Marginal Costing

TOPICS 1. 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 making 11.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 planning o

MARGINAL COSTING AS A COSTING SYSTEM

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 and proportional 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 COST In economics and finance, marginal cost is the change in total cost that arises 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 with respect 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 next unit produced.

A typical Marginal Cost Curve

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and longrun cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs. A number of other factors can affect marginal cost and its applicability to real world problems. Some of these may be considered market failures. These may include information asymmetries, the presence of negative or positive externalities, transaction costs, price discrimination and others. 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 units can be produced for less than the previous unit, that is, average cost is falling. This can only occur if average cost at any given level of production is higher than the marginal cost. Conversely, there may be levels of production where marginal cost is higher than average cost, and average cost will rise for each unit of production after that point. This type of production function is generally known as diminishing marginal productivity: at low levels of production, productivity gains are easy and marginal costs falling, but productivity gains become smaller as production increases; eventually, marginal costs rise because increasing output (with existing capital, labour or organization) becomes more expensive. For this generic case, minimum average cost occurs at the point where average cost and marginal cost are equal (when plotted, the two curves intersect); this point will not be at the minimum for marginal cost if fixed costs are greater 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.

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 of output assuming that all inputs are obtained at current prices, that current technology is employed, and everything is being built new from scratch. In view of the durability of many capital items this textbook concept is less useful than one which allows for some scrapping of existing capital items or the acquisition of new capital items to be used with the existing stock of capital items acquired in the past. Long-run marginal cost then means the additional cost or the cost saving per unit of additional or reduced production, including the expenditure on additional capital goods or any saving from disposing of existing capital goods. Note that marginal cost upwards and marginal cost downwards may differ, in contrast with marginal cost according to the less useful textbook concept. Economies of scale are said to exist when marginal cost according to the textbook concept falls as a function of output and is less than the average cost per unit. This means that the average cost of production from a larger new built-from-scratch installation falls below that from a smaller new built-from-scratch installation. Under the more useful concept, with an existing capital stock, it is necessary to distinguish those costs which vary with output from accounting costs which will also include the interest and depreciation on that 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 economies of scale then does not apply.

 Externalities Externalities are costs (or benefits) that are not borne by the parties to the economic transaction. A producer may, for example, pollute the environment, and others may bear those costs. A consumer may consume a good which produces benefits for society, such as education; because the individual does not receive all of the benefits, he may consume less than efficiency would suggest. Alternatively, an individual may be a smoker or alcoholic and impose costs on others. In these cases, production or consumption of the good in question may differ from the optimum level.

[edit] Negative externalities of production

Negative Externalities of Production Much 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 of production that creates negative externalities. Such externalities are a result of firms externalizing their costs onto a third party in order to reduce their own total cost. As a result of externalizing such costs we see that members of society will be negatively affected by such behavior of the firm. In this case, we see that an increased cost of production 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 Production When 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 create positive externalities. An example of such a

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 social cost curve that is less than that of the private curve. In an equilibrium state we see that markets creating positive externalities of production will under produce that good. As a result, the socially optimal production level would be greater than that observed. Social costs Of great importance in the theory of marginal cost is the distinction between the marginal private and social costs. The marginal private cost shows the cost associated to the firm in question. It is the marginal private cost that is used by business decision makers in their profit maximization goals, and by individuals in their purchasing and consumption choices. Marginal social cost is similar to private cost in that it includes the cost functions of private enterprise but also that of society as a whole, including parties that have no direct association with the private costs of production. It incorporates all negative and positive externalities, of both production and consumption. Hence, when deciding whether or how much to buy, buyers take account of the cost to society of their actions if private and social marginal cost coincide. The equality of price with social marginal cost, by aligning the interest of the buyer with the interest of the community as a whole is a necessary condition for economically efficient resource allocation. Other cost definitions in marginal costing •

•

• • •

Fixed costs are costs which do not vary with output, for example, rent. In the long run all costs can be considered variable. Variable cost also known as, operating costs, prime costs, on costs and direct costs, are costs which vary directly with the level of output, for example, labour, fuel, power and cost of raw material. Social costs of production are costs incurred by society, as a whole, resulting from private production. Average total cost is the total cost divided by the quantity of output. Average fixed cost is the fixed cost divided by the quantity of output.

•

Average variable cost are variable costs divided by the quantity 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

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 it’s 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;

•

It’s 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 TOOL 1. 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 question thus 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

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 relevance in 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 its complex 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 at the

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 Marginal Costing. (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 and monitoring 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 information required 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 preproduction costs (such as development costs) and phasing-out costs (such as disposal costs). Product decisions are viewed strategically.

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 activitybased 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 necessity results 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 decentralized management accounting. Standard U.S. management

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 of this 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 reflects the 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,

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

data expressed in monetary value and relating to costs and revenues as measured by the management accountant. Elements of a decision A 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 more constraints, 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. For example, in order to minimise costs of a manufacturing operation, the available alternatives may be: i) to continue manufacturing as at present ii) to change the manufacturing method iii) 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 making The 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 or avoided 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.

c) Cash flow: Expenses such as depreciation are not cash flows and 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 alternatives are 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 always irrelevant, e.g. dedicated fixed assets, development costs already incurred. f) Committed costs: A future cash outflow that will be incurred anyway, whatever decision is taken now, e.g. contracts already entered into which cannot be altered. Opportunity cost Relevant 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. Example A company is considering publishing a limited edition book bound in a special leather. It has in stock the leather bought some years ago for $1,000. To buy an 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 material which could cost $900 b) 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 go ahead with the project, the leather would not be costed at $1,000. The cost was incurred in the past for some reason which is no longer relevant. The leather exists and could be used on the book without incurring any specific cost in doing so. In using the leather on the book, however, the company will lose the opportunities of either disposing of it for $800 or of using it to save an 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

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 the book 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 costing Some 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

•

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 Ratio Formula : P V Ratio = Contribution X 100 Sales 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

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 firm’s costs were all variable, the firm could be profitable from the start. If the firm is to avoid losses, its sales must cover all costs that vary directly with production and all costs that do not change with production levels. Fixed costs are those expenses associated with the project that you would have to pay whether you sold one unit or 10,000 units. Examples include general office expenses, rent, depreciation, interest, salaries, research and development, and utilities. Variable costs vary directly with the number of units that you sell. Examples include materials, direct labour, postage, packaging, and advertising. Some costs are difficult to classify. As a general guideline, if there is a direct relationship between cost and number of units sold, consider the cost variable. If there is no relationship, then consider the cost fixed. A break-even chart is constructed with a horizontal axis representing units produced and a vertical axis representing sales and costs. Represent fixed costs by a horizontal line since they do not change with the number of units produced. Represent variable costs and sales by upward sloping lines since they vary with the number of units produced and sold. The break-even point is the intersection of the total sales and the total cost lines. Above that point, the firm begins to make a profit, but below that point, it suffers a loss. Here is a sample break-even chart:

•

•

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 and total variable costs of $6 per unit. If you could sell the units for $10 each, the equation indicates that you need to sell 300 units to break even. 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 that balances 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 in inventory. Other components include the labour costs associated with inventory maintenance and insurance costs. Also include deterioration, spoilage, and obsolescence costs. The costs of more frequent orders include lost discounts for larger quantity purchases and labour and supply costs of writing the orders. Additional costs include paying the bills and processing the paperwork, associated telephone and mail costs, and the labour costs of processing and inspecting incoming inventory.

•

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 of units 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 to place 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 you need to order at one time to minimize total costs. The reorder point, or Economic 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 time For 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 units You 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. You must be able to satisfy the customer as well as keep your inventory investment minimized. Use of BEP Analysis In capital budgeting Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables which the project’s 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.

•

•

•

Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future. Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid. 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 for the product at these various prices. It assumes that fixed costs (FC) are constant It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of 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 of changes 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

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. For example, CVP analysis attempts to answer the following 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, and output 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 to compute the volume level at which total revenues are equal to total costs. When total costs and total revenues are equal, the business organization is said to be "breaking even." The analysis is based on a set of linear equations for a straight line and the separation of variable and fixed costs.

•

Total variable costs are considered to be those costs that vary as the production volume changes. In a factory, production volume is considered to be the number of units produced, but in a governmental organization with no assembly process, the units produced might refer, for example, to the number of welfare cases processed.

•

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

•

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

•

To help alleviate the limitations of this assumption, it is also assumed that the linear relationships hold only within the relevant range of production. The relevant range is represented by the high and low output points that have been previously reached with past production. CVP analysis is best viewed within the relevant range, that is, within our previous actual experience. Outside of that range, costs may vary in a nonlinear manner. The straight-line equation for total cost is: Total cost = total fixed cost + total variable cost Total 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 + bx where a is the fixed cost, b is the variable cost per unit, x is the level of activity, and Y is the total cost. Assume that the fixed costs are $5,000, the volume of units produced is 1,000, and the per-unit variable cost is $2. In that case the total cost would be computed as follows: Y = $5,000 + ($2 1,000) Y = $7,000 It can be seen that it is important to separate variable and fixed costs. Another reason it is important to separate these costs is because variable costs are used to determine the contribution margin, and the contribution margin is used to determine the break-even point. The contribution margin is the difference between the per-unit variable cost and the selling price per unit. For example, if the per-unit variable cost is $15 and selling price per unit is $20, then the contribution margin is equal to $5. The contribution margin may provide a

$5 contribution toward the reduction of fixed costs or a $5 contribution to 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 a per-unit basis) to additional profits. If the business is operating at a volume below the break-even point (below point F), then the $5 provides for a reduction in fixed costs and continues to do so until the break-even point is passed. •

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

•

The financial information required for CVP analysis is for internal use and is usually available only to managers inside the firm; information about variable and fixed costs is not available to the general public. CVP analysis is good as a general guide for one product within the relevant range. If the company has more than one product, then the contribution 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, do not incur a significant level of variable costs. In these cases, standard CVP assumptions can lead to misleading results and decisions.

USES OF CVP ANALYSIS a) 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 each product should be sold. d) Decisions that will affect the cost structure and production capacity of the company.

THE BASIC PRINCIPLES OF CVP ANALYSIS CVP 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 SAFETY Margin 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 is given then sales/pv ratio In unit sales If 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

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 not fitting 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 sell better 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 selling the product is 60 cents. Assume that the fixed cost related to the product (the basic costs that 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 Cost

Significance: •

• • • •

Up to the BEP, the contribution is earned is sufficient only to recover the fixed costs. However the beyond the BEP, the contribution is called the profit Profit is nothing but the contribution earned out of margin of safety of sales. The size of the margin of safety shows the strength of the business. A low margin of safety indicates the firm has a large fixed expenses and is moiré vulnerable to changes. A high margin of safety implies that a slight fall in sales may not the business very much.

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 PROBLEMS Shut 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 fixed costs in the first place. By suspending the operations, the firm may save as also incur some additional expenditure. The decision is based on whether contribution is more than the difference between the fixed expenses incurred in normal operation and the fixed expense incurred when the plant is shut down. 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.

e) Employees affected by the closure must be made redundant or relocated, perhaps even offered early retirement. There will be lump sums payments involved which must be taken into consideration. For example, suppose closure of a regional office results in annual savings of $100,000, fixed assets sold off for $2 million, but redundancy payments would be $3 million. The shutdown decision would involve an assessment of the net capital cost of 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 assumptions a) 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 cash management),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

• • • • • •

-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 ENQUIRY 1. Understanding the Business Requirements Describes the information that you should gather about your company's operations in this area to adequately configure it. 2. Dates and the Cash Forecast The 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 Terminology Explains the key terms that are encountered in the configuration. Must be read before embarking on the configuration section. 4. Cash Forecast Configuration Guidelines on configuring the Cash Position and Forecast - presented in two sections - essential and then advanced configuration.

5. Related Configuration / Processing areas Describes some of the related configuration and processing areas that impact or feed data to the cash forecast. 6. Preparing test data Presents some hints on preparing test data directly without having to run the feeder programs.

PROFIT AND LOSS FORECAST

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 business Profit and Loss is also essential in providing information for Inland Revenue for Taxation purposes Understanding 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 PLANNING Profit planning is essential when you want your business to focus on enhancing its profit-making capabilities. Effective profit planning happens when you determine in advance a set of clear and realistic goals that your business or organization needs to fulfil. Those goals must be based upon objective existing and expected business conditions. Anticipating the changes in your business environment is also central to profit planning. Given the central role profit planning can play in the future prospects of an organization, it might come as a surprise to learn that a large number of businesses do not usually have or develop a financial plan. What is even more amazing is that many of the businesses which do plan for their financial future often just repeat the same procedure over and over every year. They do not take the time to look at how the plan works, or if it is really working. A very small number of businesses currently knows how to practice and benefit from proficient profit planning. However, research indicates that profit planning might be a central reason behind the increased sales and profits enjoyed by these few businesses. Appropriate profit planning can help your company enjoy those benefits too. Effective profit planning can have a deep impact in the life of your organization. The professionals at FRS Consultants believe that profit planning is a key element which has led to the success of big and small businesses alike. That said, it could truly ensure continuous prosperity for your own business, as well. FRS Consultants is a trustworthy firm of honest and experienced professionals that can lead you to make the best out of profit

planning. Many goldbricks in the field are more eager to charge you premiums for their time than to deliver what you are paying for. At FRS Consultants we do not shirk our work. We will strive to deliver on time and prove the value of our service. Other consulting firms may seem less expensive than us, but that is not the case. To learn more or to request a free consultation please complete our online form.