Lecture 7 - Cost classification and cost volume profit analysis PDF

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Cost classification and cost volume profit analysis...

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Lecture 7 Cost classification and cost volume profit analysis 1. Marginal Costing In marginal costing, revenue expenditure is classified into variable costs and fixed costs, according to the behaviour of the cost when activity levels fluctuate, and only the variable costs are charged to the cost unit’  The marginal cost is ‘the additional cost incurred as a result of the production of one additional unit of production’  A variable cost is ‘an item of expenditure that, in total, varies directly with the level of activity achieved’  A fixed cost is ‘an item of expenditure that remains unchanged, in total, irrespective of changes in the levels of production or sales’ (Law, 2010, pp. 275, 430, 194) Variable costs + Fixed costs = Total cost 2. Break-even analysis  The study of how costs, sales and profits change with changes in volume  Break-even analysis is also known as cost-volume-profit analysis  Can be done graphically using a break-even chart or mathematically  We will calculate break-even mathematically 3. Uses of break-even analysis  Aids short-term decision making  Aids forecasting and planning  Allows various scenarios (what-if) to be tested out  Analyses how changes in output, selling price or costs will affect profit levels 4. Assumption of Break-even analysis  Costs can be categorised into either fixed or variable costs – cost behaviour  Assumes both costs and revenues are linear throughout the period (only change due to volume)  Change in activity is the only factor affecting cost and sales – see example  Fixed costs remain constant throughout the period  Sales price does not change during the period  All units produced are sold 5. Terminology  Fixed Costs: These are costs which do not change with the volume of output: e.g.; heating  lighting  telephone  salaries  Cost per unit of output falls as output increases 6. Fixed Costs

7. Terminology  Variable Costs: These are costs which increase as production increases: e.g.; wages  cost of raw materials  cost of sales Assumed to increase in proportion to sales (i.e. cost per unit of output is constant)  Note: direct wage costs are treated as variable costs although not strictly variable 8. Variable Costs

9. Calculating Contribution  Contribution is ‘the additional profit that will be earned by an organization when the breakeven point production has been exceeded. The unit contribution is the difference between the selling price of a product and its marginal cost of production. This is based on the assumption that the marginal (variable) cost and the sales value will be constant’ (Law, 2010, p. 110)  Sales price - Variable costs = Contribution  Contribution represents the amount towards covering the fixed costs and any surplus is profit  Total contribution - Fixed costs = Profit 10. Application  Breakeven analysis can be used to determine a company’s breakeven point (BEP)  Breakeven point is a level of activity at which the total revenue is equal to the total costs  At this level, the company makes no profit 11. Assumptions of break-even point analysis  Relevant range  The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant  Sales  All units of output are sold  Sales price remains constant at all levels of output and sales  Fixed cost  Total fixed costs are assumed to be constant in total  Variable cost  Variable cost per unit is constant over all levels of output  Total variable costs increase in proportion to output 12. Drawing a break-even chart

13. Bedford Basketballs  Bedford Basketballs manufacture basketballs and have the following budgeted sales and cost information:  Sales price per ball £12  Variable cost per ball £3  Total fixed costs per period £45,000  Budgeted sales volume per period 7,000 balls 14. Calculating the break-even Point  Sales revenue  The total revenue will increase with the increasing number of units produced  Contribution is defined as the excess of sales revenue over variable costs  At the break-even point total contribution is equal to total fixed costs 15. Bedford Basketball Contribution

16. Breakeven Point Breakeven point in units =

Fixed costs Contribution per unit =

£45,000 £9 (£12-£3)

= 5,000 units Sales revenue at breakeven point = £12 x 5,000 = £60,000 17. Margin of Safety  Margin of safety is a measure of the amount by which the sales may decrease before a company suffers a loss.  This can be expressed as a number of units or a percentage of sales 18. Calculating the Margin of Safety  Margin of safety = Budgeted sales level – breakeven sales level  Margin of safety= Margin of safety/ Budgeted sales level x 100% 19. The Margin of Safety

Margin of safety = Budget sales level – breakeven sales level = 7,000 units – 5,000 units = 2,000 units Margin of safety as a percentage = Margin of safety x 100% Budget sales level = 2,000 x 100% = 28.6% 7,000 The margin of safety indicates that the sales can fall by 2,000 units or 28.6% from the budgeted level before losses are incurred. 20. Budgeted Profit  Budgeted sales are 7,000 balls per period

 Profit = Total contribution – fixed costs  Total contribution = 7,000 x £9 = £63,000  Profit = £63,000 - £45,000 = £18,000  Profit = margin of safety x contribution/unit  Margin of safety = 7,000 – 5,000 = 2,000 balls  Profit = 2,000 x £9 = £18,000  But what if we know the profit we need and want to know the required sales?  Profit = total contribution – fixed costs  Total contribution = fixed costs + profit  So if Bedford Balls need a profit of £18,000  Total contribution = £45,000 + £18,000 = £63,000  Sales volume required = £63,000/£9 = 7,000 balls  Sales revenue required = £63,000/0.75 = £84,000 21. Limitations of Breakeven Analysis - Breakeven analysis assumes that fixed costs, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tend to curve beyond a certain level of production 22. Limitations of breakeven analysis (contd.)

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It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products Accuracy depends upon the accuracy of the data used forecasting the future is difficult, especially long term Assumes there is a simple relationship between variable costs and sales Sales income does not necessarily rise in a constant relationship to sales volume External constraints have to be recognised It assumes that fixed costs remain constant over the volume range It can only deal with one product at a time (but weighted contributions can be used)...