Chapter 17 continued
17a: Marginal costing and breakeven analysis
After completing this topic you should be able to
Describe the main purposes of marginal costing
Construct a marginal cost statement and associated profit
statement
Conduct breakeven analysis
Independent study
Study Chapter 17
Progress test and practice question(s) as set
Business Accounting 1
The story so far ...
Cost accounting is the process of collecting,
processing and presenting financial and quantitative
data within an entity to ascertain the cost of the cost
centres and cost units’ (Collis and Hussey, 2007, p.
213)
Revenue expenditure can be divided into direct
costs (eg direct materials) and indirect costs (eg
production overheads) and the information is used to
prepare a total cost statement
Product direct costs + Indirect costs = Total cost
Business Accounting 2
Marginal costing
One problem with methods of total costing is that the
classification of revenue expenditure into direct
costs and indirect costs ignores their different
behaviours when production or sales activity varies
An alternative is to use marginal costing, where the
main purpose is to provide detailed cost information
for planning and short-term decisions in a business
where activity levels fluctuate
Actual or budgeted/planned figures can be used
Business Accounting 3
Classifying costs by behaviour
Costs and expenses are classified according to their
behaviour when activity levels fluctuate
A variable cost is ‘an item of revenue expenditure that
varies directly with changes in the level of production or
sales activity’ (Collis and Hussey, 2007, p. 292)
A fixed cost is ‘an item of revenue expenditure that is
unaffected by changes in the level of production or sales
activity’ (Collis and Hussey, 2007, p. 292)
In marginal costing
Variable costs + Fixed costs = Total cost
Business Accounting 4
Exercise 1
Variable and fixed costs
Ros expects the production costs will be as follows
Mineral water (in bulk)
Bottles, lids and labels
Rent and rates
Electricity (lighting, heating and power)
Wages (for the bottling operative)
Depreciation on the bottling machine
Required
Indicate whether the above costs are variable costs or
fixed costs
Business Accounting 5
Solution 1
Variable and fixed costs
Cost Direct Indirect
Mineral water (in bulk)
Bottles, lids and labels
Rent and rates
Electricity (lighting, heating and power) ?
Wages (for the bottling operative) ?
Depreciation of machinery
Note
Electricity and wages may have variable elements
If we compare this with our classification into direct and indirect
costs, we can conclude that product direct costs are always
variable costs and, in the short term, indirect costs are likely to
be fixed costs
Business Accounting 6
Calculating contribution
Only the variable costs are charged to the cost units
The variable cost per unit is known as the marginal cost
The difference between the sales value and the
variable costs is known as the contribution and is
based on the assumption that the sales value and
variable costs will be constant
Sales value – Variable costs = Contribution
Contribution represents the contribution towards
covering the fixed costs
Total contribution – Fixed costs = Net profit/(loss)
Business Accounting 7
Exercise 2
Marginal cost statement
A marginal cost statement allows you to calculate
the contribution per unit and net profit or loss over
the accounting period
Cotswold Coolers plans to produce and sell 1,000
units of mineral water per week
The selling price will be £3.20 per unit and variable costs
per unit will be mineral water £0.30; bottle, lid and label
£0.75. Fixed costs will be £850 per week.
Required
Complete the marginal cost statement for 1 unit and the
associated weekly profit statement based on 1,000 units
Business Accounting 8
Pro forma Cotswold Coolers
Marginal cost statement
1 unit 1,000 units
£ £ £ £
Sales 3.20 ?
Variable costs
Mineral water 0.30 ?
Bottle, lid and label 0.75 ( )? ? ( )?
Contribution ? ?
Fixed costs (850)
Net profit/(loss) ?
Business Accounting 9
Solution 2 Cotswold Coolers
Marginal cost statement
1 unit 1,000 units
£ £ £ £
Sales 3.20 3,200
Variable costs
Mineral water 0.30 300
Bottle, lid and label 0.75 (1.05) 750 (1,050)
Contribution 2.15 2,150
Fixed costs (850)
Net profit/(loss) 1,300
Notes
The contribution per unit will be £2.15
Total contribution from selling 1,000 units will be £2,150, which will
cover the fixed costs of £850 and provide a net profit of £1,300
Business Accounting 10
Techniques based on marginal costing
The information in a marginal cost statement forms
the basis of two widely used techniques for making
short-term decisions
Breakeven analysis and contribution analysis
We are going to start with breakeven analysis,
which can be used for
Setting the minimum selling price
Setting the minimum level of activity
Planning the level of activity to generate a required profit
Calculating the margin of safety at a given level of activity
Business Accounting 11
Breakeven analysis
The purpose of breakeven analysis is to identify the
breakeven point (BEP), which is ‘the level of activity
at which there is neither a profit nor a loss, as
measured by volume of production or sales,
percentage of production capacity or level of sales
revenue’ (Collis and Hussey, 2007, p. 296)
In other words, the breakeven point is where
Total contribution = total fixed costs or
Total revenue = total costs
Business Accounting 12
Exercise 3
Breakeven point in units
Ros expects the total fixed costs for 1 week will be
£850 and we know from the marginal cost statement
that the contribution per unit will be £2.15
Required
Calculate the breakeven point in units using the formula:
Fixed costs
Contribution per unit
Business Accounting 13
Solution 3
Breakeven point in units
Formula Workings
Fixed costs £850 = 395.34883
Contribution per unit £2.15 or 395 units
Interpretation
- Cotswold Coolers will break even when 395 units are sold
- This is the minimum level of activity, where the business
covers the total cost but makes neither a profit nor a loss
NB Round to the nearest whole number (no split bottles!) This
is not an exact science and the results must be interpreted in
the knowledge that the figures are based on budgeted/planned
figures, which are estimates
Business Accounting 14
Breakeven point in sales value or % of capacity
Once you’ve found the breakeven point (BEP) in units, you
can use it to find the BEP in sales value or % of capacity
Formula Workings
BEP in units Selling price 395 £3.20 = £1,264 sales value
BEP in units 100 395 100 = 39.5%
Capacity in units 1,000 or 40% of capacity
Interpretation
- Cotswold Coolers will break even when sales revenue
reaches £1,264, which is 40% of their production capacity
Business Accounting 15
Exercise 4
Level of activity to achieve a target profit
Same information from the marginal cost statement
Total fixed costs will be £850 per week
Contribution will be £2.15 per unit
Required
Calculate the level of activity required to achieve a target
profit of £500 using the formula:
Fixed costs + Target profit
Contribution per unit
Business Accounting 16
Solution 4
Level of activity to achieve a target profit
Formula Workings
Total fixed costs + Target profit £850 + £500 = 627.9
Contribution per unit £2.15 or 628 units
Interpretation
- Cotswold Coolers will achieve a profit of £500 when
the business has sold 628 units
- The contribution made by the sale of 628 units will
exceed the total fixed costs by £500, which is profit
Business Accounting 17
Margin of safety
The formula for the margin of safety is
Selected level of activity – Breakeven point
Our selected level of activity is where the business
will make a profit of £500, so inserting the figures:
628 – 395 = 233 units
Interpretation
Cotswold Coolers could miss the sales target of 628 units
by as many as 233 units before the level of activity drops
below the breakeven point of 395 units and the business
starts making a loss
All this information can be shown graphically ...
Business Accounting 18
Breakeven graph
Costs/Sales (£) Sales revenue
PROFIT
£1,350 Profit £500 Variable costs
£1,264 Breakeven point
£850 Fixed costs
LOSS
←→ Margin of safety 233 units
0 395 628 Activity level (units)
Business Accounting 19
Conclusions
Breakeven analysis is based on marginal costing
and provides detailed cost information in a business
where production and/or sales levels fluctuate
It is based on the assumption that sales value and
variable costs are constant and that variable costs
vary with changes in the level of activity whilst fixed
costs do not, but in the longer term
Variable costs may vary for other reasons (eg direct labour
may be less efficient at higher levels of activity)
Fixed costs may increase in steps (eg more machines or
larger premises needed at higher levels of activity)
Business Accounting 20