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
Business Accounting 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 activity levels fluctuate
Actual or budgeted/planned figures can be used
Business Accounting 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 activity’ (Collis and Hussey, 2007, p. 292)
In marginal costingVariable costs + Fixed costs = Total cost
Business Accounting 5
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
Business Accounting 6
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
Business Accounting 7
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)
Business Accounting 8
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
Business Accounting 9
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) ?
Business Accounting 10
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
Business Accounting 11
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
Business Accounting 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 13
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
Business Accounting 14
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
Business Accounting 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 100 395 100 = 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
Business Accounting 16
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
Business Accounting 17
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 ...
Business Accounting 19
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)