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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 Study Chapter 17 Progress test and practice question(s) as set Business Accounting

Independent study

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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)
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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
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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, Business Accounting 4

Exercise 1 Variable 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
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Required

Solution 1 Variable 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
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Exercise 2 Marginal 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.
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statement
Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss)

Marginal cost
1 unit 1,000 units

3.20

0.30 0.75 (

)? ?

? ? (

)? ? (850) ?

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statement
Sales Variable costs Mineral water Bottle, lid and label Contribution Fixed costs Net profit/(loss)

Marginal cost
1 unit 3.20 0.30 0.75 1,000 units 3,200 300 750

(1.05) 2.15

(1,050) 2,150 (850) 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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Techniques based on marginal costing 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
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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
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Exercise 3 Breakeven 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 Business Accounting per unit

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Solution 3 Breakeven 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 youve found the breakeven point (BEP) in units, you can use it to find the BEP in sales value or % of capacity Formula
BEP in units 100 Capacity in units

Workings
395 100 1,000 = 39.5% or 40% of capacity

BEP in units Selling price 395 3.20 = 1,264 sales value

Interpretation - Cotswold Coolers will break even when sales revenue

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

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Exercise 4 Level 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 Calculate the level of activity required to achieve a target profit of 500 using the formula: Fixed costs + Target profit Business Accounting
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Required

Level of activity to achieve a target profit


Formula Workings Total fixed costs + Target profit 850 + 500 Contribution per unit 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 is


Selected 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 Business Accounting 18

Breakeven graph

Costs/Sales ()

Sales revenue
PROFIT

1,350 1,264 850 0

Profit 500 Breakeven point LOSS

Variable costs

Fixed costs

Margin of safety 233 units 395 628 Activity level (units)


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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
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