17009209 marginal costing

7/29/2019 17009209 Marginal Costing

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TOPICS1. 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 making11.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 planningo

MARGINAL COSTING AS A COSTING SYSTEM


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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 andproportional 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 COSTIn economics and finance, marginal cost is the change in total cost thatarises 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 withrespect 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 nextunit produced.

A typical Marginal Cost Curve


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In general terms, marginal cost at each level of production includes anyadditional costs required to produce the next unit. If producing additionalvehicles requires, for example, building a new factory, the marginal cost ofthose extra vehicles includes the cost of the new factory. In practice, theanalysis is segregated into short and long-run cases, and over the longestrun, all costs are marginal. At each level of production and time period beingconsidered, marginal costs include all costs which vary with the level ofproduction, and other costs are considered fixed costs.A number of other factors can affect marginal cost and its applicability toreal world problems. Some of these may be considered market failures.

These may include information asymmetries, the presence of negativeor positive externalities, transaction costs, price discrimination andothers.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 unitscan be produced for less than the previous unit, that is, average costis falling.

This can only occur if average cost at any given level ofproduction is higher than the marginal cost.

Conversely, there may be levels of production where marginal cost ishigher than average cost, and average cost will rise for each unit ofproduction after that point. This type of production function is generallyknown as diminishing marginal productivity: at low levels of production,productivity gains are easy and marginal costs falling, but productivitygains become smaller as production increases; eventually, marginalcosts rise because increasing output (with existing capital, labour ororganization) becomes more expensive. For this generic case,

minimum average cost occurs at the point where average cost andmarginal cost are equal (when plotted, the two curves intersect); thispoint will notbe at the minimum for marginal cost if fixed costs aregreater 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.


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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 ofoutput assuming that all inputs are obtained at current prices, that current

technology is employed, and everything is being built new from scratch. Inview of the durability of many capital items this textbook concept is lessuseful than one which allows for some scrapping of existing capital items orthe acquisition of new capital items to be used with the existing stock ofcapital items acquired in the past. Long-run marginal cost then means theadditional cost or the cost saving per unit of additional or reduced production,including the expenditure on additional capital goods or any saving fromdisposing of existing capital goods. Note that marginal cost upwards andmarginal cost downwards may differ, in contrast with marginal cost accordingto the less useful textbook concept.

Economies of scale are said to exist when marginal cost according to thetextbook concept falls as a function of output and is less than the averagecost per unit. This means that the average cost of production from a largernew built-from-scratch installation falls below that from a smaller new built-from-scratch installation. Under the more useful concept, with an existingcapital stock, it is necessary to distinguish those costs which vary with outputfrom accounting costs which will also include the interest and depreciation onthat 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 economiesof scale then does not apply.

ExternalitiesExternalities are costs (or benefits) that are not borne by the parties to theeconomic transaction. A producer may, for example, pollute the environment,and others may bear those costs. A consumer may consume a good whichproduces benefits for society, such as education; because the individual doesnot receive all of the benefits, he may consume less than efficiency wouldsuggest. Alternatively, an individual may be a smoker or alcoholic and imposecosts on others. In these cases, production or consumption of the good inquestion may differ from the optimum level.


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[edit] Negative externalities of production

Negative Externalities of ProductionMuch 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 ofproduction that creates negative externalities.Such externalities are a result of firms externalizing their costs onto a thirdparty in order to reduce their own total cost. As a result of externalizing suchcosts we see that members of society will be negatively affected by suchbehavior of the firm. In this case, we see that an increased cost ofproduction 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 ProductionWhen 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 createpositive externalities. An example of such a


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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 socialcost curve that is less than that of the private curve. In an equilibrium state wesee that markets creating positive externalities of production will underproduce that good. As a result, the socially optimal production level would begreater than that observed.Social costs

Of great importance in the theory of marginal cost is the distinction betweenthe marginalprivate and socialcosts. The marginal private cost shows thecost associated to the firm in question. It is the marginal private cost that isused by business decision makers in their profit maximization goals, and byindividuals in their purchasing and consumption choices. Marginal social costis similar to private cost in that it includes the cost functions of privateenterprise but also that of society as a whole, including parties that have nodirect association with the private costs of production. It incorporates allnegative and positive externalities, of both production and consumption.

Hence, when deciding whether or how much to buy, buyers take accountof the cost to society of their actions ifprivate and social marginal costcoincide. The equality of price with social marginal cost, by aligning theinterest of the buyer with the interest of the community as a whole is anecessary condition for economically efficient resource allocation.Other cost definitions in marginal costing

Fixed costs are costs which do not vary with output, forexample, rent. In the long run all costs can be considered

variable. Variable cost also known as,operating costs,prime costs,oncosts

and direct costs, are costs which vary directly with thelevel of output,for example, labour, fuel, power and cost of raw material.

Social costs of production are costs incurred by society, as awhole, resulting from private production.

Average total cost is the total cost divided by the quantityof output.

Average fixed cost is the fixed cost divided by the quantity of

output.


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Average variable cost are variable costs divided by thequantity

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


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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 its 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;

Its 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

TOOL1. 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 questionthus 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


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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 relevancein 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 itscomplex 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 atthe


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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 MarginalCosting.

(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 andmonitoring 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 informationrequired 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). Productdecisions are viewed strategically.


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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 necessityresults 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 decentralizedmanagement accounting. Standard U.S. management


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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 ofthis 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 reflectsthe 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,


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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 businessbecause a manager is faced with a problem and alternative courses of actionare available. In deciding which option to choose he will need all theinformation which is relevant to his decision; and he must have some criterionon the basis of which he can choose the best alternative. Some of the factorsaffecting the decision may not be expressed in monetary value. Hence, themanager will have to make 'qualitative' judgements, e.g. in deciding which oftwo personnel should be promoted to a managerial position. A 'quantitative'decision, on the other hand, is possible when the various factors, andrelationships between them, are measurable. This chapter will concentrate onquantitative decisions based on


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data expressed in monetary value and relating to costs and

revenues as measured by the management accountant.Elements of a decisionA 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 moreconstraints,

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.Forexample, in order to minimise costs of a manufacturing operation, the

available alternatives may be:

i) to continue manufacturing as at presentii) to change the manufacturing methodiii) 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 makingThe 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 oravoided

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.


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c) Cash flow: Expenses such as depreciation are not cash flowsand 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 alternativesare

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 alwaysirrelevant,

e.g. dedicated fixed assets, development costs already incurred.

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

whatever decision is taken now, e.g. contracts already entered into which

cannot be altered.

Opportunity costRelevant 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.ExampleA company is considering publishing a limited edition book bound in a specialleather. It has in stock the leather bought some years ago for $1,000. To buyan 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 materialwhich could cost $900b) 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 goahead with the project, the leather would notbe costed at $1,000. The costwas incurred in the past for some reason which is no longer relevant. Theleather exists and could be used on the book without incurring any specificcost in doing so. In using the leather on the book, however, the company willlose the opportunities of either disposing of it for $800 or of using it to savean 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


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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 thebook 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 costingSome 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


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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 RatioFormula :

P V Ratio = Contribution X 100Sales

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


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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 firms costs were all variable, the firm could be

profitable from the start. If the firm is to avoid losses, its sales mustcover all costs that vary directly with production and all costs that donot change with production levels.

Fixed costs are those expenses associated with the project that youwould have to pay whether you sold one unit or 10,000 units. Examplesinclude general office expenses, rent, depreciation, interest, salaries,research and development, and utilities. Variable costs vary directlywith the number of units that you sell. Examples include materials,direct labour, postage, packaging, and advertising. Some costs aredifficult to classify. As a general guideline, if there is a directrelationship between cost and number of units sold, consider the costvariable. If there is no relationship, then consider the cost fixed.

A break-even chart is constructed with a horizontal axis representingunits produced and a vertical axis representing sales and costs.Represent fixed costs by a horizontal line since they do not changewith the number of units produced. Represent variable costs and salesby upward sloping lines since they vary with the number of unitsproduced and sold. The break-even point is the intersection of the totalsales and the total cost lines. Above that point, the firm begins to makea profit, but below that point, it suffers a loss. Here is a sample break-even chart:


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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 andtotal variable costs of $6 per unit. If you could sell the units for $ 10each, the equation indicates that you need to sell 300 units to breakeven. 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 thatbalances 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 ininventory. Other components include the labour costs associated withinventory maintenance and insurance costs. Also include deterioration,spoilage, and obsolescence costs. The costs of more frequent ordersinclude lost discounts for larger quantity purchases and labour andsupply costs of writing the orders. Additional costs include paying thebills and processing the paperwork, associated telephone and mailcosts, and the labour costs of processing and inspecting incominginventory.


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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 ofunits 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 toplace 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 youneed to order at one time to minimize total costs.

The reorder point, orEconomic 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 timeFor 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 unitsYou 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. Youmust be able to satisfy the customer as well as keep your inventory

investment minimized.Use of BEP Analysis In capital budgetingBreak even analysis is a special application of sensitivity analysis. It aims at

finding the value of individual variables which the projects 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.


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Often the assumptions upon which the analysis is based are madeby using past experience / data which may not hold in the future.

Variables have been adjusted one by one; however it is unlikelythat in the life of the project only one variable will change until

reaching the break even point. Management decisions made byobserving the behaviour of only one variable are most likely to beinvalid.

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 forthe product at these various prices.

It assumes that fixed costs (FC) are constant

It assumes average variable costs are constant per unit of output, atleast in the range of likely quantities of sales. (i.e. linearity)

It assumes that the quantity of goods produced is equal to the quantityof goods sold (i.e., there is no change in the quantity of goods held ininventory at the beginning of the period and the quantity of goods heldin inventory at the end of the period).

In multi-product companies, it assumes that the relative proportionsof 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 ofchanges 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


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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. Forexample, CVP analysis attempts to answer thefollowing 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, andoutput 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 tocompute the volume level at which total revenues are equal to totalcosts. When total costs and total revenues are equal, the businessorganization is said to be "breaking even." The analysis is based on aset of linear equations for a straight line and the separation of variableand fixed costs.

Total variable costs are considered to be those costs that vary as theproduction volume changes. In a factory, production volume isconsidered to be the number of units produced, but in a governmentalorganization with no assembly process, the units produced mightrefer, for example, to the number of welfare cases processed.

There are a number of costs that vary or change, but if the variation isnot due to volume changes, it is not considered to be a variable cost.Examples of variable costs are direct materials and direct labour. Totalfixed costs do not vary as volume levels change within the relevantrange. Examples of fixed costs are straight-line depreciation andannual insurance charges.


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All the lines in the chart are straight lines: Linearity is an underlyingassumption of CVP analysis. Although no one can be certain thatcosts are linear over the entire range of output or production, this is anassumption of CVP.

To help alleviate the limitations of this assumption, it is also assumedthat the linear relationships hold only within the relevant range ofproduction. The relevant range is represented by the high and lowoutput points that have been previously reached with past production.CVP analysis is best viewed within the relevant range, that is, withinour previous actual experience. Outside of that range, costs may varyin a nonlinearmanner. The straight-line equation for total cost is:

Total cost = total fixed cost + total variable costTotal 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 + bxwhere a is the fixed cost, b is the variable cost per unit,xis the levelof activity, and Yis the total cost. Assume that the fixed costs are$5,000, the volume of units produced is 1,000, and the per-unitvariable cost is $2. In that case the total cost would be computed as

follows:

Y= $5,000 + ($2 1,000) Y= $7,000It can be seen that it is important to separate variable and fixed costs.Another reason it is important to separate these costs is becausevariable costs are used to determine the contribution margin, and thecontribution margin is used to determine the break-even point. Thecontribution margin is the difference between the per-unit variable costand the selling price per unit. For example, if the per-unit variable costis $15 and selling price per unit is $20, then the contribution margin is

equal to $5. The contribution margin may provide a


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$5 contribution toward the reduction of fixed costs or a $5 contributionto 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 aper- unit basis) to additional profits. If the business is operating at avolume below the break-even point (below point F), then the $5

provides for a reduction in fixed costs and continues to do so until thebreak-even point is passed.

Once the contribution margin is determined, it can be used to calculatethe break-even point in volume of units or in total sales dollars. When aper-unit contribution margin occurs below a firm's break-even point, itis a contribution to the reduction of fixed costs. Therefore, it is logicalto divide fixed costs by the contribution margin to determine how manyunits must be produced to reach the break-even point:

The financial information required for CVP analysis is for internal useand is usually available only to managers inside the firm; informationabout variable and fixed costs is not available to the general public.CVP analysis is good as a general guide for one product within therelevant range. If the company has more than one product, then thecontribution 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, donot incura significant level of variable costs. In these cases, standardCVP assumptions can lead to misleading results and decisions.

USES OF CVP ANALYSISa) 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 eachproduct

should be sold.

d) Decisions that will affect the cost structure and

production capacity of the company.


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THE BASIC PRINCIPLES OF CVP ANALYSISCVP 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 SAFETYMargin 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 isgiven then sales/pv ratioIn unit salesIf 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


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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 notfitting 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 sellbetter 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 sellingthe product is 60 cents.

Assume that the fixed cost related to the product (the basic coststhat 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 CostSignificance:

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

the fixed costs. However the beyond the BEP, the contribution iscalled the profit

Profit is nothing but the contribution earned out of margin of safety ofsales.

The size of the margin of safety shows the strength of thebusiness.

A low margin of safety indicates the firm has a large fixedexpenses and is moir vulnerable to changes.

A high margin of safety implies that a slight fall in sales may not thebusiness very much.


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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 PROBLEMSShut 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 fixedcosts in the first place. By suspending the operations, the firm may save asalso incur some additional expenditure. The decision is based on whethercontribution is more than the difference between the fixed expenses incurredin normal operation and the fixed expense incurred when the plant is shutdown.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.


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e) Employees affected by the closure must be made redundant or relocated,perhaps even offered early retirement. There will be lump sums paymentsinvolved which must be taken into consideration. For example, supposeclosure of a regional office results in annual savings of $ 100,000, fixedassets sold off for $2 million, but redundancy payments would be $3 million.

The shutdown decision would involve an assessment of the net capital costof 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 assumptionsa) 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 cashmanagement),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


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-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 ENQUIRY1. Understanding the Business RequirementsDescribes the information that you should gather about your

company's operations in this area to adequately configure it.2. Dates and the Cash ForecastThe 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 TerminologyExplains the key terms that are encountered in the configuration. Must be

read before embarking on the configuration section.4. Cash Forecast ConfigurationGuidelines on configuring the Cash Position and Forecast - presented in two

sections - essential and then advanced configuration.

5. Related Configuration / Processing areasDescribes some of the related configuration and processing areas that

impact or feed data to the cash forecast.6. Preparing test dataPresents some hints on preparing test data directly without having to run

the feeder programs.

PROFIT AND LOSS FORECAST


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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 businessProfit and Loss is also essential in providing information for Inland Revenue

for Taxation purposesUnderstanding 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 PLANNINGProfit planning is essential when you want your business to focus onenhancing its profit-making capabilities. Effective profit planning happenswhen you determine in advance a set of clear and realistic goals that yourbusiness or organization needs to fulfil. Those goals must be based uponobjective existing and expected business conditions. Anticipating the changesin your business environment is also central to profit planning.Given the central role profit planning can play in the future prospects of anorganization, it might come as a surprise to learn that a large number ofbusinesses do not usually have or develop a financial plan. What is evenmore amazing is that many of the businesses which do plan for theirfinancial future often just repeat the same procedure over and over everyyear. They do not take the time to look at how the plan works, or if it is reallyworking.A very small number of businesses currently knows how to practice andbenefit from proficient profit planning. However, research indicates that profitplanning might be a central reason behind the increased sales and profitsenjoyed by these few businesses. Appropriate profit planning can help yourcompany enjoy those benefits too.Effective profit planning can have a deep impact in the life of yourorganization. The professionals at FRS Consultants believe that profitplanning is a key element which has led to the success of big and smallbusinesses alike. That said, it could truly ensure continuous prosperity foryour own business, as well. FRS Consultants is a trustworthy firm of honest

and experienced professionals that can lead you to make the best out ofprofit


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planning. Many goldbricks in the field are more eager to charge youpremiums for their time than to deliver what you are paying for. At FRSConsultants we do not shirk our work. We will strive to deliver on time andprove the value of our service. Other consulting firms may seem lessexpensive than us, but that is not the case. To learn more or to request a

free consultation please complete our online form.

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