marginal costing 1

8/11/2019 Marginal Costing 1

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n general terms marginal cost at each level of prodction incldesany additional costs re0ired to prodce the net nit. f prodcingadditional vehicles re0ires for eample bilding a new factory themarginal cost of those extra vehicles incldes the cost of the newfactory. n practice the analysis is segregated into short and long-rn cases and over the longest rn all costs are marginal. "t eachlevel of prodction and time period being considered marginal costsinclde all costs which vary with the level of prodction and othercosts are considered fied costs.

" nmber of other factors can affect marginal cost and itsapplicability to real world problems. ome of these may be

considered mar(et failres. hese may inclde informationasymmetries the presence of negative or positive eternalitiestransaction costs price discrimination and others.

RELATION BETWEEN MARGINAL COST AND ECONOMIES OFSCALE

• +rodction may be sbect to economies of scale 8ordiseconomies of scale9. ncreasing retrns to scale are said toeist if additional nits can be prodced for less than theprevios nit that is average cost is falling.

• his can only occr if average cost at any given level ofprodction is higher than the marginal cost.

• ,onversely there may be levels of prodction where marginalcost is higher than average cost and average cost will rise foreach nit of prodction after that point. his type ofprodction fnction is generally (nown as diminishingmarginal prodctivity< at low levels of prodction prodctivity gains are easy and marginal costs falling bt prodctivitygains become smaller as prodction increases= eventallymarginal costs rise becase increasing otpt 8with eisting

capital labor or organiation9 becomes more epensive. Forthis generic case minimm average cost occrs at the pointwhere average cost and marginal cost are e0al 8whenplotted the two crves intersect9= this point will not be at theminimm for marginal cost if fied costs are greater than ero.

Short an long r!n marginal costs an "conomi"s o#

scal"

he former ta(es as nchanged for eample the capital e0ipmentand overhead of the prodcer any change in its prodctioninvolving only changes in the inpts of labor materials and energy.

http://en.wikipedia.org/wiki/Information_asymmetry


http://en.wikipedia.org/wiki/Externality

http://en.wikipedia.org/wiki/Transaction_costs

http://en.wikipedia.org/wiki/Price_discrimination

http://en.wikipedia.org/wiki/Economies_of_scale

http://en.wikipedia.org/wiki/Diseconomy_of_scale

http://en.wikipedia.org/wiki/Increasing_returns_to_scale

http://en.wikipedia.org/wiki/Unit_of_production

http://en.wikipedia.org/wiki/Productivity



http://en.wikipedia.org/wiki/Externality

http://en.wikipedia.org/wiki/Transaction_costs

http://en.wikipedia.org/wiki/Price_discrimination

http://en.wikipedia.org/wiki/Economies_of_scale

http://en.wikipedia.org/wiki/Diseconomy_of_scale

http://en.wikipedia.org/wiki/Increasing_returns_to_scale

http://en.wikipedia.org/wiki/Unit_of_production

http://en.wikipedia.org/wiki/Productivity



he latter allows all inpts inclding capital items 8plante0ipment bildings9 to vary.

" long-rn cost fnction describes the cost of prodction as afnction of otpt assming that all inpts are obtained at crrent

prices that crrent technology is employed and everything is beingbilt new from scratch. n view of the drability of many capitalitems this tetboo( concept is less sefl than one which allows forsome scrapping of eisting capital items or the ac0isition of newcapital items to be sed with the eisting stoc( of capital itemsac0ired in the past. >ong-rn marginal cost then means theadditional cost or the cost saving per nit of additional or redcedprodction inclding the ependitre on additional capital goods orany saving from disposing of eisting capital goods. ;ote thatmarginal cost pwards and marginal cost downwards may differ incontrast with marginal cost according to the less sefl tetboo(concept.

'conomies of scale are said to eist when marginal cost accordingto the tetboo( concept falls as a fnction of otpt and is less thanthe average cost per nit. his means that the average cost ofprodction from a larger new bilt-from-scratch installation fallsbelow that from a smaller new bilt-from-scratch installation. ?nderthe more sefl concept with an eisting capital stoc( it isnecessary to distingish those costs which vary with otpt fromacconting costs which will also inclde the interest and

depreciation on that eisting capital stoc( which may be of adifferent type from what can crrently be ac0ired in past years atpast prices. he concept of economies of scale then does not apply.

E$t"rnaliti"s

'ternalities are costs 8or benefits9 that are not borne by the partiesto the economic transaction. " prodcer may for eample pollte the environment and others may bear those costs. " consmer mayconsme a good which prodces benefits for society sch asedcation= becase the individal does not receive all of thebenefits he may consme less than efficiency wold sggest."lternatively an individal may be a smo(er or alcoholic andimpose costs on others. n these cases prodction or consmptionof the good in 0estion may differ from the optimm level.

http://en.wikipedia.org/wiki/Average_cost

http://en.wikipedia.org/wiki/Transaction

http://en.wikipedia.org/wiki/Pollution

http://en.wikipedia.org/wiki/Average_cost

http://en.wikipedia.org/wiki/Transaction




%"it& N"gati'" "$t"rnaliti"s o# (ro!ction

N"gati'" E$t"rnaliti"s o# Pro!ction

Mch of the time private and social costs do not diverge from oneanother bt at times social costs may be either greater or less thanprivate costs. @hen marginal social costs of prodction are greater

than that of the private cost fnction we see the occrrence of anegative eternality of prodction. +rodctive processes that resltin polltion are a tetboo( eample of prodction that createsnegative eternalities.

ch eternalities are a reslt of firms eternaliing their costs ontoa third party in order to redce their own total cost. "s a reslt ofeternaliing sch costs we see that members of society will benegatively affected by sch behavior of the firm. n this case wesee that an increased cost of prodction on society creates a social

cost crve that depicts a greater cost than the private cost crve.

n an e0ilibrim state we see that mar(ets creating negativeeternalities of prodction will overprodce that good. "s a resltthe socially optimal prodction level wold be lower than thatobserved.

Positi'" "$t"rnaliti"s o# (ro!ction

+ositive 'ternalities of +rodction

@hen marginal social costs of prodction are less than that of theprivate cost fnction we see the occrrence of a positive eternality

of prodction. +rodction of pblic goods are a tetboo( eample ofprodction that create positive eternalities. "n eample of sch a

http://en.wikipedia.org/w/index.php?title=Marginal_cost&action=edit&section=5

http://en.wikipedia.org/wiki/Negative_externality


http://en.wikipedia.org/wiki/Positive_externality

http://en.wikipedia.org/wiki/Public_good

http://en.wikipedia.org/wiki/File:PositiveExt.svg

http://en.wikipedia.org/wiki/File:PositiveExt.svg

http://en.wikipedia.org/wiki/File:NegativeExt.svg

http://en.wikipedia.org/wiki/File:NegativeExt.svg

http://en.wikipedia.org/w/index.php?title=Marginal_cost&action=edit&section=5

http://en.wikipedia.org/wiki/Negative_externality


http://en.wikipedia.org/wiki/Positive_externality

http://en.wikipedia.org/wiki/Public_good



pblic good which creates a divergence in social and private costsincldes the prodction of edcation. t is often seen that edcationis a positive for any whole society as well as a positive for thosedirectly involved in the mar(et.

'amining the relevant diagram we see that sch prodctioncreates a social cost crve that is less than that of the private crve.n an e0ilibrim state we see that mar(ets creating positiveeternalities of prodction will nder prodce that good. "s a resltthe socially optimal prodction level wold be greater than thatobserved.

Social costs

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

between the marginal private and social costs. he marginal privatecost shows the cost associated to the firm in 0estion. t is themarginal private cost that is sed by bsiness decision ma(ers intheir profit maimiation goals and by individals in theirprchasing and consmption choices. Marginal social cost is similarto private cost in that it incldes the cost fnctions of privateenterprise bt also that of society as a whole inclding parties thathave no direct association with the private costs of prodction. tincorporates all negative and positive eternalities of bothprodction and consmption.

Bence when deciding whether or how mch to by byers ta(eaccont of the cost to society of their actions if private and socialmarginal cost coincide. he e0ality of price with social marginalcost by aligning the interest of the byer with the interest of thecommnity as a whole is a necessary condition for economicallyefficient resorce allocation.

Oth"r cost "#initions in marginal costing

• Fi$" costs are costs which do not vary with otpt foreample rent. n the long rn all costs can be consideredvariable.

• )aria*l" cost also (nown as operating costs prime costs oncosts and direct costs are costs which vary directly with thelevel of otpt for eample labor fel power and cost ofraw material.

• Social costs o# (ro!ction are costs incrred by society asa whole reslting from private prodction.

• A'"rag" total cost is the total cost divided by the 0antityof otpt.

• A'"rag" #i$" cost is the fied cost divided by the 0antity

of otpt.

http://en.wikipedia.org/wiki/Education

http://en.wikipedia.org/wiki/Externalities

http://en.wikipedia.org/wiki/Fixed_cost

http://en.wikipedia.org/wiki/Variable_cost

http://en.wikipedia.org/wiki/Social_cost

http://en.wikipedia.org/wiki/Average_total_cost

http://en.wikipedia.org/wiki/Average_fixed_cost

http://en.wikipedia.org/wiki/Education

http://en.wikipedia.org/wiki/Externalities

http://en.wikipedia.org/wiki/Fixed_cost

http://en.wikipedia.org/wiki/Variable_cost

http://en.wikipedia.org/wiki/Social_cost

http://en.wikipedia.org/wiki/Average_total_cost

http://en.wikipedia.org/wiki/Average_fixed_cost



• A'"rag" 'aria*l" cost are variable costs divided by the0antity of otpt.

What is Marginal Costing+

t is a costing techni0e where only variable cost or direct cost will becharged to the cost nit prodced.

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

of otpt by differentiating between fied and variable costs.

alient +oints<

• Marginal costing involves ascertaining marginal costs. incemarginal costs are direct cost this costing techni0e is also (nownas direct costing=

• n marginal costing fied costs are never charged to prodction. hey are treated as period charge and is written off to the profit and

loss accont in the period incrred=

• Ance marginal cost is ascertained contribtion can be compted.,ontribtion is the ecess of revene over marginal costs.

• he marginal cost statement is the basic docment/format tocaptre the marginal costs.

F"at!r"s o# Marginal Costing S,st"m-

• t is a method of recording costs and reporting profits=

• "ll operating costs are differentiated into fied and variable costs=

• Cariable cost DEcharged to prodct and treated as a prodct costwhilst

• Fied cost treated as period cost and written off to the profit and lossaccont

http://en.wikipedia.org/wiki/Average_variable_cost

http://en.wikipedia.org/wiki/Average_variable_cost



Disa'antag"s O# Marginal Costing

• Marginal cost has its limitation since it ma(es se of historicaldata while decisions by management relates to ftre events=

• t ignores fied costs to prodcts as if they are not importantto prodction=

• toc( valation nder this type of costing is not accepted by

the nland Revene as itDEGs ignore the fied cost element=

• t fails to recognie that in the long rn fied costs maybecome variable=

• ts oversimplified costs into fied and variable as if it is sosimply to demarcate them=

• tDEGs not a good costing techni0e in the long rn for pricingdecision as it ignores fied cost. n the long rn managementmst consider the total costs not only the variable portion=

• $ifficlty to classify properly variable and fied cost perfectlyhence stoc( valation can be distorted if fied cost is classifyas variable.

MARGINAL COSTING AS A MANAGEMENT ACCO.NTING

TOOL

1. Marginal ,osting is clearly the core aspect of traditional

management acconting. ome of the classical applications of

management acconting however have begn to lose theirsignificance. he 0estion ths arises< @hat is the crrent role of

Marginal ,osting in modern management accontingH

2. *sinesses today fre0ently voice their disapproval of the

traditional cost acconting approaches. "t the beginning of the

1&&)s these criticisms were ta(en p by researchers involved with

the applications of cost acconting concepts.

he main thrst of the dissatisfaction with conventional cost

acconting methods is that they are too highly developed and too



comple and frthermore are no longer needed in their crrent

form since other tools are now available. ,alls for increased se of

cost management tools investment analyses and vale-based tool

concepts are fre0ently associated with criticism of the fnctionality

of crrent cost acconting approaches as management tools. hisline of criticism sees little relevance in traditional cost acconting

tas(s sch as monitoring the economic prodction process or

assigning the costs of internal activities. "t their crrent level of

detail sch tas(s are neither necessary nor does their perceived

psedo accracy frther the goals of management.

he viewpoint of the present athor is that cost acconting has by

no means lost its right to eist for it is an easily overloo(ed fact that

the data strctre re0ired by the new tools is already present in

traditional cost acconting.

3. o assess the present-day vale of Marginal ,osting the changes

occrring in the bsiness world mst be analyed more closely. @e

need first to loo( at how the prposes of cost acconting are

shifting before we can determine its significance.

8i9 cost planning ta(es precedence over cost control. he

effort involved in planning and monitoring costs is increasingly

being seen as ecessive. he charge levied against traditional costacconting--that its comple cost allocations merely generate a (ind

of psedo precision--lends frther credence to this assessment. "n

alternative increasingly being called for is to control costs throgh

direct activity/process information 80antities times 0ality9 for

cost management at local decentralied levels instead of relying on

delayed and distorted cost data. n particlar empirical ?..

research on appropriate variables for performance measrement in

the contet of continos improvement and modern managerial

concepts is based on this view. he need for eact cost planningfor profitability management is ths toched on e ante.

8ii9 cost acconting mst be employed as a tool for cost

control at an early stage. he relative significance of traditional cost

acconting as a management acconting tool will decline as it is

applied mainly to fields where costs cannot be heavily inflenced.

More significant than inflencing the crrent costs of prodction with

cost center controlling and athoried-actal comparisons of the

cost of goods manfactred is timely and mar(et-based athoriedcost management. he greatest scope for inflencing costs is at the



early prodct development phase and when setting p the

prodction processes. "t the same time this is the stage where cost

information is most rgently needed since the time and 0antity

standards as defined by *ills of Materials 8*AMs9 and prodction

rotings are still lac(ing. his re0ires different methods of costplanning than those normally provided by Marginal ,osting.

8iii9 the behavioral effect of cost information is starting to

be recognied. here is a strong crrent of acconting research in

the ?.. that ta(es hman psychological factors into consideration.

his is reslting in an etension of cost theory beyond its pre

microeconomic basis. Reslts of theoretical and empirical research

based for eample on the principal-agent theory indicate that

(nowledge of the IrelevantI costs does not always lead to the

optimiation of overall enterprise profitability. Bence the

perspective that formed the basis for the absorption costing isse

has changed. heories according to which cost allocations can

contain information and increase the efficiency of the se of

available capacity or where ftre allocations can inflence e-ante

decisions re0ire empirical research.

4. he shift in the prposes of cost acconting is being

accompanied by a shift in the main applications of standard costing.

,osting soltions for mar(et-oriented profitability management andlife-cycle-based planning and monitoring shold be developed

frther. hey shold be implemented both in indirect areas and at

the corporate level. n addition cost acconting mst be integrated

into performance measrement.

,ompetitive dynamics are giving rise to an increasing differentiation

of mar(et-based profitability controlling. his applies to the

management of the profitability of prodcts and prodct lines as

well as distribtion channels and increasingly cstomers cstomergrops and mar(ets. he information re0ired for this prpose can

only be spplied by mltilevel and mltidimensional mar(eting

segment acconting based on contribtion margin acconting.

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

gaining in prominence compared with short-term standard costing.

+rodct decisions are increasingly based on more than st the cost

of goods manfactred and sales costs and now tend to inclde pre-

prodction costs 8sch as development costs9 and phasing-ot costs8sch as disposal costs9. +rodct decisions are viewed strategically.



@hether or not a prodct is sccessfl is determined by the

amortiation of its overall cost. Frthermore the cost and revene

trend forecasts shold be more dynamic to spport the lifecycle

pricing policy. his shift in cost and revene planning is moving cost

and revene acconting in the direction of investment-relatedcalclations.

"s management acconting is increasingly applied to the growing

share of the costs of indirect areas the tool re0irements increase.

"fter J. K. MillerLs and . '. CollmannLs discovery of the Ihidden

factoryI as an area whose costs are neglected by conventional

prodction costing in the ?.. it was only a small step to the

identification of the lost relevance of conventional cost acconting

by B. . Johnson and R. . aplan and their call to develop

acconting systems separated into Iprocess control prodct

costing and financial reportingI which eventally led to activity-

based costing. mproving the cost transparency of indirect activity

areas throgh Marginal ,osting re0ires a thorogh nderstanding

of the otpt processes. "nalysis fre0ently shows that even many

spport activities have a wide range of repetitive processes for

which planning and cost allocation sing drivers is worthwhile

providing the cost-volme is large enogh. For this prpose the

different operations in the cost centers mst be identified for which

resorce consmption is then planned and trac(ed. he nmber ofthese operations is sed as the driver. his process of costing

operations sing 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 previosly bdgeted only as a lmp sm.

ndstrial prodction and mar(eting are increasingly being handled

by grops of affiliated companies. o plan and monitor the costs of

these activities calls for the establishment of independent gropcost acconting. his necessity reslts mainly from the

re0irements of inventory valation the costing basis of transfer

prices and to frther the consistency of corporate cost acconting.

Krop cost acconting leads to the definition of independent grop

cost categories. Marginal ,osting and its tools have been developed

for individal companies and are the sitable platform for this

epansion.

+erformance measres are gaining increasing prominence indecentralied management acconting. tandard ?.. management



boo(s devote a great deal of space to performance measrement in

the broad sense of the word. he concept is broad for the reason

that performance measrement is accompanied by the provision of

decision-spport information the management of bsiness nits

and the se of incentive systems. ?sing modelling and empiricalresearch the eponents of this area are developing the idea that

monetary factors are not the only possible components of

performance measrement.

ince the 1&%)s there has been a growing consciosness of the

significance of continosly improving the performance capabilities

of the company reslting in the increased importance of

nonmonetary indicators. he recent literatre on performance

measrement has focsed on problems in the following areas<

N he sability of performance information for managers

N he assessment of teamwor(

N he motivational effects of performance measrement

N he strategic dimension.

he tenor of the recent investigations into performancemeasrement reflects the general criticism of management

acconting voiced by Johnson and aplan in Relevance >ost. t was

recognied that short-term acconting information is insfficient to

evalate and control company activities effectively. n particlar it

was ac(nowledged that the se of standard costs does not

ade0ately ta(e performance improvements into consideration.

Moreover the conventional allocation approach based on the

operating rate encorages high tiliation of capacity at any cost

nderestimates the problem of increasing nmbers of variants sesthe wrong overhead allocation base and fails to appreciate

interdepartmental interrelationships.

@hile top management benefits most from financial sccess

indicators that it eamines in monthly or longer intervals and that

can consist of mltidimensional aggregate figres lower

management mst necessarily be concerned mainly with

nonfinancial operational and very short-term data at the day or

shift level. n concrete terms measres in the categories of time0antity and 0ality--sch as e0ipment downtime lead time



response time degree of tiliation 8ratio of actal otpt 0antity

to planned otpt 0antity9 sales orders and error rate--are

becoming increasingly significant for controlling bsiness processes.

n the strategic dimension the *alanced corecard developed byaplan and ;orton--which lin(s financial and nonfinancial indicators

from different strategically relevant perspectives inclding case-

effect chains--is the main proposal nder consideration for

performance measrement. he *alanced corecard lin(s strategic

contingencies to financial measres incorporates sccess factors of

the ftre and eplicitly incldes monetary and nonmonetary

parameters. he *alanced corecard therefore provides a

framewor( for systematic mapping and control of the critical

sccess factors for an enterprise. " *alanced corecard is a system

that defines obectives measres targets and initiatives for each of

the for perspectives of financial cstomer internal bsiness

process and learning and growth. Frther analyses and eperience

in measring performance can enable identification and assessment

of case-effect relationships within the for perspectives 8sch as

the effect of delivery time on cstomer satisfaction9 and between

the perspectives 8sch as the effect of cstomer satisfaction on

profitability9. he (nowledge so gained may eventally lead to a

reformlation of strategy.

n the contet of comprehensive performance measrement even

short-term costs and financial reslts can serve as control

instrments for strategic enterprise management sch as a lower

athoried cost of goods manfactred as a benchmar(. ,oncrete

planned costs and planned reslts mst be rigorosly derived from

higher-level target factors so that specific re0irements can be

derived in trn when they are bro(en down into smaller

organiational nits for the time and 0antity standards.

nformation for decision ma(ing he need for a decision arises inbsiness becase a manager is faced with a problem and alternativecorses of action are available. n deciding which option to choosehe will need all the information which is relevant to his decision= andhe mst have some criterion on the basis of which he can choosethe best alternative. ome of the factors affecting the decision maynot be epressed in monetary vale. Bence the manager will haveto ma(e L0alitativeL dgements e.g. in deciding which of twopersonnel shold be promoted to a managerial position. "L0antitativeL decision on the other hand is possible when thevarios factors and relationships between them are measrable.

his chapter will concentrate on 0antitative decisions based on



c2 Cash #lo3- 'penses sch as depreciation are not cash flowsand are therefore not relevant. imilarly the boo( vale of eistinge0ipment is irrelevant bt the disposal vale is relevant.

Ather terms<

2 Common costs< ,osts which will be identical for all alternativesare irrelevant e.g. rent or rates on a factory wold be incrredwhatever prodcts are prodced.

"2 S!n1 costs< "nother name for past costs which are alwaysirrelevant e.g. dedicated fied assets development costs alreadyincrred.

#2 Committ" costs- " ftre cash otflow that will be incrredanyway whatever decision is ta(en now e.g. contracts alreadyentered into which cannot be altered.

O((ort!nit, cost

Relevant costs may also be epressed as opportnity costs. "nopportnity cost is the benefit foregone by choosing one opportnityinstead of the net best alternative.

E$am(l"

" company is considering pblishing a limited edition boo( bond ina special leather. t has in stoc( the leather boght some years agofor O1))). o by an e0ivalent 0antity now wold cost O2))).

he company has no plans to se the leather for other prposesalthogh it has considered the possibilities<

a9 of sing it to cover des( frnishings in replacement for othermaterial which cold cost O&))b9 of selling it if a byer cold be fond 8the proceeds are nli(ely toeceed O%))9.

n calclating the li(ely profit from the proposed boo( beforedeciding to go ahead with the proect the leather wold not becosted at O1))). he cost was incrred in the past for some reasonwhich is no longer relevant. he leather eists and cold be sed onthe boo( withot incrring any specific cost in doing so. n sing theleather on the boo( however the company will lose theopportnities of either disposing of it for O%)) or of sing it to savean otlay of O&)) on des( frnishings.

he better of these alternatives from the point of view of benefiting

from the leather is the latter. I>ost opportnityI cost of O&)) will



therefore be inclded in the cost of the boo( for decision ma(ingprposes.

he relevant costs for decision prposes will be the sm of<

i9 Lavoidable otlay costsL i.e. those costs which will be incrred onlyif the boo( proect is approved and will be avoided if it is not

ii9 the opportnity cost of the leather 8not represented by any otlaycost in connection to the proect9.

his total is a tre representation of Leconomic costL.

;ow attempt eercise 5.1.

Th" ass!m(tions in r"l"'ant costing

ome of the assmptions made in relevant costing are as follows<

a9 ,ost behavior patterns are (nown e.g. if a department closesdown the attribtable fied cost savings wold be (nown.

b9 he amont of fied costs nit variable costs sales price andsales demand are (nown with certainty.

c9 he obective of decision ma(ing in the short rn is to maimise

LsatisfactionL which is often (nown as Lshort-term profitL.

d9 he information on which a decision is based is complete andreliable.

T4E BASIC DECISION MA5ING INDICATORS IN

MARGINAL COSTING

• +RAF CA>?M' R"A

• *R'"- 'C'; +A;

• ,"B CA>?M' +RAF ";">P

• M"RK; AF "F'P

• ;$FF'R';,' +A;



• B? Q $A@; +A;

PROFIT )OL.ME RATIO 6P ) RATIO 2

he profit volme ratio is the relationship between the ,ontribtion

and ales vale.

t is also termed as ,ontribtion to ales Ratio

Formla <

P ) Ratio 7 Contri*!tion 8 9::

Sal"s

Signi#icanc" o# P) Ratio

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

bsiness.

• he higher the +C Ratio the better it is for the bsiness. n the

case of the firm enoying steady bsiness conditions over a

period of years the +C Ratio will also remain stable andsteady.

• f +C Ratio is improved it will reslt in better profits.

Im(ro'"m"nt o# P) Ratio

• *y redcing the variable costs.

• *y increasing the selling price

• *y increasing the share of prodcts with higher +C Ratio in the

overall sales mi. 8where a firm prodces a nmber of

prodcts9

.s" o# P) Ratio

• o compte the variable costs for any volme of sales

• o measre the efficiency or to choose a most profitable line.

he overall profitability of the firm can be improved by



increasing the sales/otpt of prodct giving a higher +C

Ratio.

• o determine the *rea( Q 'ven +oint and the level of otpt

re0ired to earn a desired profit.

• o decide the most profitable sales Q mi.

BREA5 ; E)EN ANALYSIS

• Br"a1<E'"n Anal,sis is a mathematical techni0e foranalying the relationship between sales and fied andvariable costs. *rea(-even analysis is also a profit-planningtool for calclating the point at which sales will e0al totalcosts.

• he brea(-even point is the intersection of the total sales andthe total cost lines. his point determines the nmber of nitsprodced to achieve brea(even.

• he analysis generally assmes linearity 81)) variable or1)) fied9 of costs. f a firmSs costs were all variable thefirm cold be profitable from the start. f the firm is to avoidlosses its sales mst cover all costs that vary directly withprodction and all costs that do not change with prodction

levels.• Fied costs are those epenses associated with the proect

that yo wold have to pay whether yo sold one nit or1)))) nits. 'amples inclde general office epenses rentdepreciation interest salaries research and developmentand tilities. Cariable costs vary directly with the nmber ofnits that yo sell. 'amples inclde materials direct laborpostage pac(aging and advertising. ome costs are difficltto classify. "s a general gideline if there is a directrelationship between cost and nmber of nits sold considerthe cost variable. f there is no relationship then consider thecost fied.

• " brea(-even chart is constrcted with a horiontal aisrepresenting nits prodced and a vertical ais representingsales and costs. Represent fied costs by a horiontal linesince they do not change with the nmber of nits prodced.Represent variable costs and sales by pward sloping linessince they vary with the nmber of nits prodced and sold.

he brea(-even point is the intersection of the total sales andthe total cost lines. "bove that point the firm begins to ma(ea profit bt below that point it sffers a loss. Bere is a sample

brea(-even chart<



he algebraic e0ation for brea(-even analysis consists of forfactors. f yo (now any three of the for yo can solve forthe forth factor. Po calclate the brea(-even amont withthe following e0ation<

ales +rice per ?nit N :antity old T Fied ,osts U 6Cariable,osts per ?nit N :antity old7

For eample assme yo have total fied monthly costs ofO12)) and total variable costs of O! per nit. f yo cold sellthe nits for O1) each the e0ation indicates that yo need tosell 3)) nits to brea( even. f yo (new yo cold sell 4))

nits the e0ation wold indicate that the sales price woldneed to be O& per nit to brea( even.

• @hen managing inventory yo shold aim for the EconomicOr"r =!antit, 8'A:9. his is the level of inventory thatbalances two (inds of inventory costs< holding 8or carrying9costs which increase with the amont of inventory orderedand order costs which decrease with the amont ordered.

• he largest components of holding costs for most companiesare the cost of space to store the inventory and the cost oftying p capital in inventory. Ather components inclde thelabor costs associated with inventory maintenance andinsrance costs. "lso inclde deterioration spoilage andobsolescence costs. he costs of more fre0ent orders incldelost disconts for larger 0antity prchases and labor andspply costs of writing the orders. "dditional costs incldepaying the bills and processing the paperwor( associatedtelephone and mail costs and the labor costs of processingand inspecting incoming inventory.



• 'A: is the sie of order that minimies the total of holdingand ordering costs. he algebraic epression of 'A: is asfollows<

'A: T s0are root of 62N?NA divided by B7 where ? is thenmber of nits sed annally A is the order cost per orderand B is the holding cost per nit.

For eample assme yo se 4)))) nits annally it costsO5) to place an order and it costs O2) to hold the rawmaterials for one nit. he e0ation yields an amont of 44#which is the nmber of nits yo need to order at one time tominimie total costs.

he reorder point or Economic Or"r Point 8'A+9 tells yowhen to place an order. ,alclating the reorder point re0ires

yo to (now the lead time from placing to receiving an order. Po compte it as follows<

'A+ T >ead time N "verage sage per nit of time

For eample assme yo need !4)) nits evenly throghot theyear there is a lead time of one wee( and there are 5) wor(ingwee(s in the year. Po calclate the reorder point to be 12% nits asfollows.

1 wee( N 6!4)) nits / 5) wee(s7 T 12% nits

Po might also consider >!st In Tim"V inventory management ifavailable and appropriate. Jst n imeV allows yo to (eep minimal

inventory in stoc(. Po only order when yo ma(e a sale. ,arefllyanalye the time lag. Po mst be able to satisfy the cstomer aswell as (eep yor inventory investment minimied.

.s" o# BEP Anal,sis In ca(ital *!g"ting

*rea( even analysis is a special application of sensitivity analysis. taims at finding the vale of individal variables which the proectSs;+C is ero. n common with sensitivity analysis variables selectedfor the brea( even analysis can be tested only one at a time.

he brea( even analysis reslts can be sed to decide abandon ofthe proect if forecasts show that below brea( even vales are li(elyto occr.

n sing brea( even analysis it is important to remember theproblem associated with sensitivity analysis as well as someetension specific to the method<

• Cariables are often interdependent which ma(es eaminingthem each individally nrealistic.



• Aften the assmptions pon which the analysis is based aremade by sing past eperience / data which may not hold inthe ftre.

• Cariables have been adsted one by one= however it isnli(ely that in the life of the proect only one variable will

change ntil reaching the brea( even point. Managementdecisions made by observing the behavior of only onevariable are most li(ely to be invalid.

• *rea( even analysis is a pessimistic approach by essence. hefigres shall be sed only as a line of defence in the proectanalysis.

Limitations O# BEP Anal,sis

• *rea(-even analysis is only a spply side 8i.e. costs only9analysis as it tells yo nothing abot what sales are actallyli(ely to be for the prodct at these varios prices.

• t assmes that fied costs 8F,9 are constant• t assmes average variable costs are constant per nit of

otpt at least in the range of li(ely 0antities of sales. 8i.e.linearity9

• t assmes that the 0antity of goods prodced is e0al to the0antity of goods sold 8i.e. there is no change in the 0antityof goods held in inventory at the beginning of the period andthe 0antity of goods held in inventory at the end of theperiod9.

• n mlti-prodct companies it assmes that the relativeproportions of each prodct sold and prodced are constant8i.e. the sales mi is constant9.

COST )OL.ME PROFIT ANALYSIS

• "nalysis that deals with how profits and costs change with achange in volme. More specifically it loo(s at the effects onprofits of changes in sch factors as variable costs fiedcosts selling prices volme and mi of prodcts sold.

• ,C+ analysis involves the analysis of how total costs totalrevenes and total profits are related to sales volme and is

therefore concerned with predicting the effects of changes in



costs and sales volme on profit. t is also (nown asLbrea(even analysisL.

• *y stdying the relationships of costs sales and net incomemanagement is better able to cope with many planningdecisions. For eample ,C+ analysis attempts to answer thefollowing 0estions< 819@hat sales volme is re0ired to brea( evenH829 @hat sales volme is necessary in order to earn a desired8target9 profitH 839 @hat profit can be epected on a givensales volmeH 849 Bow wold changes inselling price variable costs fied costs and otpt affectprofitsH859 Bow wold a change in the mi of prodcts sold affect thebrea(-even and target volme and profit potentialH

• ,ost-volme-profit analysis 8,C+9 or brea(-even analysis issed to compte the volme level at which total revenes aree0al to total costs. @hen total costs and total revenes aree0al the bsiness organiation is said to be Ibrea(ing even.I

he analysis is based on a set of linear e0ations for a straightline and the separation of variable and fied costs.

• otal variable costs are considered to be those costs that varyas the prodction volme changes. n a factory prodctionvolme is considered to be the nmber of nits prodced btin a governmental organiation with no assembly process thenits prodced might refer for eample to the nmber of

welfare cases processed.

• here are a nmber of costs that vary or change bt if thevariation is not de to volme changes it is not considered tobe a variable cost. 'amples of variable costs are directmaterials and direct labor. otal fied costs do not vary asvolme levels change within the relevant range. 'amples offied costs are straight-line depreciation and annal insrancecharges.

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• "ll the lines in the chart are straight lines< >inearity is annderlying assmption of ,C+ analysis. "lthogh no one canbe certain that costs are linear over the entire range of otptor prodction this is an assmption of ,C+.

• o help alleviate the limitations of this assmption it is alsoassmed that the linear relationships hold only within therelevant range of prodction. he relevant range isrepresented by the high and low otpt points that have beenpreviosly reached with past prodction. ,C+ analysis is bestviewed within the relevant range that is within or previosactal eperience. Atside of that range costs may vary in anonlinear manner. he straight-line e0ation for total cost is<

otal cost T total fied cost U total variable cost

otal variable cost is calclated by mltiplying the cost of anit which remains constant on a per-nit basis bythe nmber of nits prodced. herefore the total coste0ation cold be epanded as<

otal cost T total fied cost U 8variable cost per nit nmberof nits9

otal fied costs do not change.

" final version of the e0ation is<

Y = a + bx

where a is the fied cost b is the variable cost per nit x isthe level of activity and Y is the total cost. "ssme that thefied costs are O5))) the volme of nits prodced is 1)))and the per-nit variable cost is O2. n that case the total costwold be compted as follows<

Y T O5))) U 8O2 1)))9 Y T O#)))

t can be seen that it is important to separate variable andfied costs. "nother reason it is important to separate thesecosts is becase variable costs are sed to determine thecontribtion margin and the contribtion margin is sed todetermine the brea(-even point. he contribtion margin isthe difference between the per-nit variable cost and theselling price per nit. For eample if the per-nit variable cost

is O15 and selling price per nit is O2) then the contribtionmargin is e0al to O5. he contribtion margin may provide a

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http://www.answers.com/topic/nonlinear

http://www.answers.com/topic/multiply

http://www.answers.com/topic/alleviate

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O5 contribution toward the redction of fied costs or a O5contribtion to profits. f the bsiness is operating at a volmeabove the brea(-even point volme 8above point F9 then theO5 is a contribtion 8on a per-nit basis9 to additional profits. fthe bsiness is operating at a volme below the brea(-even

point 8below point F9 then the O5 provides for a redction infied costs and contines to do so ntil the brea(-even point ispassed.

• Ance the contribtion margin is determined it can be sed tocalclate the brea(-even point in volme of nits or in totalsales dollars. @hen a per-nit contribtion margin occrsbelow a firmLs brea(-even point it is a contribtion to theredction of fied costs. herefore it is logical to divide fiedcosts by the contribtion margin to determine how many nits

mst be prodced to reach the brea(-even point<

• he financial information re0ired for ,C+ analysis is forinternal se and is sally available only to managers insidethe firm= information abot variable and fied costs is notavailable to the general pblic. ,C+ analysis is good as ageneral gide for one prodct within the relevant range. f thecompany has more than one prodct then the contribtionmargins from all prodcts mst be averaged together. *t

any cost-averaging process redces the level of accracy ascompared to wor(ing with cost data from a single prodct.Frthermore some organiations sch as nonprofitsorganiations do not incr a significant level of variable costs.n these cases standard ,C+ assmptions can lead tomisleading reslts and decisions.

.SES OF C)P ANALYSIS

a2 B!g"t (lanning. he volme of sales re0ired to ma(e a profit8brea(even point9 and the Lsafety marginL for profits in the bdgetcan be measred.

*2 Pricing an sal"s 'ol!m" "cisions?

c2 Sal"s mi$ "cisions to determine in what proportions eachprodct shold be sold.

2 D"cisions that 3ill a##"ct th" cost str!ct!r" an(ro!ction ca(acit, o# th" com(an,?

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http://www.answers.com/topic/incur



T4E BASIC PRINCIPLES OF C)P ANALYSIS

,C+ analysis is based on the assmption of a linear total costfnction 8constant nit variable cost and constant fied costs9 andso is an application of marginal costing principles.

he principles of marginal costing can be smmarised as follows<

a9 +eriod fied costs are a constant amont therefore if oneetra nit of prodct is made and sold total costs will only riseby the variable cost 8the marginal cost 9 of prodction andsales for that nit.

b9 "lso total costs will fall by the variable cost per nit foreach redction by one nit in the level of activity.

c9 he additional profit earned by ma(ing and selling oneetra nit is the etra revene from its sales mins its variablecosts i.e. the contribtion per nit.

d9 "s the volme of activity increases there will be anincrease in total profits 8or a redction in losses9 e0al to thetotal revene mins the total etra variable costs. his is theetra contribtion from the etra otpt and sales.

e9 he total profit in a period is the total revene mins the

total variable cost of goods sold mins the fied costs of theperiod.

MARGIN OF SAFETY

Margin of safety represents the strength of the bsiness. t enablesa bsiness to (now that what is the eact amont he/ she hasgained or loss over or below brea( even point9.

Margin of safety T 88 sales - brea(-even sales9 / sales9 1)) f +/Cratio is given then sales/pv ratio

In !nit sal"s

f the prodct can be sold in a larger 0antity that occrs at thebrea(even point then the firm will ma(e a profit= below this point aloss. *rea(-even 0antity is calclated by<

otal fied costs / 8selling price - average variable costs9.

'planation - in the denominator Iprice mins average

variable costI is the variable profit per nit or contribtion



margin of each nit that is sold.

his relationship is derived from the profit e0ation< +rofit T

Revenes - ,osts where Revenes T 8selling price N 0antity

of prodct9 and ,osts T 8average variable costs N 0antity9 U

total fied costs. herefore +rofit T 8selling price N 0antity9 - 8average variable

costs N 0antity U total fied costs9.

olving for :antity of prodct at the brea(even point when

+rofit e0als ero the 0antity of prodct at brea(even is otal

fied costs / 8selling price - average variable costs9.

Firms may still decide not to sell low-profit prodcts for eamplethose not fitting well into their sales mi. Firms may also sellprodcts that lose money - as a loss leader to offer a complete line

of prodcts etc. *t if a prodct does not brea( even or a potentialprodct loo(s li(e it clearly will not sell better than the brea(evenpoint then the firm will not sell or will stop selling that prodct.

"n eample<

• "ssme we are selling a prodct for O2 each.• "ssme that the variable cost associated with prodcing and

selling the prodct is !) cents.• "ssme that the fied cost related to the prodct 8the basic

costs that are incrred in operating the bsiness even if noprodct is prodced9 is O1))).

• n this eample the firm wold have to sell 81))) / 82.)) -).!)9 T #159 #15 nits to brea( even. in that case the marginof safety vale of ;> and the vale of *'+ is not profitable ornot gaining loss.

*rea( 'ven T FC / 8SP W VC9

where F, is Fied ,ost + is selling +rice and C, is Cariable ,ost

Signi#icanc"-

• ?p to the *'+ the contribtion is earned is sfficient only torecover the fied costs. Bowever the beyond the *'+ thecontribtion is called the profit

• +rofit is nothing bt the contribtion earned ot of margin ofsafety of sales.

• he sie of the margin of safety shows the strength of thebsiness.

• " low margin of safety indicates the firm has a large fiedepenses and is moirX vlnerable to changes.

• " high margin of safety implies that a slight fall in sales maynot the bsiness very mch.



Im(ro'"m"nts in margin o# sa#"t,-

he possible steps for improve the margin of safety.

• ncrease in selling price provided the demand is inelastic so

as to absorb the increased prices.• Redction in fied epenses• Redction in variable epenses• ncreasing the sales volme provided capacity is available.• bstittion or introdction of a prodct mi sch that more

profitable lines are introdced.

S4.T DOWN PROBLEMS

ht down point indicates the level of operation8sales9 below whichit is not stifiable to prse prodction. For this prpose fiedepenses of a bsiness are classified as 8i9 avoidable ordiscretionary fied costs 8ii9 navoidable or committed fied costs.

he focs of sht down point calclation is to recover the avoidablefied costs in the first place. *y sspending the operations the firmmay save as also incr some additional ependitre. he decision isbased on whether contribtion is more than the difference betweenthe fied epenses incrred in normal operation and the fiedepense incrred when the plant is sht down.

" firm has to close down if its contribtion is insfficient to recovereven the avoidable fied costs.

htdown problems involve the following types of decisions<

a9 @hether or not to close down a factory department prodct lineor other activity either becase it is ma(ing losses or becase it istoo epensive to rn.

b9 f the decision is to sht down whether the closre shold bepermanent or temporary. htdown decisions often involve longterm considerations and capital ependitres and revenes.

c9 " shtdown shold reslt in savings in annal operating costs fora nmber of years in the ftre.

d9 ,losre reslts in release of some fied assets for sale. omeassets might have a small scrap vale bt others e.g. propertymight have a sbstantial sale vale.



e9 'mployees affected by the closre mst be made redndant orrelocated perhaps even offered early retirement. here will be lmpsms payments involved which mst be ta(en into consideration.For eample sppose closre of a regional office reslts in annalsavings of O1))))) fied assets sold off for O2 million bt

redndancy payments wold be O3 million. he shtdown decisionwold involve an assessment of the net capital cost of closre 8O1million9 against the annal benefits 8O1))))) per annm9.

t is possible for shtdown problems to be simplified into short rndecisions by ma(ing one of the following assmptions

a9 Fied asset sales and redndancy costs wold be negligible.b9 ncome from fied asset sales wold match redndancy costs andso these items wold be self-cancelling.

n these circmstances the financial aspects of shtdown decisionswold be based on short rn relevant costs.

CAS4 POSITION AND FORECAST

• he ,ash position and forecast en0iry is sally sed by the reasrer or whoever is responsible for ensring that thecompany has ade0ate fnds for epected otgoings.

•

he ,ash +osition inpt data is the (nown balances<

• +ostings in cash and ban( acconts 8any accont relevant tocash management9the nreconciled entries in the ban(clearing acconts 8ncashed che0es etc9 and

• any memo records which may have been manally entered8planning advices9 as relevant to a cash position

• cash flows from transactions managed in reasryManagement

'amples are<

• -ban( balances



• -otgoing chec(s posted to the ban( clearing accont• -otgoing transfers posted to the ban( clearing accont• -matring deposits and loans• -notified incoming payments posted to the ban( accont• -incoming payments with a vale date•

G.IDELINES FOR R.NNING T4E CAS4POSITION OR FORECAST EN=.IRY

9? .n"rstaning th" B!sin"ss R"0!ir"m"nts

$escribes the information that yo shold gather abot yor

companyLs operations in this area to ade0ately configre it.

@? Dat"s an th" Cash For"cast

he ,ash position and forecast is all abot amonts and dates. hesection eplains how the dates are determined for the variosinpts.

? Cash For"cast T"rminolog,

'plains the (ey terms that are encontered in the configration.Mst be read before embar(ing on the configration section.

? Cash For"cast Con#ig!ration

Kidelines on configring the ,ash +osition and Forecast - presentedin two sections - essential and then advanced configration.

? R"lat" Con#ig!ration Proc"ssing ar"as

$escribes some of the related configration and processing areasthat impact or feed data to the cash forecast.

? Pr"(aring t"st ata

+resents some hints on preparing test data directly withot havingto rn the feeder programs.

PROFIT AND LOSS FORECAST



" +rofit and >oss "ccont is designed to show the financialperformance of a bsiness over a given period 8sally Monthly or"nnally9 and to indicate whether it is 8or in the case of a + Y >Forecast if it will9 ma(e or lose money.

@ithot +rofit there eventally will be no bsiness

+rofit and >oss is also essential in providing information for nlandRevene for aation prposes

?nderstanding how a +rofit and >oss "ccont wor(s will help yo tochoose the right time to by items that yo need for the bsinessredce yor ta liability 8a *ill9 and wor( ot how mch a yowill have to pay.

PROFIT AND PLANNING

+rofit planning is essential when yo want yor bsiness to focs onenhancing its profit-ma(ing capabilities. 'ffective profit planninghappens when yo determine in advance a set of clear and realisticgoals that yor bsiness or organiation needs to flfil. hose goalsmst be based pon obective eisting and epected bsinessconditions. "nticipating the changes in yor bsiness environment isalso central to profit planning.

Kiven the central role profit planning can play in the ftreprospects of an organiation it might come as a srprise to learnthat a large nmber of bsinesses do not sally have or develop afinancial plan. @hat is even more amaing is that many of thebsinesses which do plan for their financial ftre often st repeatthe same procedre over and over every year. hey do not ta(e thetime to loo( at how the plan wor(s or if it is really wor(ing.

" very small nmber of bsinesses crrently (nows how to practiceand benefit from proficient profit planning. Bowever researchindicates that profit planning might be a central reason behind theincreased sales and profits enoyed by these few bsinesses."ppropriate profit planning can help yor company enoy thosebenefits too.

'ffective profit planning can have a deep impact in the life of yororganiation. he professionals at FR ,onsltants believe thatprofit planning is a (ey element which has led to the sccess of bigand small bsinesses ali(e. hat said it cold trly ensrecontinos prosperity for yor own bsiness as well. FR

,onsltants is a trstworthy firm of honest and eperiencedprofessionals that can lead yo to ma(e the best ot of profit



planning. Many goldbric(s in the field are more eager to charge yopremims for their time than to deliver what yo are paying for. "tFR ,onsltants we do not shir( or wor(. @e will strive to deliveron time and prove the vale of or service. Ather conslting firmsmay seem less epensive than s bt that is not the case. o learn

more or to re0est a free consltation please complete or onlineform.

marginal costing 1

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