ACCOUNTING FOR NON-ACCOUNTANTS MARGINAL COSTING

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1 ACCOUNTING FOR NON-ACCOUNTANTS MARGINAL COSTING

2 MARGINAL COSTING OBJECTIVE To be able to: Explain the relevance to management decisions of: Fixed costs Variable costs Contribution Prepare an operating (profit) statement using a marginal cost approach Calculate Breakeven point Margin of safety Establish manufacturing priorities where there is limited resource. Evaluate proposals for changes to operating strategy, including make or buy opportunities. Establish appropriate prices for special contracts.

3 COST BEHAVIOUR In order to forecast how costs will behave, they are separated into FIXED and VARIABLE The term Variable Cost has a specific meaning in management accounting; variable costs change as the level of activity (output) changes. It does not relate to price changes over time; this affects all costs. Fixed costs may only be constant over a limited range of activity. Cost FIXED COST Cost VARIABLE COST Output Output Cost TOTAL (SEMI-VARIABLE) COST Output

4 CONTRIBUTION CONTRIBUTION = SALES REVENUE VARIABLE COST Eg. For a single item: Sell for 1.00, variable costs 0.40, Contribution per unit = = 0.60 For total output over a period: Sales revenue is 100, variable costs are 40 Total contribution = = 60 PROFIT PROFIT = TOTAL CONTRIBUTION FIXED COSTS Eg. Example as above, fixed costs in period are 25 Profit = = 35

5 OPERATING (PROFIT) STATEMENT Conventional presentation: Sales Cost of goods sold Gross profit Overheads Operating profit 9200 Marginal costing presentation Sales Variable costs Contribution Fixed costs Operating profit 9200

6 BREAKEVEN ANALYSIS: GRAPHICAL METHOD Revenue Cost/ Revenue Total cost Output Breakeven Point BREAKEVEN POINT (CALCULATED) Breakeven point = Fixed Cost Unit Contribution (answer in units) Eg. Selling price 15, variable cost 6, fixed costs 630,000 p.a. Breakeven point = 630,000 = 70,000 units 15 6 MARGIN OF SAFETY This is the difference between the planned sales level and the breakeven point. Eg. Planned sales are 100,000 units, breakeven point is 70,000 units, so: Margin of safety = 100,000 70,000 = 30,000 units

7 LIMITING FACTOR If there is a choice of products to make, in the absence of other factors, priority is given to the product with greatest unit contribution. If a resource has only a limited supply, optimise use of this resource by giving priority to the product with the greatest Eg. Contribution per unit of scarce resource Product A Product B Contribution per unit 4 9 Labour hours 1 3 Contribution per labour hour 4 3 MAKE OR BUY Eg. Planned production of Component X is 80,000 units, variable costs 204,000, proportion of fixed costs charged to Component X is 24,000, so standard cost is 2.85 per unit (204, ,000 / 80,000). If an opportunity arises to purchase this component for 2.65 each, instead of manufacturing it in-house, is this an acceptable price? Solution If there is no significant change to the business, fixed costs are unlikely to change, so they are ignored Variable cost to make = 2.55 per unit (204,000/80,000) Variable cost to buy = 2.65 Not acceptable.

8 SPECIAL CONTRACT PRICING Eg. Horsham Products Ltd. had budgeted to sell 100,000 units of Product Y this year. Selling price is 8 per unit, variable costs 5 per unit, fixed costs 150,000 for the year. During the year a unique opportunity arises to sell 1000 units to an overseas market but they are not prepared to pay more than 6 per unit. Is the price acceptable? Solution If there is no significant change to the rest of the business, a marginal costing approach is required and the aim should be to maximise contribution. Contribution per unit under special contract = Sales price - Variable cost = 6 5 = 1 This would therefore increase total contribution and is acceptable.

9 SUMMARY: MARGINAL COSTING In order to forecast how costs will behave, they are separated into fixed and variable costs. Variable costs change as the level of activity (output) changes. Fixed costs may only be constant over a limited range of activity. Contribution = Sales Revenue Variable Cost Profit = Total Contribution Fixed Costs Operating (profit) statements presented using marginal costing show the calculation of total contribution first, then the calculation of profit. Breakeven point = Fixed Cost (answer in units) Unit Contribution The margin of safety is the difference between the planned sales level and the breakeven point. If a resource has only a limited supply, optimise use of this resource by giving priority to the product with the greatest contribution per unit of scarce resource. Marginal costing is used for make or buy decisions and special contract pricing.

10 QUESTIONS

11 QUESTIONS 1. If Product X is sold for 10 per unit, the variable costs amount to 6 per unit and the fixed costs are 60,000 a year, a) What is the breakeven point? b) How many units need to be sold to make a profit of 20,000 c) If the variable costs increase to 6.50 and fixed costs increase to 80,000, how many units must be sold to keep profits at 20,000 p.a.? 2. Arun Products Ltd. has produced the following budget: Sales: 30, per unit FIXED VARIABLE COST COST TOTAL Production Administration Distribution REQUIRED: a) The breakeven point b) The profit or loss if only 20,000 units are sold c) The new breakeven point if and extra 80,000 is spent on advertising. d) Which of these proposals would you recommend: i) Improve product, adding 2 to variable production cost and increasing sales to 40,000 units. ii) Pay 1 per unit sales commission, increasing sales to 38,500 units. iii) Accept an additional order for 8,000 units at per unit for export, incurring additional administrative cost of 10,000.

12 ANSWERS

13 ANSWERS 1. a) Breakeven = 60,000 = 15,000 units 10 6 b) Sales required = 60, ,000 = 20,000 4 c) Sales required = 80, ,000 = 28, Variable cost per unit = /30000 = 10 Contribution per unit = = 5 a) Breakeven = /5 = 23,500 units b) Total contribution( 5 x 20,000) Fixed costs Loss c) Breakeven = /5 = 39,500 units d) ORIGINAL (I) (ii) (iii) Revenue Variable costs Contribution Fixed costs Profit Original profit Total profit

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