demand are (nown with certainty.
c9 he obective of decision ma(ing in the short rn is to maimise
LsatisfactionL which is often (nown as Lshort-term profitL.
d9 he information on which a decision is based is complete andreliable.
T4E BASIC DECISION MA5ING INDICATORS IN
MARGINAL COSTING
• +RAF CA>?M' R"A
• *R'"- 'C'; +A;
• ,"B CA>?M' +RAF ";">P
• M"RK; AF "F'P
• ;$FF'R';,' +A;
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• B? Q $A@; +A;
PROFIT )OL.ME RATIO 6P ) RATIO 2
he profit volme ratio is the relationship between the ,ontribtion
and ales vale.
t is also termed as ,ontribtion to ales Ratio
Formla <
P ) Ratio 7 Contri*!tion 8 9::
Sal"s
Signi#icanc" o# P) Ratio
• t is considered to be the basic indicator of profitability of
bsiness.
• he higher the +C Ratio the better it is for the bsiness. n the
case of the firm enoying steady bsiness conditions over a
period of years the +C Ratio will also remain stable andsteady.
• f +C Ratio is improved it will reslt in better profits.
Im(ro'"m"nt o# P) Ratio
• *y redcing the variable costs.
• *y increasing the selling price
• *y increasing the share of prodcts with higher +C Ratio in the
overall sales mi. 8where a firm prodces a nmber of
prodcts9
.s" o# P) Ratio
• o compte the variable costs for any volme of sales
• o measre the efficiency or to choose a most profitable line.
he overall profitability of the firm can be improved by
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increasing the sales/otpt of prodct giving a higher +C
Ratio.
• o determine the *rea( Q 'ven +oint and the level of otpt
re0ired to earn a desired profit.
• o decide the most profitable sales Q mi.
BREA5 ; E)EN ANALYSIS
• Br"a1<E'"n Anal,sis is a mathematical techni0e foranalying the relationship between sales and fied andvariable costs. *rea(-even analysis is also a profit-planningtool for calclating the point at which sales will e0al totalcosts.
• he brea(-even point is the intersection of the total sales andthe total cost lines. his point determines the nmber of nitsprodced to achieve brea(even.
• he analysis generally assmes linearity 81)) variable or1)) fied9 of costs. f a firmSs costs were all variable thefirm cold be profitable from the start. f the firm is to avoidlosses its sales mst cover all costs that vary directly withprodction and all costs that do not change with prodction
levels.• Fied costs are those epenses associated with the proect
that yo wold have to pay whether yo sold one nit or1)))) nits. 'amples inclde general office epenses rentdepreciation interest salaries research and developmentand tilities. Cariable costs vary directly with the nmber ofnits that yo sell. 'amples inclde materials direct laborpostage pac(aging and advertising. ome costs are difficltto classify. "s a general gideline if there is a directrelationship between cost and nmber of nits sold considerthe cost variable. f there is no relationship then consider thecost fied.
• " brea(-even chart is constrcted with a horiontal aisrepresenting nits prodced and a vertical ais representingsales and costs. Represent fied costs by a horiontal linesince they do not change with the nmber of nits prodced.Represent variable costs and sales by pward sloping linessince they vary with the nmber of nits prodced and sold.
he brea(-even point is the intersection of the total sales andthe total cost lines. "bove that point the firm begins to ma(ea profit bt below that point it sffers a loss. Bere is a sample
brea(-even chart<
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he algebraic e0ation for brea(-even analysis consists of forfactors. f yo (now any three of the for yo can solve forthe forth factor. Po calclate the brea(-even amont withthe following e0ation<
ales +rice per ?nit N :antity old T Fied ,osts U 6Cariable,osts per ?nit N :antity old7
For eample assme yo have total fied monthly costs ofO12)) and total variable costs of O! per nit. f yo cold sellthe nits for O1) each the e0ation indicates that yo need tosell 3)) nits to brea( even. f yo (new yo cold sell 4))
nits the e0ation wold indicate that the sales price woldneed to be O& per nit to brea( even.
• @hen managing inventory yo shold aim for the EconomicOr"r =!antit, 8'A:9. his is the level of inventory thatbalances two (inds of inventory costs< holding 8or carrying9costs which increase with the amont of inventory orderedand order costs which decrease with the amont ordered.
• he largest components of holding costs for most companiesare the cost of space to store the inventory and the cost oftying p capital in inventory. Ather components inclde thelabor costs associated with inventory maintenance andinsrance costs. "lso inclde deterioration spoilage andobsolescence costs. he costs of more fre0ent orders incldelost disconts for larger 0antity prchases and labor andspply costs of writing the orders. "dditional costs incldepaying the bills and processing the paperwor( associatedtelephone and mail costs and the labor costs of processingand inspecting incoming inventory.
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• 'A: is the sie of order that minimies the total of holdingand ordering costs. he algebraic epression of 'A: is asfollows<
'A: T s0are root of 62N?NA divided by B7 where ? is thenmber of nits sed annally A is the order cost per orderand B is the holding cost per nit.
For eample assme yo se 4)))) nits annally it costsO5) to place an order and it costs O2) to hold the rawmaterials for one nit. he e0ation yields an amont of 44#which is the nmber of nits yo need to order at one time tominimie total costs.
he reorder point or Economic Or"r Point 8'A+9 tells yowhen to place an order. ,alclating the reorder point re0ires
yo to (now the lead time from placing to receiving an order. Po compte it as follows<
'A+ T >ead time N "verage sage per nit of time
For eample assme yo need !4)) nits evenly throghot theyear there is a lead time of one wee( and there are 5) wor(ingwee(s in the year. Po calclate the reorder point to be 12% nits asfollows.
1 wee( N 6!4)) nits / 5) wee(s7 T 12% nits
Po might also consider >!st In Tim"V inventory management ifavailable and appropriate. Jst n imeV allows yo to (eep minimal
inventory in stoc(. Po only order when yo ma(e a sale. ,arefllyanalye the time lag. Po mst be able to satisfy the cstomer aswell as (eep yor inventory investment minimied.
.s" o# BEP Anal,sis In ca(ital *!g"ting
*rea( even analysis is a special application of sensitivity analysis. taims at finding the vale of individal variables which the proectSs;+C is ero. n common with sensitivity analysis variables selectedfor the brea( even analysis can be tested only one at a time.
he brea( even analysis reslts can be sed to decide abandon ofthe proect if forecasts show that below brea( even vales are li(elyto occr.
n sing brea( even analysis it is important to remember theproblem associated with sensitivity analysis as well as someetension specific to the method<
• Cariables are often interdependent which ma(es eaminingthem each individally nrealistic.
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• Aften the assmptions pon which the analysis is based aremade by sing past eperience / data which may not hold inthe ftre.
• Cariables have been adsted one by one= however it isnli(ely that in the life of the proect only one variable will
change ntil reaching the brea( even point. Managementdecisions made by observing the behavior of only onevariable are most li(ely to be invalid.
• *rea( even analysis is a pessimistic approach by essence. hefigres shall be sed only as a line of defence in the proectanalysis.
Limitations O# BEP Anal,sis
• *rea(-even analysis is only a spply side 8i.e. costs only9analysis as it tells yo nothing abot what sales are actallyli(ely to be for the prodct at these varios prices.
• t assmes that fied costs 8F,9 are constant• t assmes average variable costs are constant per nit of
otpt at least in the range of li(ely 0antities of sales. 8i.e.linearity9
• t assmes that the 0antity of goods prodced is e0al to the0antity of goods sold 8i.e. there is no change in the 0antityof goods held in inventory at the beginning of the period andthe 0antity of goods held in inventory at the end of theperiod9.
• n mlti-prodct companies it assmes that the relativeproportions of each prodct sold and prodced are constant8i.e. the sales mi is constant9.
COST )OL.ME PROFIT ANALYSIS
• "nalysis that deals with how profits and costs change with achange in volme. More specifically it loo(s at the effects onprofits of changes in sch factors as variable costs fiedcosts selling prices volme and mi of prodcts sold.
• ,C+ analysis involves the analysis of how total costs totalrevenes and total profits are related to sales volme and is
therefore concerned with predicting the effects of changes in
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costs and sales volme on profit. t is also (nown asLbrea(even analysisL.
• *y stdying the relationships of costs sales and net incomemanagement is better able to cope with many planningdecisions. For eample ,C+ analysis attempts to answer thefollowing 0estions< 819@hat sales volme is re0ired to brea( evenH829 @hat sales volme is necessary in order to earn a desired8target9 profitH 839 @hat profit can be epected on a givensales volmeH 849 Bow wold changes inselling price variable costs fied costs and otpt affectprofitsH859 Bow wold a change in the mi of prodcts sold affect thebrea(-even and target volme and profit potentialH
• ,ost-volme-profit analysis 8,C+9 or brea(-even analysis issed to compte the volme level at which total revenes aree0al to total costs. @hen total costs and total revenes aree0al the bsiness organiation is said to be Ibrea(ing even.I
he analysis is based on a set of linear e0ations for a straightline and the separation of variable and fied costs.
• otal variable costs are considered to be those costs that varyas the prodction volme changes. n a factory prodctionvolme is considered to be the nmber of nits prodced btin a governmental organiation with no assembly process thenits prodced might refer for eample to the nmber of
welfare cases processed.
• here are a nmber of costs that vary or change bt if thevariation is not de to volme changes it is not considered tobe a variable cost. 'amples of variable costs are directmaterials and direct labor. otal fied costs do not vary asvolme levels change within the relevant range. 'amples offied costs are straight-line depreciation and annal insrancecharges.
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• "ll the lines in the chart are straight lines< >inearity is annderlying assmption of ,C+ analysis. "lthogh no one canbe certain that costs are linear over the entire range of otptor prodction this is an assmption of ,C+.
• o help alleviate the limitations of this assmption it is alsoassmed that the linear relationships hold only within therelevant range of prodction. he relevant range isrepresented by the high and low otpt points that have beenpreviosly reached with past prodction. ,C+ analysis is bestviewed within the relevant range that is within or previosactal eperience. Atside of that range costs may vary in anonlinear manner. he straight-line e0ation for total cost is<
otal cost T total fied cost U total variable cost
otal variable cost is calclated by mltiplying the cost of anit which remains constant on a per-nit basis bythe nmber of nits prodced. herefore the total coste0ation cold be epanded as<
otal cost T total fied cost U 8variable cost per nit nmberof nits9
otal fied costs do not change.
" final version of the e0ation is<
Y = a + bx
where a is the fied cost b is the variable cost per nit x isthe level of activity and Y is the total cost. "ssme that thefied costs are O5))) the volme of nits prodced is 1)))and the per-nit variable cost is O2. n that case the total costwold be compted as follows<
Y T O5))) U 8O2 1)))9 Y T O#)))
t can be seen that it is important to separate variable andfied costs. "nother reason it is important to separate thesecosts is becase variable costs are sed to determine thecontribtion margin and the contribtion margin is sed todetermine the brea(-even point. he contribtion margin isthe difference between the per-nit variable cost and theselling price per nit. For eample if the per-nit variable cost
is O15 and selling price per nit is O2) then the contribtionmargin is e0al to O5. he contribtion margin may provide a
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O5 contribution toward the redction of fied costs or a O5contribtion to profits. f the bsiness is operating at a volmeabove the brea(-even point volme 8above point F9 then theO5 is a contribtion 8on a per-nit basis9 to additional profits. fthe bsiness is operating at a volme below the brea(-even
point 8below point F9 then the O5 provides for a redction infied costs and contines to do so ntil the brea(-even point ispassed.
• Ance the contribtion margin is determined it can be sed tocalclate the brea(-even point in volme of nits or in totalsales dollars. @hen a per-nit contribtion margin occrsbelow a firmLs brea(-even point it is a contribtion to theredction of fied costs. herefore it is logical to divide fiedcosts by the contribtion margin to determine how many nits
mst be prodced to reach the brea(-even point<
• he financial information re0ired for ,C+ analysis is forinternal se and is sally available only to managers insidethe firm= information abot variable and fied costs is notavailable to the general pblic. ,C+ analysis is good as ageneral gide for one prodct within the relevant range. f thecompany has more than one prodct then the contribtionmargins from all prodcts mst be averaged together. *t
any cost-averaging process redces the level of accracy ascompared to wor(ing with cost data from a single prodct.Frthermore some organiations sch as nonprofitsorganiations do not incr a significant level of variable costs.n these cases standard ,C+ assmptions can lead tomisleading reslts and decisions.
.SES OF C)P ANALYSIS
a2 B!g"t (lanning. he volme of sales re0ired to ma(e a profit8brea(even point9 and the Lsafety marginL for profits in the bdgetcan be measred.
*2 Pricing an sal"s 'ol!m" "cisions?
c2 Sal"s mi$ "cisions to determine in what proportions eachprodct shold be sold.
2 D"cisions that 3ill a##"ct th" cost str!ct!r" an(ro!ction ca(acit, o# th" com(an,?
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T4E BASIC PRINCIPLES OF C)P ANALYSIS
,C+ analysis is based on the assmption of a linear total costfnction 8constant nit variable cost and constant fied costs9 andso is an application of marginal costing principles.
he principles of marginal costing can be smmarised as follows<
a9 +eriod fied costs are a constant amont therefore if oneetra nit of prodct is made and sold total costs will only riseby the variable cost 8the marginal cost 9 of prodction andsales for that nit.
b9 "lso total costs will fall by the variable cost per nit foreach redction by one nit in the level of activity.
c9 he additional profit earned by ma(ing and selling oneetra nit is the etra revene from its sales mins its variablecosts i.e. the contribtion per nit.
d9 "s the volme of activity increases there will be anincrease in total profits 8or a redction in losses9 e0al to thetotal revene mins the total etra variable costs. his is theetra contribtion from the etra otpt and sales.
e9 he total profit in a period is the total revene mins the
total variable cost of goods sold mins the fied costs of theperiod.
MARGIN OF SAFETY
Margin of safety represents the strength of the bsiness. t enablesa bsiness to (now that what is the eact amont he/ she hasgained or loss over or below brea( even point9.
Margin of safety T 88 sales - brea(-even sales9 / sales9 1)) f +/Cratio is given then sales/pv ratio
In !nit sal"s
f the prodct can be sold in a larger 0antity that occrs at thebrea(even point then the firm will ma(e a profit= below this point aloss. *rea(-even 0antity is calclated by<
otal fied costs / 8selling price - average variable costs9.
'planation - in the denominator Iprice mins average
variable costI is the variable profit per nit or contribtion
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margin of each nit that is sold.
his relationship is derived from the profit e0ation< +rofit T
Revenes - ,osts where Revenes T 8selling price N 0antity
of prodct9 and ,osts T 8average variable costs N 0antity9 U
total fied costs. herefore +rofit T 8selling price N 0antity9 - 8average variable
costs N 0antity U total fied costs9.
olving for :antity of prodct at the brea(even point when
+rofit e0als ero the 0antity of prodct at brea(even is otal
fied costs / 8selling price - average variable costs9.
Firms may still decide not to sell low-profit prodcts for eamplethose not fitting well into their sales mi. Firms may also sellprodcts that lose money - as a loss leader to offer a complete line
of prodcts etc. *t if a prodct does not brea( even or a potentialprodct loo(s li(e it clearly will not sell better than the brea(evenpoint then the firm will not sell or will stop selling that prodct.
"n eample<
• "ssme we are selling a prodct for O2 each.• "ssme that the variable cost associated with prodcing and
selling the prodct is !) cents.• "ssme that the fied cost related to the prodct 8the basic
costs that are incrred in operating the bsiness even if noprodct is prodced9 is O1))).
• n this eample the firm wold have to sell 81))) / 82.)) -).!)9 T #159 #15 nits to brea( even. in that case the marginof safety vale of ;> and the vale of *'+ is not profitable ornot gaining loss.
*rea( 'ven T FC / 8SP W VC9
where F, is Fied ,ost + is selling +rice and C, is Cariable ,ost
Signi#icanc"-
• ?p to the *'+ the contribtion is earned is sfficient only torecover the fied costs. Bowever the beyond the *'+ thecontribtion is called the profit
• +rofit is nothing bt the contribtion earned ot of margin ofsafety of sales.
• he sie of the margin of safety shows the strength of thebsiness.
• " low margin of safety indicates the firm has a large fiedepenses and is moirX vlnerable to changes.
• " high margin of safety implies that a slight fall in sales maynot the bsiness very mch.
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Im(ro'"m"nts in margin o# sa#"t,-
he possible steps for improve the margin of safety.
• ncrease in selling price provided the demand is inelastic so
as to absorb the increased prices.• Redction in fied epenses• Redction in variable epenses• ncreasing the sales volme provided capacity is available.• bstittion or introdction of a prodct mi sch that more
profitable lines are introdced.
S4.T DOWN PROBLEMS
ht down point indicates the level of operation8sales9 below whichit is not stifiable to prse prodction. For this prpose fiedepenses of a bsiness are classified as 8i9 avoidable ordiscretionary fied costs 8ii9 navoidable or committed fied costs.
he focs of sht down point calclation is to recover the avoidablefied costs in the first place. *y sspending the operations the firmmay save as also incr some additional ependitre. he decision isbased on whether contribtion is more than the difference betweenthe fied epenses incrred in normal operation and the fiedepense incrred when the plant is sht down.
" firm has to close down if its contribtion is insfficient to recovereven the avoidable fied costs.
htdown problems involve the following types of decisions<
a9 @hether or not to close down a factory department prodct lineor other activity either becase it is ma(ing losses or becase it istoo epensive to rn.
b9 f the decision is to sht down whether the closre shold bepermanent or temporary. htdown decisions often involve longterm considerations and capital ependitres and revenes.
c9 " shtdown shold reslt in savings in annal operating costs fora nmber of years in the ftre.
d9 ,losre reslts in release of some fied assets for sale. omeassets might have a small scrap vale bt others e.g. propertymight have a sbstantial sale vale.
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e9 'mployees affected by the closre mst be made redndant orrelocated perhaps even offered early retirement. here will be lmpsms payments involved which mst be ta(en into consideration.For eample sppose closre of a regional office reslts in annalsavings of O1))))) fied assets sold off for O2 million bt
redndancy payments wold be O3 million. he shtdown decisionwold involve an assessment of the net capital cost of closre 8O1million9 against the annal benefits 8O1))))) per annm9.
t is possible for shtdown problems to be simplified into short rndecisions by ma(ing one of the following assmptions
a9 Fied asset sales and redndancy costs wold be negligible.b9 ncome from fied asset sales wold match redndancy costs andso these items wold be self-cancelling.
n these circmstances the financial aspects of shtdown decisionswold be based on short rn relevant costs.
CAS4 POSITION AND FORECAST
• he ,ash position and forecast en0iry is sally sed by the reasrer or whoever is responsible for ensring that thecompany has ade0ate fnds for epected otgoings.
•
he ,ash +osition inpt data is the (nown balances<
• +ostings in cash and ban( acconts 8any accont relevant tocash management9the nreconciled entries in the ban(clearing acconts 8ncashed che0es etc9 and
• any memo records which may have been manally entered8planning advices9 as relevant to a cash position
• cash flows from transactions managed in reasryManagement
'amples are<
• -ban( balances
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• -otgoing chec(s posted to the ban( clearing accont• -otgoing transfers posted to the ban( clearing accont• -matring deposits and loans• -notified incoming payments posted to the ban( accont• -incoming payments with a vale date•
G.IDELINES FOR R.NNING T4E CAS4POSITION OR FORECAST EN=.IRY
9? .n"rstaning th" B!sin"ss R"0!ir"m"nts
$escribes the information that yo shold gather abot yor
companyLs operations in this area to ade0ately configre it.
@? Dat"s an th" Cash For"cast
he ,ash position and forecast is all abot amonts and dates. hesection eplains how the dates are determined for the variosinpts.
? Cash For"cast T"rminolog,
'plains the (ey terms that are encontered in the configration.Mst be read before embar(ing on the configration section.
? Cash For"cast Con#ig!ration
Kidelines on configring the ,ash +osition and Forecast - presentedin two sections - essential and then advanced configration.
? R"lat" Con#ig!ration Proc"ssing ar"as
$escribes some of the related configration and processing areasthat impact or feed data to the cash forecast.
? Pr"(aring t"st ata
+resents some hints on preparing test data directly withot havingto rn the feeder programs.
PROFIT AND LOSS FORECAST
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" +rofit and >oss "ccont is designed to show the financialperformance of a bsiness over a given period 8sally Monthly or"nnally9 and to indicate whether it is 8or in the case of a + Y >Forecast if it will9 ma(e or lose money.
@ithot +rofit there eventally will be no bsiness
+rofit and >oss is also essential in providing information for nlandRevene for aation prposes
?nderstanding how a +rofit and >oss "ccont wor(s will help yo tochoose the right time to by items that yo need for the bsinessredce yor ta liability 8a *ill9 and wor( ot how mch a yowill have to pay.
PROFIT AND PLANNING
+rofit planning is essential when yo want yor bsiness to focs onenhancing its profit-ma(ing capabilities. 'ffective profit planninghappens when yo determine in advance a set of clear and realisticgoals that yor bsiness or organiation needs to flfil. hose goalsmst be based pon obective eisting and epected bsinessconditions. "nticipating the changes in yor bsiness environment isalso central to profit planning.
Kiven the central role profit planning can play in the ftreprospects of an organiation it might come as a srprise to learnthat a large nmber of bsinesses do not sally have or develop afinancial plan. @hat is even more amaing is that many of thebsinesses which do plan for their financial ftre often st repeatthe same procedre over and over every year. hey do not ta(e thetime to loo( at how the plan wor(s or if it is really wor(ing.
" very small nmber of bsinesses crrently (nows how to practiceand benefit from proficient profit planning. Bowever researchindicates that profit planning might be a central reason behind theincreased sales and profits enoyed by these few bsinesses."ppropriate profit planning can help yor company enoy thosebenefits too.
'ffective profit planning can have a deep impact in the life of yororganiation. he professionals at FR ,onsltants believe thatprofit planning is a (ey element which has led to the sccess of bigand small bsinesses ali(e. hat said it cold trly ensrecontinos prosperity for yor own bsiness as well. FR
,onsltants is a trstworthy firm of honest and eperiencedprofessionals that can lead yo to ma(e the best ot of profit
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planning. Many goldbric(s in the field are more eager to charge yopremims for their time than to deliver what yo are paying for. "tFR ,onsltants we do not shir( or wor(. @e will strive to deliveron time and prove the vale of or service. Ather conslting firmsmay seem less epensive than s bt that is not the case. o learn
more or to re0est a free consltation please complete or onlineform.