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TOPICS

1. Marginal costing

2. Marginal cost

3. Relationship b/w marginal costing and economies of scale

4. Relevance of marginal private and social costs in marginal


cost theory

5. Features of marginal costing system

6. Advantages of marginal costing system

7. Disadvantages of marginal costing system

8. Marginal costing as a management accounting tool

9. Elements of decision making

10.Relevant costs of decision making

11.Basic decision making indicators in marginal costing

o Profit volume ratio

o Cash volume profit analysis

o Break-even analysis

o Margin of safety

o Shut down point

12.Cash position and forecast

13.Profit and loss forecast

14.Profit planning

MARGINAL COSTING AS A COSTING SYSTEM


Marginal Costing is a type of flexible standard costing that
separates fixed costs from proportional costs in relation to the
output quantity of the objects. In particular, Marginal Costing is a
comprehensive and sophisticated method of planning and
monitoring costs based on resource drivers. Selecting the resource
drivers and separating the costs into fixed and proportional
components ensures that cost fluctuations caused by changes in
operating levels, as defined by marginal analysis, are accurately
predicted as changes in authorized costs and incorporated into
variance analysis.

This form of internal management accounting has become widely


accepted in business practice over the last 50 years. During this
time, however, the demands placed on costing systems by cost
management requirements have changed radically.

MARGINAL COST
In economics and finance, marginal cost is the change in total cost
that arises when the quantity produced changes by one unit. It is
the cost of producing one more unit of a good.[1] Mathematically, the
marginal cost (MC) function is expressed as the first derivative of
the total cost (TC) function with respect to quantity (Q). Note that
the marginal cost may change with volume, and so at each level of
production, the marginal cost is the cost of the next unit produced.

A typical Marginal Cost Curve


In general terms, marginal cost at each level of production includes
any additional costs required to produce the next unit. If producing
additional vehicles requires, for example, building a new factory, the
marginal cost of those extra vehicles includes the cost of the new
factory. In practice, the analysis is segregated into short and long-
run cases, and over the longest run, all costs are marginal. At each
level of production and time period being considered, marginal costs
include all costs which vary with the level of production, and other
costs are considered fixed costs.

A number of other factors can affect marginal cost and its


applicability to real world problems. Some of these may be
considered market failures. These may include information
asymmetries, the presence of negative or positive externalities,
transaction costs, price discrimination and others.

RELATION BETWEEN MARGINAL COST AND ECONOMIES OF


SCALE

• Production may be subject to economies of scale (or


diseconomies of scale). Increasing returns to scale are said to
exist if additional units can be produced for less than the
previous unit, that is, average cost is falling.
• This can only occur if average cost at any given level of
production is higher than the marginal cost.
• Conversely, there may be levels of production where marginal
cost is higher than average cost, and average cost will rise for
each unit of production after that point. This type of
production function is generally known as diminishing
marginal productivity: at low levels of production, productivity
gains are easy and marginal costs falling, but productivity
gains become smaller as production increases; eventually,
marginal costs rise because increasing output (with existing
capital, labour or organization) becomes more expensive. For
this generic case, minimum average cost occurs at the point
where average cost and marginal cost are equal (when
plotted, the two curves intersect); this point will not be at the
minimum for marginal cost if fixed costs are greater than zero.

 Short and long run marginal costs and economies of


scale

The former takes as unchanged, for example, the capital equipment


and overhead of the producer, any change in its production
involving only changes in the inputs of labour, materials and energy.
The latter allows all inputs, including capital items (plant,
equipment, buildings) to vary.

A long-run cost function describes the cost of production as a


function of output assuming that all inputs are obtained at current
prices, that current technology is employed, and everything is being
built new from scratch. In view of the durability of many capital
items this textbook concept is less useful than one which allows for
some scrapping of existing capital items or the acquisition of new
capital items to be used with the existing stock of capital items
acquired in the past. Long-run marginal cost then means the
additional cost or the cost saving per unit of additional or reduced
production, including the expenditure on additional capital goods or
any saving from disposing of existing capital goods. Note that
marginal cost upwards and marginal cost downwards may differ, in
contrast with marginal cost according to the less useful textbook
concept.

Economies of scale are said to exist when marginal cost according


to the textbook concept falls as a function of output and is less than
the average cost per unit. This means that the average cost of
production from a larger new built-from-scratch installation falls
below that from a smaller new built-from-scratch installation. Under
the more useful concept, with an existing capital stock, it is
necessary to distinguish those costs which vary with output from
accounting costs which will also include the interest and
depreciation on that existing capital stock, which may be of a
different type from what can currently be acquired in past years at
past prices. The concept of economies of scale then does not apply.

 Externalities

Externalities are costs (or benefits) that are not borne by the parties
to the economic transaction. A producer may, for example, pollute
the environment, and others may bear those costs. A consumer may
consume a good which produces benefits for society, such as
education; because the individual does not receive all of the
benefits, he may consume less than efficiency would suggest.
Alternatively, an individual may be a smoker or alcoholic and
impose costs on others. In these cases, production or consumption
of the good in question may differ from the optimum level.
[edit] Negative externalities of production

Negative Externalities of Production

Much of the time, private and social costs do not diverge from one
another, but at times social costs may be either greater or less than
private costs. When marginal social costs of production are greater
than that of the private cost function, we see the occurrence of a
negative externality of production. Productive processes that result
in pollution are a textbook example of production that creates
negative externalities.

Such externalities are a result of firms externalizing their costs onto


a third party in order to reduce their own total cost. As a result of
externalizing such costs we see that members of society will be
negatively affected by such behavior of the firm. In this case, we
see that an increased cost of production on society creates a social
cost curve that depicts a greater cost than the private cost curve.

In an equilibrium state we see that markets creating negative


externalities of production will overproduce that good. As a result,
the socially optimal production level would be lower than that
observed.

Positive externalities of production

Positive Externalities of Production

When marginal social costs of production are less than that of the
private cost function, we see the occurrence of a positive externality
of production. Production of public goods are a textbook example of
production that create positive externalities. An example of such a
public good, which creates a divergence in social and private costs,
includes the production of education. It is often seen that education
is a positive for any whole society, as well as a positive for those
directly involved in the market.

Examining the relevant diagram we see that such production


creates a social cost curve that is less than that of the private curve.
In an equilibrium state we see that markets creating positive
externalities of production will under produce that good. As a result,
the socially optimal production level would be greater than that
observed.

Social costs

Of great importance in the theory of marginal cost is the distinction


between the marginal private and social costs. The marginal private
cost shows the cost associated to the firm in question. It is the
marginal private cost that is used by business decision makers in
their profit maximization goals, and by individuals in their
purchasing and consumption choices. Marginal social cost is similar
to private cost in that it includes the cost functions of private
enterprise but also that of society as a whole, including parties that
have no direct association with the private costs of production. It
incorporates all negative and positive externalities, of both
production and consumption.

Hence, when deciding whether or how much to buy, buyers take


account of the cost to society of their actions if private and social
marginal cost coincide. The equality of price with social marginal
cost, by aligning the interest of the buyer with the interest of the
community as a whole is a necessary condition for economically
efficient resource allocation.

Other cost definitions in marginal costing

• Fixed costs are costs which do not vary with output, for
example, rent. In the long run all costs can be considered
variable.
• Variable cost also known as, operating costs, prime costs, on
costs and direct costs, are costs which vary directly with the
level of output, for example, labour, fuel, power and cost of
raw material.
• Social costs of production are costs incurred by society, as
a whole, resulting from private production.
• Average total cost is the total cost divided by the quantity
of output.
• Average fixed cost is the fixed cost divided by the quantity
of output.
• Average variable cost are variable costs divided by the
quantity of output.

What is Marginal Costing?

It is a costing technique where only variable cost or direct cost will be


charged to the cost unit produced.

Marginal costing also shows the effect on profit of changes in volume/type


of output by differentiating between fixed and variable costs.

Salient Points:

• Marginal costing involves ascertaining marginal costs. Since


marginal costs are direct cost, this costing technique is also known
as direct costing;

• In marginal costing, fixed costs are never charged to production.


They are treated as period charge and is written off to the profit and
loss account in the period incurred;

• Once marginal cost is ascertained contribution can be computed.


Contribution is the excess of revenue over marginal costs.

• The marginal cost statement is the basic document/format to


capture the marginal costs.

Features of Marginal Costing System:

• It is a method of recording costs and reporting profits;

• All operating costs are differentiated into fixed and variable costs;

• Variable cost –charged to product and treated as a product cost


whilst

• Fixed cost treated as period cost and written off to the profit and loss
account
Disadvantages Of Marginal Costing

• Marginal cost has its limitation since it makes use of historical


data while decisions by management relates to future events;

• It ignores fixed costs to products as if they are not important


to production;

• Stock valuation under this type of costing is not accepted by


the Inland Revenue as it’s ignore the fixed cost element;

• It fails to recognize that in the long run, fixed costs may


become variable;

• Its oversimplified costs into fixed and variable as if it is so


simply to demarcate them;

• It’s not a good costing technique in the long run for pricing
decision as it ignores fixed cost. In the long run, management
must consider the total costs not only the variable portion;

• Difficulty to classify properly variable and fixed cost perfectly,


hence stock valuation can be distorted if fixed cost is classify
as variable.
MARGINAL COSTING AS A MANAGEMENT ACCOUNTING
TOOL

1. Marginal Costing is clearly the core aspect of traditional


management accounting. Some of the classical applications of
management accounting, however, have begun to lose their
significance. The question thus arises: What is the current role of
Marginal Costing in modern management accounting?

2. Businesses today frequently voice their disapproval of the


traditional cost accounting approaches. At the beginning of the
1990s, these criticisms were taken up by researchers involved with
the applications of cost accounting concepts.

The main thrust of the dissatisfaction with conventional cost


accounting methods is that they are too highly developed and too
complex, and furthermore are no longer needed in their current
form since other tools are now available. Calls for increased use of
cost management tools, investment analyses, and value-based tool
concepts are frequently associated with criticism of the functionality
of current cost accounting approaches as management tools. This
line of criticism sees little relevance in traditional cost accounting
tasks such as monitoring the economic production process or
assigning the costs of internal activities. At their current level of
detail, such tasks are neither necessary nor does their perceived
pseudo accuracy further the goals of management.

The viewpoint of the present author is that cost accounting has by


no means lost its right to exist, for it is an easily overlooked fact that
the data structure required by the new tools is already present in
traditional cost accounting.

3. To assess the present-day value of Marginal Costing, the changes


occurring in the business world must be analyzed more closely. We
need first to look at how the purposes of cost accounting are
shifting before we can determine its significance.

(i) cost planning takes precedence over cost control. The


effort involved in planning and monitoring costs is increasingly
being seen as excessive. The charge levied against traditional cost
accounting--that its complex cost allocations merely generate a kind
of pseudo precision--lends further credence to this assessment. An
alternative increasingly being called for is to control costs through
direct activity/process information (quantities, times, quality) for
cost management at local, decentralized levels instead of relying on
delayed and distorted cost data. In particular, empirical U.S.
research on appropriate variables for performance measurement, in
the context of continuous improvement and modern managerial
concepts, is based on this view. The need for exact cost planning
for profitability management is thus touched on ex ante.

(ii) cost accounting must be employed as a tool for cost


control at an early stage. The relative significance of traditional cost
accounting as a management accounting tool will decline as it is
applied mainly to fields where costs cannot be heavily influenced.
More significant than influencing the current costs of production with
cost center controlling and authorized-actual comparisons of the
cost of goods manufactured is timely and market-based authorized
cost management. The greatest scope for influencing costs is at the
early product development phase and when setting up the
production processes. At the same time, this is the stage where cost
information is most urgently needed since the time and quantity
standards as defined by Bills of Materials (BOMs) and production
routings are still lacking. This requires different methods of cost
planning than those normally provided by Marginal Costing.

(iii) the behavioural effect of cost information is starting to


be recognized. There is a strong current of accounting research in
the U.S. that takes human psychological factors into consideration.
This is resulting in an extension of cost theory beyond its pure
microeconomic basis. Results of theoretical and empirical research
based, for example, on the principal-agent theory indicate that
knowledge of the "relevant" costs does not always lead to the
optimization of overall enterprise profitability. Hence, the
perspective that formed the basis for the absorption costing issue
has changed. Theories according to which cost allocations can
contain information and increase the efficiency of the use of
available capacity, or where future allocations can influence ex-ante
decisions, require empirical research.

4. The shift in the purposes of cost accounting is being


accompanied by a shift in the main applications of standard costing.
Costing solutions for market-oriented profitability management and
life-cycle-based planning and monitoring should be developed
further. They should be implemented both in indirect areas and at
the corporate level. In addition, cost accounting must be integrated
into performance measurement.

Competitive dynamics are giving rise to an increasing differentiation


of market-based profitability controlling. This applies to the
management of the profitability of products and product lines, as
well as distribution channels and increasingly customers, customer
groups, and markets. The information required for this purpose can
only be supplied by multilevel and multidimensional marketing
segment accounting based on contribution margin accounting.

Long-term cost planning based on the idea of lifecycle costing is


gaining in prominence compared with short-term standard costing.
Product decisions are increasingly based on more than just the cost
of goods manufactured and sales costs and now tend to include pre-
production costs (such as development costs) and phasing-out costs
(such as disposal costs). Product decisions are viewed strategically.
Whether or not a product is successful is determined by the
amortization of its overall cost. Furthermore, the cost and revenue
trend forecasts should be more dynamic to support the lifecycle
pricing policy. This shift in cost and revenue planning is moving cost
and revenue accounting in the direction of investment-related
calculations.

As management accounting is increasingly applied to the growing


share of the costs of indirect areas, the tool requirements increase.
After J. G. Miller's and T. E. Vollmann's discovery of the "hidden
factory" as an area whose costs are neglected by conventional
production costing in the U.S., it was only a small step to the
identification of the lost relevance of conventional cost accounting
by H. T. Johnson and R. S. Kaplan and their call to develop
accounting systems separated into "process control, product
costing, and financial reporting," which eventually led to activity-
based costing. Improving the cost transparency of indirect activity
areas through Marginal Costing requires a thorough understanding
of the output processes. Analysis frequently shows that even many
support activities have a wide range of repetitive processes for
which planning and cost allocation using drivers is worthwhile,
providing the cost-volume is large enough. For this purpose, the
different operations in the cost centers must be identified, for which
resource consumption is then planned and tracked. The number of
these operations is used as the driver. This process of costing
operations using 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 previously budgeted only as a lump sum.

Industrial production and marketing are increasingly being handled


by groups of affiliated companies. To plan and monitor the costs of
these activities calls for the establishment of independent group
cost accounting. This necessity results mainly from the
requirements of inventory valuation, the costing basis of transfer
prices, and to further the consistency of corporate cost accounting.
Group cost accounting leads to the definition of independent group
cost categories. Marginal Costing and its tools have been developed
for individual companies and are the suitable platform for this
expansion.

Performance measures are gaining increasing prominence in


decentralized management accounting. Standard U.S. management
books devote a great deal of space to performance measurement in
the broad sense of the word. The concept is broad for the reason
that performance measurement is accompanied by the provision of
decision-support information, the management of business units,
and the use of incentive systems. Using modelling and empirical
research, the exponents of this area are developing the idea that
monetary factors are not the only possible components of
performance measurement.

Since the 1980s there has been a growing consciousness of the


significance of continuously improving the performance capabilities
of the company, resulting in the increased importance of
nonmonetary indicators. The recent literature on performance
measurement has focused on problems in the following areas:

* The usability of performance information for managers,

* The assessment of teamwork,

* The motivational effects of performance measurement,

* The strategic dimension.

The tenor of the recent investigations into performance


measurement reflects the general criticism of management
accounting voiced by Johnson and Kaplan in Relevance Lost. It was
recognized that short-term accounting information is insufficient to
evaluate and control company activities effectively. In particular, it
was acknowledged that the use of standard costs does not
adequately take performance improvements into consideration.
Moreover, the conventional allocation approach based on the
operating rate encourages high utilization of capacity at any cost,
underestimates the problem of increasing numbers of variants, uses
the wrong overhead allocation base, and fails to appreciate
interdepartmental interrelationships.

While top management benefits most from financial success


indicators that it examines in monthly or longer intervals and that
can consist of multidimensional aggregate figures, lower
management must necessarily be concerned mainly with
nonfinancial, operational, and very short-term data at the day or
shift level. In concrete terms, measures in the categories of time,
quantity, and quality--such as equipment downtime, lead time,
response time, degree of utilization (ratio of actual output quantity
to planned output quantity), sales orders, and error rate--are
becoming increasingly significant for controlling business processes.

In the strategic dimension, the Balanced Scorecard developed by


Kaplan and Norton--which links financial and nonfinancial indicators
from different strategically relevant perspectives including cause-
effect chains--is the main proposal under consideration for
performance measurement. The Balanced Scorecard links strategic
contingencies to financial measures, incorporates success factors of
the future, and explicitly includes monetary and nonmonetary
parameters. The Balanced Scorecard therefore provides a
framework for systematic mapping and control of the critical
success factors for an enterprise. A Balanced Scorecard is a system
that defines objectives, measures, targets, and initiatives for each of
the four perspectives of financial, customer, internal business
process, and learning and growth. Further analyses and experience
in measuring performance can enable identification and assessment
of cause-effect relationships within the four perspectives (such as
the effect of delivery time on customer satisfaction) and between
the perspectives (such as the effect of customer satisfaction on
profitability). The knowledge so gained may eventually lead to a
reformulation of strategy.

In the context of comprehensive performance measurement, even


short-term costs and financial results can serve as control
instruments for strategic enterprise management, such as a lower
authorized cost of goods manufactured as a benchmark. Concrete
planned costs and planned results must be rigorously derived from
higher-level target factors so that specific requirements can be
derived in turn when they are broken down into smaller
organizational units for the time and quantity standards.

Information for decision making The need for a decision arises in


business because a manager is faced with a problem and alternative
courses of action are available. In deciding which option to choose
he will need all the information which is relevant to his decision; and
he must have some criterion on the basis of which he can choose
the best alternative. Some of the factors affecting the decision may
not be expressed in monetary value. Hence, the manager will have
to make 'qualitative' judgements, e.g. in deciding which of two
personnel should be promoted to a managerial position. A
'quantitative' decision, on the other hand, is possible when the
various factors, and relationships between them, are measurable.
This chapter will concentrate on quantitative decisions based on
data expressed in monetary value and relating to costs and
revenues as measured by the management accountant.

Elements of a decision

A quantitative decision problem involves six parts:

a) An objective that can be quantified Sometimes referred to as


'choice criterion' or 'objective function', e.g. maximisation of profit
or minimisation of total costs.

b) Constraints Many decision problems have one or more


constraints, e.g. limited raw materials, labour, etc. It is therefore
common to find an objective that will maximise profits subject to
defined constraints.

c) A range of alternative courses of action under consideration.


For example, in order to minimise costs of a manufacturing
operation, the available alternatives may be:

i) to continue manufacturing as at present


ii) to change the manufacturing method
iii) to sub-contract the work to a third party.

d) Forecasting of the incremental costs and benefits of each


alternative course of action.

e) Application of the decision criteria or objective function, e.g. the


calculation of expected profit or contribution, and the ranking of
alternatives.

f) Choice of preferred alternatives.

Relevant costs for decision making

The costs which should be used for decision making are often
referred to as "relevant costs". CIMA defines relevant costs as 'costs
appropriate to aiding the making of specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them by


current decisions and they are common to all alternatives that we
may choose.

b) Incremental: ' Meaning, expenditure which will be incurred or


avoided as a result of making a decision. Any costs which would be
incurred whether or not the decision is made are not said to be
incremental to the decision.
c) Cash flow: Expenses such as depreciation are not cash flows
and are therefore not relevant. Similarly, the book value of existing
equipment is irrelevant, but the disposal value is relevant.

Other terms:

d) Common costs: Costs which will be identical for all alternatives


are irrelevant, e.g. rent or rates on a factory would be incurred
whatever products are produced.

e) Sunk costs: Another name for past costs, which are always
irrelevant, e.g. dedicated fixed assets, development costs already
incurred.

f) Committed costs: A future cash outflow that will be incurred


anyway, whatever decision is taken now, e.g. contracts already
entered into which cannot be altered.

Opportunity cost

Relevant costs may also be expressed as opportunity costs. An


opportunity cost is the benefit foregone by choosing one opportunity
instead of the next best alternative.

Example

A company is considering publishing a limited edition book bound in


a special leather. It has in stock the leather bought some years ago
for $1,000. To buy an equivalent quantity now would cost $2,000.
The company has no plans to use the leather for other purposes,
although it has considered the possibilities:

a) of using it to cover desk furnishings, in replacement for other


material which could cost $900
b) of selling it if a buyer could be found (the proceeds are unlikely to
exceed $800).

In calculating the likely profit from the proposed book before


deciding to go ahead with the project, the leather would not be
costed at $1,000. The cost was incurred in the past for some reason
which is no longer relevant. The leather exists and could be used on
the book without incurring any specific cost in doing so. In using the
leather on the book, however, the company will lose the
opportunities of either disposing of it for $800 or of using it to save
an outlay of $900 on desk furnishings.

The better of these alternatives, from the point of view of benefiting


from the leather, is the latter. "Lost opportunity" cost of $900 will
therefore be included in the cost of the book for decision making
purposes.

The relevant costs for decision purposes will be the sum of:

i) 'avoidable outlay costs', i.e. those costs which will be incurred only
if the book project is approved, and will be avoided if it is not

ii) the opportunity cost of the leather (not represented by any outlay
cost in connection to the project).

This total is a true representation of 'economic cost'.

Now attempt exercise 5.1.

The assumptions in relevant costing

Some of the assumptions made in relevant costing are as follows:

a) Cost behaviour patterns are known, e.g. if a department closes


down, the attributable fixed cost savings would be known.

b) The amount of fixed costs, unit variable costs, sales price and
sales demand are known with certainty.

c) The objective of decision making in the short run is to maximise


'satisfaction', which is often known as 'short-term profit'.

d) The information on which a decision is based is complete and


reliable.

THE BASIC DECISION MAKING INDICATORS IN


MARGINAL COSTING
• PROFIT VOLUME RATIO
• BREAK- EVEN POINT
• CASH VOLUME PROFIT ANALYSIS
• MARGIN OF SAFETY
• INDIFFERENCE POINT
• SHUT – DOWN POINT

PROFIT VOLUME RATIO (P V RATIO )


The profit volume ratio is the relationship between the Contribution
and Sales value.

It is also termed as Contribution to Sales Ratio

Formula :

P V Ratio = Contribution X 100

Sales

Significance of PV Ratio

• It is considered to be the basic indicator of profitability of


business.

• The higher the PV Ratio, the better it is for the business. In the
case of the firm enjoying steady business conditions over a
period of years, the PV Ratio will also remain stable and
steady.

• If PV Ratio is improved, it will result in better profits.

Improvement of PV Ratio

• By reducing the variable costs.

• By increasing the selling price

• By increasing the share of products with higher PV Ratio in the


overall sales mix. (where a firm produces a number of
products)

Use of PV Ratio

• To compute the variable costs for any volume of sales

• To measure the efficiency or to choose a most profitable line.


The overall profitability of the firm can be improved by
increasing the sales/output of product giving a higher PV
Ratio.

• To determine the Break – Even Point and the level of output


required to earn a desired profit.

• To decide the most profitable sales – mix.

BREAK – EVEN ANALYSIS


• Break-Even Analysis is a mathematical technique for
analyzing the relationship between sales and fixed and
variable costs. Break-even analysis is also a profit-planning
tool for calculating the point at which sales will equal total
costs.
• The break-even point is the intersection of the total sales and
the total cost lines. This point determines the number of units
produced to achieve breakeven.
• The analysis generally assumes linearity (100% variable or
100% fixed) of costs. If a firm’s costs were all variable, the
firm could be profitable from the start. If the firm is to avoid
losses, its sales must cover all costs that vary directly with
production and all costs that do not change with production
levels.
• Fixed costs are those expenses associated with the project
that you would have to pay whether you sold one unit or
10,000 units. Examples include general office expenses, rent,
depreciation, interest, salaries, research and development,
and utilities. Variable costs vary directly with the number of
units that you sell. Examples include materials, direct labour,
postage, packaging, and advertising. Some costs are difficult
to classify. As a general guideline, if there is a direct
relationship between cost and number of units sold, consider
the cost variable. If there is no relationship, then consider the
cost fixed.
• A break-even chart is constructed with a horizontal axis
representing units produced and a vertical axis representing
sales and costs. Represent fixed costs by a horizontal line
since they do not change with the number of units produced.
Represent variable costs and sales by upward sloping lines
since they vary with the number of units produced and sold.
The break-even point is the intersection of the total sales and
the total cost lines. Above that point, the firm begins to make
a profit, but below that point, it suffers a loss. Here is a sample
break-even chart:
The algebraic equation for break-even analysis consists of four
factors. If you know any three of the four, you can solve for
the fourth factor. You calculate the break-even amount with
the following equation:
Sales Price per Unit * Quantity Sold = Fixed Costs + [Variable
Costs per Unit * Quantity Sold]
For example, assume you have total fixed monthly costs of
$1200 and total variable costs of $6 per unit. If you could sell
the units for $10 each, the equation indicates that you need to
sell 300 units to break even. If you knew you could sell 400
units, the equation would indicate that the sales price would
need to be $9 per unit to break even.

• When managing inventory, you should aim for the Economic


Order Quantity (EOQ). This is the level of inventory that
balances two kinds of inventory costs: holding (or carrying)
costs, which increase with the amount of inventory ordered,
and order costs, which decrease with the amount ordered.

• The largest components of holding costs for most companies


are the cost of space to store the inventory and the cost of
tying up capital in inventory. Other components include the
labour costs associated with inventory maintenance and
insurance costs. Also include deterioration, spoilage, and
obsolescence costs. The costs of more frequent orders include
lost discounts for larger quantity purchases and labour and
supply costs of writing the orders. Additional costs include
paying the bills and processing the paperwork, associated
telephone and mail costs, and the labour costs of processing
and inspecting incoming inventory.
• EOQ is the size of order that minimizes the total of holding
and ordering costs. The algebraic expression of EOQ is as
follows:
EOQ = square root of [2*U*O divided by H] where U is the
number of units used annually, O is the order cost per order,
and H is the holding cost per unit.
For example, assume you use 40,000 units annually, it costs
$50 to place an order, and it costs $20 to hold the raw
materials for one unit. The equation yields an amount of 447,
which is the number of units you need to order at one time to
minimize total costs.
The reorder point, or Economic Order Point (EOP), tells you
when to place an order. Calculating the reorder point requires
you to know the lead time from placing to receiving an order.
You compute it as follows:
EOP = Lead time * Average usage per unit of time
For example, assume you need 6400 units evenly throughout the
year, there is a lead time of one week, and there are 50 working
weeks in the year. You calculate the reorder point to be 128 units as
follows.
1 week * [6400 units / 50 weeks] = 128 units
You might also consider “Just In Time” inventory management, if
available and appropriate. “Just In Time” allows you to keep minimal
inventory in stock. You only order when you make a sale. Carefully
analyze the time lag. You must be able to satisfy the customer as
well as keep your inventory investment minimized.

Use of BEP Analysis In capital budgeting

Break even analysis is a special application of sensitivity analysis. It


aims at finding the value of individual variables which the project’s
NPV is zero. In common with sensitivity analysis, variables selected
for the break even analysis can be tested only one at a time.

The break even analysis results can be used to decide abandon of


the project if forecasts show that below break even values are likely
to occur.

In using break even analysis, it is important to remember the


problem associated with sensitivity analysis as well as some
extension specific to the method:

• Variables are often interdependent, which makes examining


them each individually unrealistic.
• Often the assumptions upon which the analysis is based are
made by using past experience / data which may not hold in
the future.
• Variables have been adjusted one by one; however it is
unlikely that in the life of the project only one variable will
change until reaching the break even point. Management
decisions made by observing the behaviour of only one
variable are most likely to be invalid.
• Break even analysis is a pessimistic approach by essence. The
figures shall be used only as a line of defence in the project
analysis.

Limitations Of BEP Analysis

• Break-even analysis is only a supply side (i.e. costs only)


analysis, as it tells you nothing about what sales are actually
likely to be for the product at these various prices.
• It assumes that fixed costs (FC) are constant
• It assumes average variable costs are constant per unit of
output, at least in the range of likely quantities of sales. (i.e.
linearity)
• It assumes that the quantity of goods produced is equal to the
quantity of goods sold (i.e., there is no change in the quantity
of goods held in inventory at the beginning of the period and
the quantity of goods held in inventory at the end of the
period).
• In multi-product companies, it assumes that the relative
proportions of each product sold and produced are constant
(i.e., the sales mix is constant).

COST VOLUME PROFIT ANALYSIS


• Analysis that deals with how profits and costs change with a
change in volume. More specifically, it looks at the effects on
profits of changes in such factors as variable costs, fixed
costs, selling prices, volume, and mix of products sold.

• CVP analysis involves the analysis of how total costs, total


revenues and total profits are related to sales volume, and is
therefore concerned with predicting the effects of changes in
costs and sales volume on profit. It is also known as
'breakeven analysis'.

• By studying the relationships of costs, sales, and net income,


management is better able to cope with many planning
decisions. For example, CVP analysis attempts to answer the
following questions: (1)
What sales volume is required to break even?
(2) What sales volume is necessary in order to earn a desired
(target) profit? (3) What profit can be expected on a given
sales volume? (4) How would changes in
selling price, variable costs, fixed costs, and output affect
profits?
(5) How would a change in the mix of products sold affect the
break-even and target volume and profit potential?

• Cost-volume-profit analysis (CVP), or break-even analysis, is


used to compute the volume level at which total revenues are
equal to total costs. When total costs and total revenues are
equal, the business organization is said to be "breaking even."
The analysis is based on a set of linear equations for a straight
line and the separation of variable and fixed costs.

• Total variable costs are considered to be those costs that vary


as the production volume changes. In a factory, production
volume is considered to be the number of units produced, but
in a governmental organization with no assembly process, the
units produced might refer, for example, to the number of
welfare cases processed.

• There are a number of costs that vary or change, but if the


variation is not due to volume changes, it is not considered to
be a variable cost. Examples of variable costs are direct
materials and direct labour. Total fixed costs do not vary as
volume levels change within the relevant range. Examples of
fixed costs are straight-line depreciation and annual insurance
charges.
• All the lines in the chart are straight lines: Linearity is an
underlying assumption of CVP analysis. Although no one can
be certain that costs are linear over the entire range of output
or production, this is an assumption of CVP.

• To help alleviate the limitations of this assumption, it is also


assumed that the linear relationships hold only within the
relevant range of production. The relevant range is
represented by the high and low output points that have been
previously reached with past production. CVP analysis is best
viewed within the relevant range, that is, within our previous
actual experience. Outside of that range, costs may vary in a
nonlinear manner. The straight-line equation for total cost is:

Total cost = total fixed cost + total variable cost

Total variable cost is calculated by multiplying the cost of a


unit, which remains constant on a per-unit basis, by
the number of units produced. Therefore the total cost
equation could be expanded as:

Total cost = total fixed cost + (variable cost per unit number
of units)

Total fixed costs do not change.

A final version of the equation is:

Y = a + bx

where a is the fixed cost, b is the variable cost per unit, x is


the level of activity, and Y is the total cost. Assume that the
fixed costs are $5,000, the volume of units produced is 1,000,
and the per-unit variable cost is $2. In that case the total cost
would be computed as follows:

Y = $5,000 + ($2 1,000) Y = $7,000

It can be seen that it is important to separate variable and


fixed costs. Another reason it is important to separate these
costs is because variable costs are used to determine the
contribution margin, and the contribution margin is used to
determine the break-even point. The contribution margin is
the difference between the per-unit variable cost and the
selling price per unit. For example, if the per-unit variable cost
is $15 and selling price per unit is $20, then the contribution
margin is equal to $5. The contribution margin may provide a
$5 contribution toward the reduction of fixed costs or a $5
contribution to profits. If the business is operating at a volume
above the break-even point volume (above point F), then the
$5 is a contribution (on a per-unit basis) to additional profits. If
the business is operating at a volume below the break-even
point (below point F), then the $5 provides for a reduction in
fixed costs and continues to do so until the break-even point is
passed.

• Once the contribution margin is determined, it can be used to


calculate the break-even point in volume of units or in total
sales dollars. When a per-unit contribution margin occurs
below a firm's break-even point, it is a contribution to the
reduction of fixed costs. Therefore, it is logical to divide fixed
costs by the contribution margin to determine how many units
must be produced to reach the break-even point:

• The financial information required for CVP analysis is for


internal use and is usually available only to managers inside
the firm; information about variable and fixed costs is not
available to the general public. CVP analysis is good as a
general guide for one product within the relevant range. If the
company has more than one product, then the contribution
margins from all products must be averaged together. But,
any cost-averaging process reduces the level of accuracy as
compared to working with cost data from a single product.
Furthermore, some organizations, such as nonprofits
organizations, do not incur a significant level of variable costs.
In these cases, standard CVP assumptions can lead to
misleading results and decisions.

USES OF CVP ANALYSIS

a) Budget planning. The volume of sales required to make a profit


(breakeven point) and the 'safety margin' for profits in the budget
can be measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions each


product should be sold.

d) Decisions that will affect the cost structure and


production capacity of the company.
THE BASIC PRINCIPLES OF CVP ANALYSIS
CVP analysis is based on the assumption of a linear total cost
function (constant unit variable cost and constant fixed costs) and
so is an application of marginal costing principles.

The principles of marginal costing can be summarised as follows:

a) Period fixed costs are a constant amount, therefore if one


extra unit of product is made and sold, total costs will only rise
by the variable cost (the marginal cost) of production and
sales for that unit.

b) Also, total costs will fall by the variable cost per unit for
each reduction by one unit in the level of activity.

c) The additional profit earned by making and selling one


extra unit is the extra revenue from its sales minus its variable
costs, i.e. the contribution per unit.

d) As the volume of activity increases, there will be an


increase in total profits (or a reduction in losses) equal to the
total revenue minus the total extra variable costs. This is the
extra contribution from the extra output and sales.

e) The total profit in a period is the total revenue minus the


total variable cost of goods sold, minus the fixed costs of the
period.

MARGIN OF SAFETY
Margin of safety represents the strength of the business. It enables
a business to know that what is the exact amount he/ she has
gained or loss over or below break even point).

Margin of safety = (( sales - break-even sales) / sales) x 100% If P/V


ratio is given then sales/pv ratio

In unit sales

If the product can be sold in a larger quantity that occurs at the


breakeven point, then the firm will make a profit; below this point, a
loss. Break-even quantity is calculated by:

Total fixed costs / (selling price - average variable costs).


Explanation - in the denominator, "price minus average
variable cost" is the variable profit per unit, or contribution
margin of each unit that is sold.
This relationship is derived from the profit equation: Profit =
Revenues - Costs where Revenues = (selling price * quantity
of product) and Costs = (average variable costs * quantity) +
total fixed costs.
Therefore, Profit = (selling price * quantity) - (average variable
costs * quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when
Profit equals zero, the quantity of product at breakeven is Total
fixed costs / (selling price - average variable costs).

Firms may still decide not to sell low-profit products, for example
those not fitting well into their sales mix. Firms may also sell
products that lose money - as a loss leader, to offer a complete line
of products, etc. But if a product does not break even, or a potential
product looks like it clearly will not sell better than the breakeven
point, then the firm will not sell, or will stop selling, that product.

An example:

• Assume we are selling a product for $2 each.


• Assume that the variable cost associated with producing and
selling the product is 60 cents.
• Assume that the fixed cost related to the product (the basic
costs that are incurred in operating the business even if no
product is produced) is $1000.
• In this example, the firm would have to sell (1000 / (2.00 -
0.60) = 715) 715 units to break even. in that case the margin
of safety value of NIL and the value of BEP is not profitable or
not gaining loss.

Break Even = FC / (SP − VC)

where FC is Fixed Cost, SP is selling Price and VC is Variable Cost

Significance:

• Up to the BEP, the contribution is earned is sufficient only to


recover the fixed costs. However the beyond the BEP, the
contribution is called the profit
• Profit is nothing but the contribution earned out of margin of
safety of sales.
• The size of the margin of safety shows the strength of the
business.
• A low margin of safety indicates the firm has a large fixed
expenses and is moiré vulnerable to changes.
• A high margin of safety implies that a slight fall in sales may
not the business very much.
Improvements in margin of safety:

The possible steps for improve the margin of safety.

• Increase in selling price, provided the demand is inelastic so


as to absorb the increased prices.
• Reduction in fixed expenses
• Reduction in variable expenses
• Increasing the sales volume provided capacity is available.
• Substitution or introduction of a product mix such that more
profitable lines are introduced.

SHUT DOWN PROBLEMS


Shut down point indicates the level of operation(sales), below which
it is not justifiable to pursue production. For this purpose fixed
expenses of a business are classified as (i) avoidable or
discretionary fixed costs (ii) unavoidable or committed fixed costs.

The focus of shut down point calculation is to recover the avoidable


fixed costs in the first place. By suspending the operations, the firm
may save as also incur some additional expenditure. The decision is
based on whether contribution is more than the difference between
the fixed expenses incurred in normal operation and the fixed
expense incurred when the plant is shut down.

A firm has to close down if its contribution is insufficient to recover


even the avoidable fixed costs.

Shutdown problems involve the following types of decisions:

a) Whether or not to close down a factory, department, product line


or other activity, either because it is making losses or because it is
too expensive to run.

b) If the decision is to shut down, whether the closure should be


permanent or temporary. Shutdown decisions often involve long
term considerations, and capital expenditures and revenues.

c) A shutdown should result in savings in annual operating costs for


a number of years in the future.

d) Closure results in release of some fixed assets for sale. Some


assets might have a small scrap value, but others, e.g. property,
might have a substantial sale value.
e) Employees affected by the closure must be made redundant or
relocated, perhaps even offered early retirement. There will be lump
sums payments involved which must be taken into consideration.
For example, suppose closure of a regional office results in annual
savings of $100,000, fixed assets sold off for $2 million, but
redundancy payments would be $3 million. The shutdown decision
would involve an assessment of the net capital cost of closure ($1
million) against the annual benefits ($100,000 per annum).

It is possible for shutdown problems to be simplified into short run


decisions, by making one of the following assumptions

a) Fixed asset sales and redundancy costs would be negligible.


b) Income from fixed asset sales would match redundancy costs and
so these items would be self-cancelling.

In these circumstances the financial aspects of shutdown decisions


would be based on short run relevant costs.

CASH POSITION AND FORECAST


• The Cash position and forecast enquiry is usually used by the
Treasurer or whoever is responsible for ensuring that the
company has adequate funds for expected outgoings.

• The Cash Position input data is the known balances:

• Postings in cash and bank accounts (any account relevant to


cash management),the unreconciled entries in the bank
clearing accounts (uncashed cheques etc), and
• any memo records which may have been manually entered
(planning advices) as relevant to a cash position
• cash flows from transactions managed in Treasury
Management

Examples are:

• -bank balances
• -outgoing checks posted to the bank clearing account
• -outgoing transfers posted to the bank clearing account
• -maturing deposits and loans
• -notified incoming payments posted to the bank account
• -incoming payments with a value date

GUIDELINES FOR RUNNING THE CASH


POSITION OR FORECAST ENQUIRY
1. Understanding the Business Requirements

Describes the information that you should gather about your


company's operations in this area to adequately configure it.

2. Dates and the Cash Forecast

The Cash position and forecast is all about amounts and dates. The
section explains how the dates are determined for the various
inputs.

3. Cash Forecast Terminology

Explains the key terms that are encountered in the configuration.


Must be read before embarking on the configuration section.

4. Cash Forecast Configuration

Guidelines on configuring the Cash Position and Forecast - presented


in two sections - essential and then advanced configuration.

5. Related Configuration / Processing areas

Describes some of the related configuration and processing areas


that impact or feed data to the cash forecast.

6. Preparing test data

Presents some hints on preparing test data directly without having


to run the feeder programs.

PROFIT AND LOSS FORECAST


A Profit and Loss Account is designed to show the financial
performance of a business over a given period (usually Monthly or
Annually) and to indicate whether it is (or, in the case of a P & L
Forecast, if it will) make or lose money.

Without Profit there eventually will be no business

Profit and Loss is also essential in providing information for Inland


Revenue for Taxation purposes

Understanding how a Profit and Loss Account works will help you to
choose the right time to buy items that you need for the business,
reduce your tax liability (Tax Bill) and work out how much Tax you
will have to pay.

PROFIT AND PLANNING


Profit planning is essential when you want your business to focus on
enhancing its profit-making capabilities. Effective profit planning
happens when you determine in advance a set of clear and realistic
goals that your business or organization needs to fulfil. Those goals
must be based upon objective existing and expected business
conditions. Anticipating the changes in your business environment is
also central to profit planning.

Given the central role profit planning can play in the future
prospects of an organization, it might come as a surprise to learn
that a large number of businesses do not usually have or develop a
financial plan. What is even more amazing is that many of the
businesses which do plan for their financial future often just repeat
the same procedure over and over every year. They do not take the
time to look at how the plan works, or if it is really working.

A very small number of businesses currently knows how to practice


and benefit from proficient profit planning. However, research
indicates that profit planning might be a central reason behind the
increased sales and profits enjoyed by these few businesses.
Appropriate profit planning can help your company enjoy those
benefits too.

Effective profit planning can have a deep impact in the life of your
organization. The professionals at FRS Consultants believe that
profit planning is a key element which has led to the success of big
and small businesses alike. That said, it could truly ensure
continuous prosperity for your own business, as well. FRS
Consultants is a trustworthy firm of honest and experienced
professionals that can lead you to make the best out of profit
planning. Many goldbricks in the field are more eager to charge you
premiums for their time than to deliver what you are paying for. At
FRS Consultants we do not shirk our work. We will strive to deliver
on time and prove the value of our service. Other consulting firms
may seem less expensive than us, but that is not the case. To learn
more or to request a free consultation please complete our online
form.