marginal-costing-and-absorption-costing

39

Topic list Learning outcomes Syllabus references Ability required

1 The principles of marginal costing A(i) A 1 Analysis

2 The principles of absorption costing A(i) A 2 Analysis

3 The effect of marginal costing and absorption costing on reported profit and inventory valuation

A(i) A 1, 2 Analysis

4 Marginal costing and absorption costing compared

A(i) A 1, 2 Analysis

5 Job costing and batch costing A(ii) A 1, 2 Application

Marginal costing andabsorption costing

Introduction The main principles underlying the content of this chapter should be familiar to you from your earlier studies. You should already be able to apply a system of marginal costing and understand how it differs from absorption costing.

Whereas absorption costing recognises fixed costs (usually fixed production costs) as part of the cost of a unit of output and hence as product costs, marginal costing treats all fixed costs as period costs.

The emphasis in your Management Accounting Performance Evaluation syllabus is on a comparison between the two systems and their effect on reported profit and inventory valuation, and on their application in different learning environments.

PART A COST ACCOUNTING SYSTEMS

40

Knowledge brought forward from earlier studies

Terminology

• Absorption costing 'Assigns direct costs, and all or part of overhead to cost units using one or more overhead absorption rates'.

• Marginal cost is 'Part of the cost of one unit of product or service that would be avoided if the unit were not produced, or that would increase if one extra unit were produced'.

• Contribution is 'Sales value less variable cost of sales'. CIMA Official Terminology

• Marginal costing is an alternative method of costing to absorption costing. In marginal costing, only variable costs are charged as a cost of sale and a contribution is calculated which is sales revenue minus the variable cost of sales. Closing inventories of work in progress or finished goods are valued at marginal (variable) production cost. Fixed costs are treated as a period cost, and are charged in full to the income statement in the accounting period in which they are incurred.

1 The principles of marginal costing The principles of marginal costing (also known as variable costing) are as follows.

(a) Period fixed costs are the same for any volume of sales and production (provided that the level of activity is within the 'relevant range'). Therefore, by selling an extra item of product or service the following will happen.

• Revenue will increase by the sales value of the item sold • Costs will increase by the variable cost per unit • Profit will increase by the amount of contribution earned from the extra item.

(b) Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item.

The marginal costing philosophy is that profit measurement should be based on an analysis of total contribution, that is sales value less the variable cost of sales.

(c) Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. Absorption costing is therefore misleading, and it is more appropriate to deduct fixed costs from total contribution for the period to derive a profit figure.

(d) When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased.

Supporters of marginal costing argue that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.

Before reviewing marginal costing principles any further, it will be helpful to remind yourself of the basics by looking at a numerical example.

FAST FORWARD

FAST FORWARD

1: MARGINAL COSTING AND ABSORPTION COSTING

41

1.1 Example: marginal costing Water and Sons makes a product, the Splash, which has a variable production cost of £6 per unit and a sales price of £10 per unit. At the beginning of September 20X0, there were no opening inventories and production during the month was 20,000 units. Fixed costs for the month were £30,000 for production and £15,000 for administration, sales and distribution. There were no variable marketing costs.

Required

Calculate the contribution and profit for September, using marginal costing principles, if sales were as follows.

(a) 10,000 Splashes (b) 15,000 Splashes (c) 20,000 Splashes

Solution The first stage in the profit calculation must be to identify the variable costs, and then the contribution. Fixed costs are deducted from the total contribution to derive the profit. All closing inventories are valued at marginal production cost (£6 per unit). Production during the month in all three cases is 20,000 units.

10,000 Splashes 15,000 Splashes 20,000 Splashes

£ £ £ £ £ £ Sales (at £10) 100,000 150,000 200,000 Opening inventory 0 0 0 Variable production cost 120,000 120,000 120,000

120,000 120,000 120,000 Less value of closing inventory (at marginal cost) 60,000 30,000 0

Variable cost of sales 60,000 90,000 120,000

Contribution 40,000 60,000 80,000

Less fixed costs 45,000 45,000 45,000

Profit/(loss) (5,000) 15,000 35,000

Profit/(loss) per unit £(0.50) £1 £1.75

Contribution per unit £4 £4 £4

The conclusions which may be drawn from this example are as follows.

(a) The profit per unit varies at differing levels of sales, because the average fixed overhead cost per unit changes with the volume of output and sales.

(b) The contribution per unit is constant at all levels of output and sales. Total contribution, which is the contribution per unit multiplied by the number of units sold, increases in direct proportion to the volume of sales.

(c) Since the contribution per unit does not change, the most effective way of calculating the expected profit at any level of output and sales would be as follows.

(i) Calculate the total contribution

(ii) Deduct fixed costs as a period charge in order to find the profit

(d) In our example the expected profit from the sale of 17,000 Splashes would be as follows.

£ Total contribution (17,000 × £4) 68,000 Less fixed costs 45,000 Profit 23,000


42

2 The principles of absorption costing The principles of absorption costing are as follows.

(a) Fixed production costs are an integral part of the production cost of an item and so should be absorbed into product costs.

With absorption costing, fixed production costs are absorbed into product unit costs using a predetermined overhead absorption rate, based on the normal level of production for the period.

(b) Inventories are valued at their full production cost including absorbed fixed production costs.

If the actual production is different from the normal level, or actual expenditure on fixed production costs is different from that budgeted, there may be an under or over absorption of fixed production costs for the period. This amount is written off against the absorption costing profit for the period.

2.1 Example: absorption costing Using the earlier example of Water and Sons, assume that the normal level of activity is 15,000 Splashes per month and that budgeted fixed production costs were £30,000 for the month.

Required

Prepare profit statements for September, using absorption costing, for the three sales levels given.

Solution The fixed production cost per unit, based on the normal level of activity, is £30,000/15,000 = £2 per unit.

The full production cost per unit = £6 + £2 = £8 per unit

With production of 20,000 Splashes the fixed overhead will be over-absorbed.

£ Fixed production costs absorbed (20,000 units × £2) 40,000 Fixed production costs incurred 30,000 Over-absorbed fixed production cost 10,000 10,000 Splashes 15,000 Splashes 20,000 Splashes £ £ £ £ £ £ Sales 100,000 150,000 200,000 Opening inventory 0 0 0 Full production costs 160,000 160,000 160,000 160,000 160,000 160,000 Less closing inventory (at full production cost) 80,000 40,000 0 Full production of sales 80,000 120,000 160,000 Adjustment for over- absorbed overhead 10,000 10,000 10,000 Full production costs 70,000 110,000 150,000 Gross profit 30,000 40,000 50,000 Administration, sales and distribution costs 15,000 15,000 15,000 Net profit 15,000 25,000 35,000

FAST FORWARD

FAST FORWARD


43

3 The effect of marginal costing and absorption costing on reported profit and inventory valuation 5/05 (OT), 11/05 (OT) The results of the last two examples can be compared as follows. Sales volume (Splashes) 10,000 15,000 20,000 Marginal costing profit/(loss) £(5,000) £15,000 £35,000 Absorption costing profit £15,000 £25,000 £35,000 Increase in inventory units 10,000 5,000 0

An important conclusion can be drawn from these results.

If there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures.

In this example the inventory levels increased with the two lower sales volume figures and the reported profit figure was higher with absorption costing than with marginal costing.

If inventory levels increase, absorption costing will report a higher profit than marginal costing.

This is because some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.

If inventory levels decrease, absorption costing will report the lower profit.

This is because as well as the fixed overhead incurred, fixed production overhead which had been brought forward in opening inventory is released and is included in cost of sales.

In our example the two reported profit figures were the same when sales volume was 20,000 Splashes, ie when production and sales volumes were equal and there was no change in inventory.

If the opening and closing inventory volumes and values are the same, marginal costing and absorption costing will report the same profit figure.

It is important to appreciate that the differences in reported profits occur only in the short run, ie in reporting the profit of individual accounting periods.

In the long run, the total reported profit will be the same whether marginal or absorption costing is used.

This is because in the long run, total costs will be the same by either method of accounting. Short term differences are the result of changes in the level of inventory.

3.1 Calculating the difference in reported profit The difference in the profit reported by the two systems therefore results from the fixed production overhead that is carried forward in inventory in an absorption costing system.

The difference in reported profit is equal to the change in inventory volume multiplied by the fixed production overhead rate per unit.

FAST FORWARD

FAST FORWARD

FAST FORWARD

FAST FORWARD

FAST FORWARD

FAST FORWARD


44

In our example the profit figures can be reconciled as follows. Sales volume (Splashes) 10,000 15,000 £ £ Marginal costing profit/(loss) (5,000) 15,000 Increase in inventory units @ £2 per unit (10,000 × £2) 20,000 (5,000 × £2) 10,000 Absorption costing profit 15,000 25,000

In both cases the absorption costing profit was higher because the inventory level increased and fixed production overhead was carried forward to next month in the absorption costing valuation.

The calculation of the difference between reported profits and inventory valuation in the two costing systems is a subject that lends itself well to objective testing questions and has been examined in several papers, including the November 2006 exam.

Question Marginal versus Absorption costing – effect on profit

Learning outcome: A(i)

The overhead absorption rate for product X is £10 per machine hour. Each unit of product X requires five machine hours. Opening inventory of product X on 1 January was 150 units and closing inventory on 31 December it was 100 units. What is the difference in profit between results reported using absorption costing and results reported using marginal costing?

A The absorption costing profit would be £2,500 less B The absorption costing profit would be £2,500 greater C The absorption costing profit would be £5,000 less D The absorption costing profit would be £5,000 greater

Answer

Difference in profit = change in inventory levels × fixed overhead absorption per unit = (150 – 100) × £10 × 5 = £2,500 lower profit, because stock levels decreased. The correct answer is therefore option A. The key is the change in the volume of inventory. Inventory levels have decreased therefore absorption costing will report a lower profit. This eliminates options B and D.

Option C is incorrect because it is based on the closing inventory only (100 units × £10 × 5 hours).

4 Marginal costing and absorption costing compared There are arguments in favour of each costing method.

4.1 Arguments in favour of absorption costing (a) Fixed production costs are incurred in order to make output; it is therefore 'fair' to charge all

output with a share of these costs.

(b) Closing inventory values, include a share of fixed production overhead, and therefore follow the requirements of the international accounting standard on inventory valuation (IAS 2).

FAST FORWARD

Exam focus point


45

(c) Absorption costing is consistent with the accruals concept as a proportion of the costs of production are carried forward to be matched against future sales.

(d) A problem with calculating the contribution of various products made by an enterprise is that it may not be clear whether the contribution earned by each product is enough to cover fixed costs, whereas by charging fixed overhead to a product it is possible to ascertain whether it is profitable or not. This is particularly important where fixed production overheads are a large proportion of total production costs. Not absorbing production would mean that a large portion of expenditure is not accounted for in unit costs.

(e) In a job or batch costing environment (see section 5 below), absorption costing is particularly useful in the pricing decision to ensure that the profit markup is sufficient to cover fixed costs.

4.2 Arguments in favour of marginal costing (a) It is simple to operate.

(b) There are no apportionments, which are frequently done on an arbitrary basis, of fixed costs. Many costs, such as the marketing director's salary, are indivisible by nature.

(c) Fixed costs will be the same regardless of the volume of output, because they are period costs. It makes sense, therefore, to charge them in full as a cost to the period.

(d) The cost to produce an extra unit is the variable production cost. It is realistic to value closing inventory items at this directly attributable cost.

(e) Under or over absorption of overheads is avoided.

(f) Marginal costing provides the best information for decision making.

(g) Fixed costs (such as depreciation, rent and salaries) relate to a period of time and should be charged against the revenues of the period in which they are incurred.

(h) Absorption costing may encourage over-production since reported profits can be increased by increasing inventory levels.

Part of a Section B question in November 2006 asked for a profit calculation using absorption costing and an explanation of why marginal costing may be more useful than absorption costing. Make sure you are completely happy with the pros and cons and calculations for each method.

4.3 Example: absorption costing encouraging over-production To demonstrate the last argument in favour of marginal costing, consider an organisation that produces a product that sells for £60 per unit.

Variable production costs are £35 per unit and the fixed production costs of £30,000 per period are absorbed on the basis of the normal capacity of 5,000 units per period.

Fixed administration, selling and distribution overheads are £19,000 per period. There was no opening inventory for the latest period.

Required

Calculate the profit reported for sales of 5,000 units last period for production volumes of 5,000 units, 6,000 units and 7,000 units, using:

(a) Absorption costing (b) Marginal costing

Exam focus point


46

Solution: absorption costing Fixed production cost per unit = £30,000/5,000 = £6 per unit

Full production cost per unit = £35 + £6 = £41 per unit Production 5,000 units 6,000 units 7,000 units £'000 £'000 £'000 £'000 £'000 £'000 Sales (5,000 units × £60) 300 300 300 Production cost @ £41 per unit 205 246 287 Less closing inventory – 41 82 205 205 205 Less over-absorbed fixed production cost – 6 12 Total production cost of sales 205 199 193 Gross profit 95 101 107 Administration costs 19 19 19 Net profit 76 82 88

Solution: marginal costing Production 5,000 units 6,000 units 7,000 units £'000 £'000 £'000 £'000 £'000 £'000 Sales 300 300 300 Variable cost of production @ £35 per unit 175 210 245 Less closing inventory – 35 70 Variable production cost of sales 175 175 175 Contribution 125 125 125 Fixed production costs 30 30 30 Administration costs 19 19 19 Net profit 76 76 76

This example demonstrates an important point when considering the impact on profit reporting of marginal and absorption costing methods.

For a given level of sales, marginal costing will report the same level of profit whatever the level of production. In contrast, absorption costing will report higher levels of profit for the same level of sales, if production levels are higher.

Question Shortcomings of absorption costing

Learning outcome: A(i)

A criticism of the use of absorption costing for the internal reporting of profit is that, if a manager's reward is based on the profit for the period, the manager will be encouraged to increase production even if the resulting output cannot be sold. Explain why absorption costing can have this effect.

(5 marks)

FAST FORWARD


47

Answer

If a manager's reward is based on the profit for the period then the manager will be encouraged to take actions which will increase the reported profit in the short term.

With absorption costing, all production costs are absorbed into product unit costs. Any inventory remaining at the end of the period would include absorbed fixed production costs. The higher production for the period, the greater the amount of fixed production cost that will be carried forward in inventory to be charged against the revenues of future periods. Furthermore, the higher the production level for the period, the lower will be the full unit cost of production because the same amount of fixed production cost will be shared out over a higher number of units.

Thus, the higher the production for the period, the higher will be the reported profit for the period, for a given level of sales, when an absorption costing system is used.

4.4 Marginal costing – concluding remarks In spite of the arguments in favour of marginal costing as a decision making tool, absorption costing is widely used for general accounting purposes and inventory valuation. Fixed production costs should ultimately be charged to cost units in a fair and meaningful way. A central problem in cost accounting is to identify the best method of attributing these costs.

In the following few chapters we shall look at new approaches developed to address the weaknesses of both marginal and absorption costing.

Activity based costing (ABC), discussed in Chapter 6, is a form of absorption costing. It is a relatively modern costing approach seeking to address certain weaknesses of traditional absorption costing and identify the most appropriate way of attributing overhead costs to units of production.

5 Job costing and batch costing


Job costing

• Job costing is a costing method applied to work undertaken to customers' special requirements; each job is of comparatively short duration and is a continuously identifiable unit.

• Each job is given a unique number and the cost of a job is collected and summarised on a job cost sheet or job card, which may be simply a separate file in a computerised system.

Batch costing

• The procedures for costing batches are very similar to those for costing jobs.

• The batch is treated as a job during production and costs are collected in the same manner as for job costing.

• Once the batch has been completed, the cost per unit can be calculated as the total batch cost divided by the number of units in the batch

So far in this chapter all of the examples of the application of absorption costing and marginal costing have related to a situation where a number of identical units have been produced and sold in a period.


48

Marginal and absorption costing approaches can also be applied in job and batch environments.

5.1 Absorption costing in a job costing environment Since each job is different from any other it would not usually be equitable to absorb fixed production overheads using a pre-determined rate per job, since the same amount of fixed production overhead would then be absorbed by each job. This is unlikely to result in a fair absorption of overheads since some jobs would place a greater load on the organisation’s facilities than other jobs.

An overhead absorption rate based upon machine hours or labour hours would usually be more appropriate but it would be very important to ensure that the absorption base reflected the incidence of fixed overheads. For example in a machine intensive environment a machine hour rate would be most appropriate and in a labour intensive environment a labour hour rate is likely to lead to fairer overhead absorption.

The absorption base selected should result in the fairest distribution of overhead costs between jobs.

5.2 Example: the effect of the overhead absorption base in job costing Fixit uses the job costing method and currently absorbs fixed production overhead into job costs using a pre-determined rate per labour hour. The general manager is considering changing the absorption base to a pre-determined rate per machine hour.

Information for the latest period is as follows.

$ Budgeted fixed production overhead 350,000 Budgeted machine hours 70,000 Budgeted labour hours 87,500

Extracts from data concerning two jobs completed during the period are as follows.

Job 876 Job 890 Direct labour hours 24 9 Machine hours 11 15

Required

Calculate the fixed production overhead to be absorbed by each job using:

(a) A direct labour hour rate of overhead absorption (b) A machine hour rate of overhead absorption

Solution Direct labour hour rate = $350,000/87,500 = $4 per direct labour hour Machine hour rate = $350,000/70,000 = $5 per machine hour

Fixed production overhead absorbed: Job 876 Job 890 $ $ (a) Direct labour hour rate ($4 × 24) 96 ($4 × 9) 36 (b) Machine hour rate ($5 × 11) 55 ($5 × 15) 75

The alteration in overhead absorption basis would thus have a significant impact on the amount of production overhead absorbed by each of these jobs. If Fixit uses cost plus pricing this could lead to under or over pricing of the jobs to the customer.

FAST FORWARD


49

5.3 Activity based costing in a job costing environment A costing method that might be used to ensure that each job absorbs an amount of fixed overhead that more accurately reflects the incidence of overhead costs is activity based costing (ABC). We will return later in this text to learn more about the application of ABC.

5.4 Absorption costing in a batch environment The same principles apply to absorption costing in a batch environment as in a job environment. Once the total production cost of each batch has been determined the total cost is divided by the number of units in the batch to ascertain the total production cost of each unit in the batch.

5.5 Marginal costing in a job and batch environment If marginal costing is applied in a job or batch environment then each job or batch would be valued at its variable or direct cost. Fixed production overhead costs would not be absorbed into the cost of individual jobs or batches. Instead the total fixed production overhead cost for the period would be deducted from the contribution earned by all jobs or batches, to determine the profit for the period.

The use of marginal costing in a cost plus pricing system within a job or batch environment can create real dangers of under pricing of jobs or batches. In this situation it is extremely important for managers to ensure that the profit mark-up is sufficient to cover fixed costs as well as leave sufficient profit for the organisation.

Question Absorption costing and inventory valuation

Learning outcome: A(ii)

P uses an absorption costing system and absorbs fixed production overheads as a percentage of direct labour cost.

Three jobs were worked on last period, details of which are as follows.

Job X Job Y Job Z € € € € € € Opening work in progress: materials 4,200 800 labour 1,900 600 production overhead 3,325 1,050 9,425 2,450 0 Costs incurred in period: materials 540 120 545 labour 860 380 220

Job X was completed during the period.

What was the value of the work in progress inventory at the end of the period? (2 marks)


50

Answer

Production overhead absorption rate = €3,325/€1,900 = 175% of the labour cost

Jobs Y and Z are still in progress at the end of the period.

The value of work in progress can now be calculated. Job Y Job Z Total € € € Opening work in progress 2,450 0 2,450 Costs incurred in period 500 765 1,265 Production overhead absorbed (380 × 175%) 665 (220 × 175%) 385 1,050 Total value of closing work in progress 3,615 1,150 4,765

Chapter Roundup

• The marginal costing philosophy is that profit measurement should be based on an analysis of total contribution, that is sales value less the variable cost of sales.

• Supporters of marginal costing argue that the valuation of closing inventories should be at variable production cost (direct materials, direct labour, direct expenses (if any) and variable production overhead) because these are the only costs properly attributable to the product.

• With absorption costing, fixed production costs are absorbed into product unit costs using a predetermined overhead absorption rate, based on the normal level of production for the period.

• If the actual production is different from the normal level, or actual expenditure on fixed production costs is different from that budgeted, there may be an under or over absorption of fixed production costs for the period. This amount is written off against the absorption costing profit for the period.

• If there are changes in inventories during a period, marginal costing and absorption costing systems will report different profit figures.

• If inventory levels increase, absorption costing will report a higher profit than marginal costing.

• If inventory levels decrease, absorption costing will report the lower profit.

• If the opening and closing inventory volumes and values are the same, marginal costing and absorption costing will report the same profit figure.

• In the long run, the total reported profit will be the same whether marginal or absorption costing is used.

• The difference in reported profit is equal to the change in inventory volume multiplied by the fixed production overhead rate per unit.

• There are arguments in favour of each costing method.

• For a given level of sales, marginal costing will report the same level of profit whatever the level of production. In contrast, absorption costing will report higher levels of profit for the same level of sales, if production levels are higher.

• Marginal and absorption costing approaches can also be applied in job and batch environments.


51

Quick Quiz 1 Marginal costing and absorption costing are different techniques for assessing profit in a period. If there

are changes in inventory during a period, marginal costing and absorption costing give different results for profit obtained.

Which of the following statements are true?

I If inventory levels increase, marginal costing will report the higher profit.

II If inventory levels decrease, marginal costing will report the lower profit.

III If inventory levels decrease, marginal costing will report the higher profit.

IV If the opening and closing inventory volumes are the same, marginal costing and absorption costing will give the same profit figure.

A All of the above B I, II and IV C I and IV D III and IV

2 Identify which of the following relate to either

A = Absorption costing M = Marginal costing

A or M (a) Closing inventories valued at marginal production cost (b) Closing inventories valued at full production cost (c) Cost of sales include some fixed overhead incurred in previous period in

opening inventory values

(d) Fixed costs are charged in full against profit for the period

3 Which of the following are arguments in favour of marginal costing?

(a) Closing inventory is valued in accordance with international accounting standards. (b) It is simple to operate. (c) There is no under or over absorption of overheads. (d) Fixed costs are the same regardless of activity levels. (e) The information from this costing method may be used for decision making.

4 When opening inventories were 8,500 litres and closing stocks 6,750 litres, a firm had a profit of $62,100 using marginal costing.

Assuming that the fixed overhead absorption rate was $3 per litre, what would be the profit using absorption costing?

5 When sales fluctuate but production is constant, absorption costing smooths out fluctuations in profit.

(delete as appropriate) True/false

6 HMF Ltd produces a single product. The budgeted fixed production overheads for the period are $500,000. The budgeted output for the period is 2,500 units. Opening stock at the start of the period consisted of 900 units and closing stock at the end of the period consisted of 300 units. If absorption costing principles were applied, the profit for the period compared to the marginal costing profit would be:

A $125,000 higher B $125,000 lower C $120,000 higher D $120,000 lower


52

Answers to Quick Quiz 1 D

2 A or M (a) Closing inventories valued at marginal production cost M (b) Closing inventories valued at full production cost A (c) Cost of sales include some fixed overhead incurred in previous period in

opening inventory values

A (d) Fixed costs are charged in full against profit for the period M

3 (b), (c), (d), (e)

4 Difference in profit = (8,500 – 6,750) × $3 = $5,250

Since inventory levels reduced, the absorption costing profit will be lower than the marginal costing profit.

Absorption costing profit = $62,100 – $5,250 = $56,850

5 True. Absorption costing carries fixed production overheads forward in inventory values to be matched against sales as they arise.

6 D Units Opening stock 900 Closing stock 300

Decrease 600 × ( $500,0002,500

) = 120,000 lower

Now try the question below from the Exam Question Bank

Number Level Marks Time

Q1 Introductory 30 54 mins

53

Topic list Learning outcomes Syllabus references Ability required

1 Integrated and interlocking systems A(iii) A 1,2 Application

2 Ledger accounts in job or batch environments A(iii) A 1,2 Application

3 Cost behaviour patterns and level of activity Revision n/a Knowledge/comprehension

4 Determining the fixed and variable elements of semi-variable costs

Revision n/a Knowledge/comprehension

5 CVP and breakeven analysis Revision n/a Knowledge/comprehension

6 The contribution/sales (C/S) ratio and the margin of safety


7 Profit targets, breakeven charts and profit volume graphs


8 Relevant costs Revision n/a Knowledge/comprehension

n/a: not applicable

Cost bookkeeping, cost behaviour and basic management accounting techniques

Introduction You should already have a good understanding of the principal ledger accounts in a cost bookkeeping system and how the most common transactions are recorded in the double entry system from your earlier studies.

Your Management Accounting Performance Evaluation syllabus requires you to be able to prepare ledger accounts according to context: marginal or absorption costing based in job, batch or process environments.

You will have encountered the ideas and principles covered in this chapter in your earlier studies. We revisit these because, although not directly related to any syllabus references, they underpin a lot of what follows in this text, and as knowledge brought forward, are examinable.

First we look at cost behaviour at various levels of output and we examine more closely the two ways used to split costs between fixed and variable. This is an important area which helps you understand the critique that marginal costing may be based on an artificial distinction between fixed and variable costs.

We also revisit the technique of breakeven and cost-volume-profit analysis and in the last section of this chapter we look at relevant costing, the technique required for decision-making situations. We explain how to assess which costs need to be taken into account when a decision is being made and which costs do not.


54


Terminology

• Interlocking accounts. 'Set of accounting records where the cost and financial accounts are distinct, the two being kept continuously in agreement by the use of control accounts or reconciled by other means.'

• Integrated accounts 'Set of accounting records that integrates both financial and cost accounts using a common input of data for all accounting purposes.'

CIMA Official Terminology

Interlocking and integrated accounts

• The cost accounts in interlocking systems use the same basic data (purchases, wages and so on) as the financial accounts, but frequently adopt different bases for matters such as depreciation and inventory valuation.

• With integrated accounts the same basis for items such as inventory valuation and depreciation will be used and there is no need for a reconciliation between cost profit and financial profit. Financial profit will simply be the cost profit adjusted by non-cost items such as income from investments and charitable donations.

1 Integrated and interlocking systems 1.1 The principal accounts in a system of integrated accounts

There are four main groups of accounts in an integrated system

• The resources accounts

– Materials control account or stores control account – Wages (and salaries) control account – Production overhead control account – Administration overhead control account – Selling and distribution overhead control account

• Accounts which record the cost of production items from the start of production and work through to cost of sales

– Work in progress control account – Finished goods control account – Cost of sales control account

• Sales account

• Income statement

FAST FORWARD

2: COST BOOKKEEPING, COST BEHAVIOUR AND BASIC MANAGEMENT ACCOUNTING TECHNIQUES

55

1.2 Accounting entries in an integrated system The general principles relating to the accounting entries in an integrated system are given below.

(a) Expenditure incurred on materials, wages or overheads, is debited to the appropriate resources accounts and the credit entries are made in the cash or payables accounts.

(b) When production begins, resources are allocated to work in progress. The resources accounts are credited and the work in progress account is debited. In the case of production overheads in an absorption costing system, the amount credited to the overhead account and debited to work in progress should be the amount of overhead absorbed. If this differs from the amount of overhead incurred, there will be a difference on the overhead control account; this should be written off to an under-/over-absorbed overhead account. (One other point to remember is that when indirect materials and labour are allocated to production, the entries are to credit the materials and wages accounts and debit production overhead account.)

(c) As finished goods are produced, work in progress is reduced. The finished goods control account is debited and the work in progress control account is credited.

(d) At the end of the period, the cost of goods sold is transferred from the finished goods account to the cost of sales account, and from there to the income statement.

(e) The balances on the administration overhead control account and the selling and distribution overhead control account are usually transferred direct to the income statement at the period end.

(f) Sales are debited to the receivables control account and credited to the sales account.

(g) Profit is established by transferring to the income statement the balances on the sales account, cost of sales account and under-/over-absorbed overhead account.

1.3 Accounting entries in absorption and marginal costing in integrated systems

The two diagrams on the following page summarise the principal entries in integrated systems using absorption and marginal costing. Note the main differences between the two diagrams.

Marginal costing

• Fixed and variable overheads are analysed separately as the flowchart shows. In some cases the total overhead may first be collected in a single overhead control account pending analysis into fixed and variable overhead

• Only the variable production overheads are absorbed into the cost of work in progress. Transfers from work in progress to finished goods, and from finished goods to the income statement, are valued at marginal cost. Work in progress and finished goods are valued at marginal cost

• The fixed overheads are collected in a fixed overhead control account and transferred in full to the income statement at the end of the period. There is no need to account for under– or over-absorbed overheads

Absorption costing

• All production overheads are collected in a single control account and then absorbed into the cost of work in progress. Transfers from work in progress to finished goods, and from finished goods to the income statement, are valued at full production cost. Work in progress and finished goods are valued at full production cost, including absorbed overhead


56


57

Question Raw materials inventory control account

Learning outcome: A(iii)

The following information relates to E for March.

Opening balance of raw materials £12,000 Raw materials purchased on credit £80,000 Raw materials issued: to production £73,000 to production maintenance £8,000 Raw materials returned to supplier £2,000

Required

Complete the raw materials inventory control account for March.

Answer

RAW MATERIALS INVENTORY CONTROL

£ £ Balance b/d 12,000 Work in progress 73,000 Payables 80,000 Production overhead control 8,000 Payables 2,000 Balance c/d 9,000 92,000 92,000

Balance b/d 9,000

Question Production overhead control account


The following information relates to Jamboree.

Production overheads incurred $50,000 Labour hours worked 5,000 Production overhead absorption rate $11 per labour hour

Required

Complete the production overhead control account for the period.

Answer

PRODUCTION OVERHEAD CONTROL ACCOUNT

$ $ Cash/payables 50,000 Work in progress control Over-absorbed overhead to income (5,000 hr × $11) 55,000 statement 5,000 55,000 55,000


58

Question Integrated system


At the end of a period, in an integrated cost and financial accounting system, the accounting entries for £18,000 overheads under-absorbed would be

A Debit work-in-progress control account Credit overhead control account B Debit income statement Credit work-in-progress control account C Debit income statement Credit overhead control account D Debit overhead control account Credit income statement

Answer

Eliminate the incorrect options first. The only overhead charge made to work in progress (WIP) is the overhead absorbed into production based on the predetermined rate. Under or over absorption does not affect WIP. This eliminates A and B. Under-absorbed overhead means that overhead charges have been too low therefore there must be a further debit to the income statement. This eliminates D, and the correct answer is C.

1.4 How an interlocking system works An interlocking system features two separate ledgers.

(a) The financial ledger contains asset, liability, revenue, expense and appropriation (eg dividend) accounts. The trial balance of an enterprise is prepared from the financial ledger.

(b) The cost ledger is where cost information such as the build-up of work in progress is analysed in more detail.

1.5 The cost ledger control account in an interlocking system Certain items of cost or revenue are of no interest to the cost accountant because they are financial accounting items. These include the following.

• Interest or dividends received • Dividends paid • Discounts allowed, or received for prompt payment of invoices

Some financial accounting items are related to costs and profits (and hence they interest the cost accountant), although accounts for these items are not included in the separate cost accounting books. The most important of these items are cash, payables, receivables and accumulated profits.

To overcome the need to have accounts for cash, payables and so on in the cost books in an interlocking system, a cost ledger control account is used. It represents all the accounts in the financial accounting books which are not included in the corresponding cost accounting books.

FAST FORWARD


59

Question Interlocking system


M uses an interlocking marginal costing bookkeeping system. The following data has been extracted from M's records for March. €

Work in progress inventory opening 8,040 closing 2,100 Production overhead expenditure incurred on credit 41,300 Direct material issued to production 21,880 Materials issued to production maintenance department 3,930 Direct labour cost incurred 29,100 Indirect labour cost incurred 7,200 Depreciation of production machinery 10,000

Thirty per cent of all production overhead costs are deemed to be variable.

Required

Prepare the following ledger accounts for March

(a) Production overhead control account (b) Work in progress control account

Answer

(a) PRODUCTION OVERHEAD CONTROL ACCOUNT

€ € Cost ledger control 41,300 Work in progress (variable Material stores control 3,930 overhead 30% × €62,430) 18,729 Wages control 7,200 Income statement – fixed Cost ledger control 10,000 overhead 43,701 62,430 62,430

(b) WORK IN PROGRESS CONTROL ACCOUNT

€ € Balance b/d 8,040 Finished goods control 75,649 Material stores control 21,880 Balance b/d 2,100 Wages control 29,100 Production overhead control 18,729 77,749 77,749 Balance b/d 2,100


60

2 Ledger accounts in job or batch environments The ledger accounts in a job or batch environment use exactly the same principles that we have demonstrated so far in this chapter. The difference is that a separate work in progress account is maintained for each individual job or batch.

The work in progress control account in a job or batch environment contains the summary totals of the entries in the individual job or batch accounts.

Another difference in a job costing environment is that goods are not produced for inventory, but for individual customers' requirements.

In a job costing environment, the cost of completed production is transferred direct from work in progress control to the cost of sales account. There is unlikely to be a ledger account for finished goods inventory.

2.1 Example: ledger accounts in a job environment This example demonstrates the ledger accounts in an absorption costing system. If a marginal costing system was used instead, only the variable production overhead cost would be added to job costs work in progress. The fixed production overhead would be charged direct to the income statement and there would be no account for under-/over-absorbed overheads.

A jobbing company operates an absorption costing system. On 1 June 20X2, there was one uncompleted job in the factory. The job card for this work is summarised as follows.

Job Card, Job No 6832 Costs to date £ Direct materials 630 Direct labour (120 hours) 840 Factory overhead (£2 per direct labour hour) 240 Factory cost to date 1,710

During June, three new jobs were started in the factory, and costs of production were as follows.

Direct materials £ Issued to: Job 6832 2,390 Job 6833 1,680 Job 6834 3,950 Job 6835 4,420 Damaged inventory written off from stores 2,300 Material transfers £ Job 6834 to Job 6833 250 Job 6832 to Job 6834 620 Materials returned to store £ From Job 6832 870 From Job 6835 170 Direct labour hours recorded Job 6832 430 hrs Job 6833 650 hrs Job 6834 280 hrs Job 6835 410 hrs

FAST FORWARD

FAST FORWARD


61

The cost of labour hours during June 20X2 was £8 per hour, and production overhead is absorbed at the rate of £2 per direct labour hour. Production overheads incurred during the month amounted to £3,800. Completed jobs were delivered to customers as soon as they were completed, and the invoiced amounts were as follows.

Job 6832 £8,500 Job 6834 £9,000 Job 6835 £9,500

Administration and marketing overheads are added to the cost of sales at the rate of 20% of factory cost. Actual costs incurred during June 20X2 amounted to £4,418.

Required

(a) Prepare the job accounts for each individual job during June 20X2; (the accounts should only show the cost of production, and not the full cost of sale).

(b) Prepare the summarised job cost cards for each job, and calculate the profit on each completed job.

(c) Show how the costs would be shown in the company's cost control accounts.

Solution (a) Job accounts JOB 6832

£ £ Balance b/f 1,710 Job 6834 a/c 620 Materials (stores a/c) 2,390 (materials transfer) Labour (wages a/c) 3,440 Stores a/c (materials returned) 870 Production overhead (o'hd a/c) 860 Cost of sales a/c (balance) 6,910 8,400 8,400

JOB 6833

£ £ Materials (stores a/c) 1,680 Balance c/f 8,430 Labour (wages a/c) 5,200 Production overhead (o'hd a/c) 1,300 Job 6834 a/c (materials transfer) 250 8,430 8,430

JOB 6834

£ £ Materials (stores a/c) 3,950 Job 6833 a/c (materials transfer) 250 Labour (wages a/c) 2,240 Production overhead (o'hd a/c) 560 Cost of sales a/c (balance) 7,120 Job 6832 a/c (materials transfer) 620 7,370 7,370

JOB 6835

£ £ Materials (stores a/c) 4,420 Stores a/c (materials returned) 170 Labour (wages a/c) 3,280 Production overhead (o'hd a/c) 820 Cost of sales a/c (balance) 8,350 8,520 8,520


62

(b) Job cards, summarised Job 6832 Job 6833 Job 6834 Job 6835 £ £ £ £ Materials 1,530* 1,930 4,320 ** 4,250 Labour 4,280 5,200 2,240 3,280 Production overhead 1,100 1,300 560 820 Factory cost 6,910 (c/f) 8,430 7,120 8,350 Admin & marketing o'hd (20%) 1,382 1,424 1,670 Cost of sale 8,292 8,544 10,020 Invoice value 8,500 9,000 9,500 Profit/(loss) on job 208 456 (520)

* £(630 + 2,390 – 620 – 870) ** £(3,950 + 620 – 250)

(c) Control accounts STORES CONTROL (incomplete)

£ £ WIP a/c (returns) 1,040 WIP a/c (2,390 + 1,680 + 3,950 + 4,420) 12,440 Income statement: inventory written off 2,300

WORK IN PROGRESS CONTROL

£ £ Balance b/f 1,710 Stores control a/c (returns) 1,040 Stores control a/c 12,440 Cost of sales a/c Wages control a/c *14,160 (6,910 + 7,120 + 8,350) 22,380 Production o'hd control a/c **3,540 Balance c/f (Job No 6833) 8,430 31,850 31,850

* 1,770 hours at £8 per hour ** 1,770 hours at £2 per hour

COST OF SALES CONTROL

£ £ WIP control a/c 22,380 Income statement 26,856 Admin & marketing o'hd a/c (1,382 + 1,424 + 1,670) 4,476 26,856 26,856

SALES

£ £ Income statement 27,000 Receivables 27,000 (8,500 + 9,000 + 9,500) 27,000 27,000

PRODUCTION OVERHEAD CONTROL

£ £ Overhead incurred – payables 3,800 WIP a/c 3,540 Under-absorbed o'hd a/c 260 3,800 3,800

UNDER-/OVER-ABSORBED OVERHEADS

£ £ Production o'hd control a/c 260 Admin & marketing o'hd a/c 58 Income statement 202 260 260


63

ADMIN & MARKETING OVERHEAD CONTROL

£ £ Overhead incurred – payables 4,418 Cost of sales a/c 4,476 Over absorbed o'hd a/c 58 4,476 4,476

INCOME STATEMENT

£ £ Cost of sales a/c 26,856 Sales a/c 27,000 Stores a/c (inventory written off) 2,300 Under-absorbed overhead a/c 202 Loss 2,358 29,358 29,358

The loss of £2,358 is the sum of the profits/losses on each completed job £(208 + 456 – 520) = £144, minus the total of under-absorbed overhead (£202) and the inventory write-off (£2,300).

3 Cost behaviour patterns and levels of activity

Cost behaviour is the variability of input costs with activity undertaken.

3.1 Levels of activity The level of activity refers to the amount of work done, or the number of events that have occurred. Measures of the level of activity include:

• The volume of production in a period • The number of invoices issued • The number of items sold • The number of units of electricity consumed • The value of items sold • The number of purchase orders placed

3.2 Basic principles of cost behaviour and cost behaviour patterns The basic principle of cost behaviour is that as the level of activity rises, costs will usually rise. The question is to determine, for each item of cost, the relationship between costs and the level of activity.

The level of activity will generally be taken to be the volume of production/output.

Costs which are not affected by the level of activity are fixed costs or period costs.

3.3 Fixed costs A fixed cost tends to be unaffected by changes in the volume of output. Fixed costs are a period charge, relating to a time period; as the period increases, so too will the fixed costs. Examples of fixed costs include the salary of the managing director and factory rent.

FAST FORWARD

FAST FORWARD


64

3.4 Step costs

A step cost is a cost which is fixed in nature but only within certain levels of activity.

Consider the depreciation of a machine which may be fixed if production remains below 1,000 units per month. If production exceeds 1,000 units, a second machine may be required, and the cost of depreciation (on two machines) would go up a step. A sketch graph of a step cost could look like this.

Examples of step costs may include rent, as accommodation requirements increase with higher output levels, or pay of employees as higher output may require, more employees.

3.5 Variable costs

Variable costs increase or decrease with the level of activity.

A variable cost is a cost which tends to vary directly with the volume of output. The variable cost per unit is the same amount for each unit produced whereas total variable cost increases as volume of output increases.

A sketch graph of a variable cost would look like this.

Examples of variable costs may be the cost of raw materials (where there is no discount for bulk purchasing since bulk purchase discounts reduce the unit cost of purchases), sales commission or direct labour costs. The latter are usually classed as a variable cost even though basic wages are often fixed.

FAST FORWARD

FAST FORWARD


65

3.6 Non-linear variable costs Although variable costs are usually assumed to be linear, there are situations where these are curvilinear.

Graph (a) Graph (b)

Graph (a) becomes steeper as levels of activity increase. Each additional unit of activity is adding more to total variable cost than the previous unit. Graph (b) becomes less steep as levels of activity increase. Each additional unit is adding less to total variable cost than the previous unit.

3.7 Semi-variable costs (or semi-fixed costs or mixed costs)

Semi-variable/semi-fixed or mixed costs are costs which are part-fixed and part-variable and which are thus partly affected by a change in the level of activity.

Examples of semi-variable costs may be electricity and gas bills, where there is a basic charge plus a charge per unit of consumption. A sales representative's salary is another example where a basic monthly amount is supplemented by commission on the value of sales made.

The behaviour of a semi-variable cost can be presented graphically as follows.

Cost£

Volume of output

Variable part

Fixed part

Graph of semi-variable cost

3.8 Cost behaviour and total and unit costs If the variable cost of producing a unit is £5 per unit then it will remain at that cost per unit no matter how many units are produced. However, if the business's fixed costs are £5,000 then the fixed cost per unit will decrease the more units are produced: one unit will have fixed costs of £5,000 per unit; if 2,500 are produced the fixed cost per unit will be £2; if 5,000 are produced the fixed cost per unit will be only £1. Thus as the level of activity increases the total costs per unit (fixed cost plus variable cost) will decrease.

In sketch graph form this may be illustrated as follows.

FAST FORWARD


66

3.9 Assumptions about cost behaviour

It is often possible to assume that, within the normal or relevant range of output, costs are either fixed, variable or semi-variable.

Question Activity levels

Select the correct words in the following sentence.

The basic principle of cost behaviour is that as the level of activity rises, costs will usually (a) rise/fall/stay the same. In general, as activity levels rise, the variable cost per unit will (b) rise/fall/stay the same, the fixed cost per unit will (c) rise/fall/stay the same and the total cost per unit will (d) rise/fall/stay the same.

Answer

(a) Rise (b) Stay the same (c) Fall (d) Fall

Question Cost behaviour graphs

Show, by means of a sketch, a separate graph of cost behaviour patterns for each of the listed items of expense. In each case the vertical axis should relate to total cost. Label each horizontal axis clearly.

(a) Electricity bill: a standing charge for each period plus a charge for each unit of electricity consumed.

(b) Supervisory labour.

(c) Production bonus, which is payable when output in a period exceeds 10,000 units. The bonus amounts in total to £20,000 plus £50 per unit for additional output above 10,000 units.

(d) Sales commission, which amounts to 2% of sales turnover.

(e) Machine rental costs of a single item of equipment. The rental agreement is that £10 should be paid for every machine hour worked each month, subject to a maximum monthly charge of £480.

Answer

FAST FORWARD


67

(e)

4 Determining the fixed and variable elements of semi- variable costs 4.1 Analysing semi-variable costs

The fixed and variable elements of semi-variable costs can be determined by the high-low method or the scattergraph method.

There are several ways in which fixed cost elements and variable cost elements within semi-variable costs may be ascertained. Each method only gives an estimate, and can therefore give differing results from the other methods. The main methods that you will have encountered so far are the high-low method and the scattergraph method. Although you would not actually be required to draw a scattergraph, you may perhaps be required to answer an objective test question about how the technique works, or its advantages and limitations.

4.2 High-low method (a) Records of costs in previous periods are reviewed and the two periods with the highest and

lowest volumes of activity selected

(b) The difference between the total cost of these two periods will be the variable cost of the difference in activity levels (since the same fixed cost is included in each total cost).

(c) The variable cost per unit may be calculated from this (difference in total costs ÷ difference in activity levels), and the fixed cost may then be determined by substitution.

FAST FORWARD


68

4.3 Example: the high-low method The costs of operating the maintenance department of a computer manufacturer, Bread and Butter Ltd, for the last four months have been as follows.

Month Cost Production volume £ Units

1 110,000 7,000 2 115,000 8,000 3 111,000 7,700 4 97,000 6,000

Required

Calculate the costs that should be expected in month five when output is expected to be 7,500 units. Ignore inflation.

Solution (a) Units £ High output 8,000 total cost 115,000 Low output 6,000 total cost 97,000 Variable cost of 2,000 18,000

Variable cost per unit £18,000/2,000 = £9

(b) Substituting in either the high or low volume cost:

High Low £ £ Total cost 115,000 97,000 Variable costs (8,000 × £9) 72,000 (6,000 × £9) 54,000 Fixed costs 43,000 43,000

(c) Estimated maintenance costs when output is 7,500 units: £ Fixed costs 43,000 Variable costs (7,500 × £9) 67,500 Total costs 110,500

Question High-low method

The Valuation Department of a large firm of surveyors wishes to develop a method of predicting its total costs in a period. The following past costs have been recorded at two activity levels.

Number of valuations Total cost (V) (TC) Period 1 420 82,200 Period 2 515 90,275

Formulate the total cost model for a period.


69

Answer

Although we only have two activity levels in this question we can still apply the high-low method.

Valuations Total cost V £ Period 2 515 90,275 Period 1 420 82,200 Change due to variable cost 95 8,075

∴Variable cost per valuation = £8,075/95 = £85.

Period 2: fixed cost = £90,275 – (515 × £85) = £46,500

The variable cost of £85 per valuation must be added to the fixed cost.

Therefore Total Costs (TC) = Fixed costs + Variable costs = £46,500 + £85V

4.4 Scattergraph method A scattergraph of costs in previous periods can be prepared (with cost on the vertical axis and volume of output on the horizontal axis). A line of best fit, which is a line drawn by judgement to pass through the middle of the points, thereby having as many points above the line as below it, can then be drawn and the fixed and variable costs determined.

A scattergraph of the cost and volume data in Paragraph 4.3 is shown below.

The point where the line cuts the vertical axis (approximately £40,000) is the fixed cost (the cost if there is no output). If we take the value of one of the plotted points which lies close to the line and deduct the fixed cost from the total cost, we can calculate the variable cost per unit.

Total cost for 8,000 units = £115,000 Variable cost for 8,000 units = £(115,000 – 40,000) = £75,000 Variable cost per unit = £75,000/8,000 = £9.375

5 CVP and breakeven analysis

Cost-volume-profit (CVP) /breakeven analysis is the study of the interrelationships between costs, volume and profit at various levels of activity.

FAST FORWARD


70

5.1 Breakeven point The management of an organisation usually wishes to know the profit likely to be made if the aimed-for production and sales for the year are achieved. Management may also be interested to know the following.

(a) The breakeven point which is the activity level at which there is neither profit nor loss.

(b) The amount by which actual sales can fall below anticipated sales, without a loss being incurred.

The breakeven point (BEP) can be calculated arithmetically as follows.

Breakeven point = Number of units of sale required to break even = unit per onContributi

costs Fixed

5.2 Example: breakeven point Expected sales 10,000 units at £8 = £80,000 Variable cost £5 per unit Fixed costs £21,000

Required

Compute the breakeven point.

Solution The contribution per unit is £(8 – 5) = £3

Contribution required to break even = fixed costs = £21,000

Breakeven point (BEP) = 21,000 ÷ 3 = 7,000 units In revenue, BEP = (7,000 × £8) = £56,000

Sales above £56,000 will result in profit of £3 per unit of additional sales and sales below £56,000 will mean a loss of £3 per unit for each unit by which sales fall short of 7,000 units. In other words, profit will improve or worsen by the amount of contribution per unit.

7,000 units 7,001 units £ £ Revenue 56,000 56,008 Less variable costs 35,000 35,005 Contribution 21,000 21,003 Less fixed costs 21,000 21,000 Profit 0 (= breakeven) 3

6 The contribution/sales (C/S) ratio and the margin of safety

The C/S ratio (or profit/volume P/V ratio) is a measure of how much contribution is earned from each £1 of sales.

6.1 C/S ratio and breakeven point An alternative way of calculating the breakeven point to give an answer in terms of sales revenue and using the C/S ratio is as follows.

FAST FORWARD


71

Breakeven point = Sales revenue required to break even = ratio C/S

even break torequiredonContributi

= ratio C/Scosts Fixed

6.2 Example: C/S ratio

In the example in Paragraph 1.2 the C/S ratio is £8£3

= 37.5%

Breakeven is where sales revenue equals 37.5%

£21,000 = £56,000

At a price of £8 per unit, this represents 7,000 units of sales.

The C/S ratio is a measure of how much contribution is earned from each £1 of sales. The C/S ratio of 37.5% in the above example means that for every £1 of sales, a contribution of 37.5p is earned. Thus, in order to earn a total contribution of £21,000 and if contribution increases by 37.5p per £1 of sales, sales must be:

37.5p£1

× £21,000 = £56,000

Question C/S ratio

The C/S ratio of product W is 20%. IB Ltd, the manufacturer of product W, wishes to make a contribution of £50,000 towards fixed costs. How many units of product W must be sold if the selling price is £10 per unit?

Answer

ratio C/Soncontributi Required

=20%

£50,000 = £250,000

∴ Number of units = £250,000 ÷ £10 = 25,000.

6.3 The margin of safety

The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. Alternatively the margin of safety can be expressed as the difference between the budgeted sales revenue and breakeven sales revenue, expressed as a percentage of the budgeted sales revenue.

6.4 Example: margin of safety Mal de Mer Ltd makes and sells a product which has a variable cost of £30 and which sells for £40. Budgeted fixed costs are £70,000 and budgeted sales are 8,000 units.

Required

Calculate the breakeven point and the margin of safety.

FAST FORWARD

FAST FORWARD


72

Solution

(a) Breakeven point = unit per onContributi

costsfixedTotal=

)3040£(000,70£−

= 7,000 units

(b) Margin of safety = 8,000 – 7,000 units = 1,000 units

which may be expressed as units8,000units1,000

× 100 = 12½% of budget

(c) The margin of safety indicates to management that actual sales can fall short of budget by 1,000 units or 12½% before the breakeven point is reached and no profit at all is made.

7 Profit targets, breakeven charts and profit volume graphs

At the breakeven point, sales revenue equals total costs and there is no profit.

S = V + F

where S = Sales revenue V = Total variable costs F = Total fixed costs

Subtracting V from each side of the equation, we get:

S – V = F, that is, total contribution = fixed costs

7.1 Example: breakeven arithmetic Butterfingers Ltd makes a product which has a variable cost of £7 per unit.

Required

If fixed costs are £63,000 per annum, calculate the selling price per unit if the company wishes to break even with a sales volume of 12,000 units.

Solution Contribution required to break even (= Fixed costs) = £63,000 Volume of sales = 12,000 units £ Required contribution per unit (S – V) = £63,000 ÷ 12,000 = 5.25 Variable cost per unit (V) = 7.00 Required sales price per unit (S) = 12.25

7.2 Target profits

The target profit is achieved when sales revenue equals variable costs plus fixed costs plus profit. Therefore the total contribution required for a target profit = fixed costs + required profit.

A similar formula may be applied where a company wishes to achieve a certain profit during a period. To achieve this profit, sales must cover all costs and leave the required profit.

FAST FORWARD


73

The target profit is achieved when:

S = V + F + P

Where S = Sales revenue V = Variable costs F = Fixed costs P = required profit

Subtracting V from each side of the equation, we get:

S – V = F + P, so

Total contribution required = F + P

7.3 Example: target profits Riding Breeches Ltd makes and sells a single product, for which variable costs are as follows.

£ Direct materials 10 Direct labour 8 Variable production overhead 6 24

The sales price is £30 per unit, and fixed costs per annum are £68,000. The company wishes to make a profit of £16,000 per annum.

Required

Determine the sales required to achieve this profit.

Solution Required contribution = fixed costs + profit = £68,000 + £16,000 = £84,000

Required sales can be calculated in one of two ways.

(a) unitper onContributi

oncontributi Required =

24)£(30£84,000

− = 14,000 units, or £420,000 in revenue

(b) ratio C/S

oncontributi Required =

*20%£84,000

= £420,000 of revenue, or 14,000 units.

* C/S ratio = 30£

24£30£ −=

30£6£

= 0.2 = 20%.

Question Target profits

Seven League Boots Ltd wishes to sell 14,000 units of its product, which has a variable cost of £15 to make and sell. Fixed costs are £47,000 and the required profit is £23,000.

Required

Calculate the required sales price per unit.

Answer

Required contribution = fixed costs plus profit = £47,000 + £23,000 = £70,000

Required sales = 14,000 units


74

£ Required contribution per unit sold 5 Variable cost per unit 15 Required sales price per unit 20

7.4 Decisions to change sales price, sales volume or costs Problems as to the effect of altering the selling price, sales volume or variable cost per unit or fixed cost. Such problems are slight variations on basic breakeven arithmetic.

7.5 Example: profit maximisation C Ltd has developed a new product which is about to be launched on to the market. The variable cost of selling the product is £12 per unit. The marketing department has estimated that at a sales price of £20, annual demand would be 10,000 units.

However, if the sales price is set above £20, sales demand would fall by 500 units for each 50p increase above £20. Similarly, if the price is set below £20, demand would increase by 500 units for each 50p stepped reduction in price below £20.

Required

Determine the price which would maximise C Ltd's profit in the next year.

Solution At a price of £20 per unit, the unit contribution would be £(20 – 12) = £8. Each 50p increase (or decrease) in price would raise (or lower) the unit contribution by 50p. The total contribution is calculated at each sales price by multiplying the unit contribution by the expected sales volume.

Unit price Unit contribution Sales volume Total contribution £ £ Units £

20.00 8.00 10,000 80,000

(a) Reduce price

19.50 7.50 10,500 78,750 19.00 7.00 11,000 77,000

(b) Increase price 20.50 8.50 9,500 80,750 21.00 9.00 9,000 81,000 21.50 9.50 8,500 80,750 22.00 10.00 8,000 80,000 22.50 10.50 7,500 78,750

The total contribution would be maximised, and therefore profit maximised, at a sales price of £21 per unit, and sales demand of 9,000 units.

7.6 Breakeven charts

The breakeven point can also be determined graphically using a breakeven chart. This is a chart which shows approximate levels of profit or loss at different sales volume levels within a limited range.

A breakeven chart has the following axes.

• A horizontal axis showing the sales/output (in value or units) • A vertical axis showing £ for sales revenues and costs

FAST FORWARD


75

7.7 Lines on a breakeven chart The following lines are drawn on the breakeven chart.

(a) The sales line

• Starts at the origin • Ends at the point signifying expected sales

(b) The fixed costs line

• Runs parallel to the horizontal axis • Meets the vertical axis at a point which represents total fixed costs

(c) The total costs line

• Starts where the fixed costs line meets the vertical axis

• Ends at the point which represents anticipated sales on the horizontal axis and total costs of anticipated sales on the vertical axis

The breakeven point is the intersection of the sales line and the total costs line.

The distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the margin of safety.

7.8 Example: a breakeven chart The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to £40,000 and the variable costs are 50p per unit. The sales price is £1 per unit.

Required

Construct a breakeven chart showing the current breakeven point and profit earned up to the present maximum capacity.

Solution We begin by calculating the profit at the budgeted annual output.

£ Sales (120,000 units) 120,000 Variable costs 60,000 Contribution 60,000 Fixed costs 40,000 Profit 20,000

The breakeven chart is shown on the following page.

The chart is drawn as follows.

(a) The vertical axis represents money (costs and revenue) and the horizontal axis represents the level of activity (production and sales).

(b) The fixed costs are represented by a straight line parallel to the horizontal axis (in our example, at £40,000).

(c) The variable costs are added 'on top of' fixed costs, to give total costs. It is assumed that fixed costs are the same in total and variable costs are the same per unit at all levels of output.

The line of costs is therefore a straight line and only two points need to be plotted and joined up. Perhaps the two most convenient points to plot are total costs at zero output, and total costs at the budgeted output and sales.


76

• At zero output, costs are equal to the amount of fixed costs only, £40,000, since there are no variable costs.

• At the budgeted output of 120,000 units, costs are £100,000. £ Fixed costs 40,000 Variable costs 120,000 × 50p 60,000 Total costs 100,000

(d) The sales line is also drawn by plotting two points and joining them up.

• At zero sales, revenue is nil. • At the budgeted output and sales of 120,000 units, revenue is £120,000.

7.9 Interpreting the breakeven chart The breakeven point is where total costs are matched exactly by total revenue. From the chart, this can be seen to occur at output and sales of 80,000 units, when revenue and costs are both £80,000. This breakeven point can be proved mathematically as:

unit per onContributicosts)fixed ( oncontributiRequired =

=unit per 50p

000,40£= 80,000 units

The margin of safety can be seen on the chart as the difference between the budgeted level of activity and the breakeven level.

7.10 The contribution breakeven chart

A contribution breakeven chart depicts variable costs instead of fixed costs, so that contribution can be read directly from the chart.

The main problem with the traditional breakeven chart is that it is not possible to read contribution directly from the chart.

FAST FORWARD


77

The contribution breakeven chart remedies this by drawing the variable cost line instead of the fixed cost line. A contribution breakeven chart for the example above would include the variable cost line passing through the origin and the total variable cost of £60,000 for 120,000 units. The contribution breakeven chart will look like this.

Contribution breakeven chart

If you look back at the breakeven chart above you will see that the breakeven point is the same, but that the budgeted contribution can now be read more easily from the chart.

7.11 The profit/volume (P/V) chart

The profit/volume (P/V) chart is a variation of the breakeven chart which illustrates the relationship of costs and profit to sales, and the margin of safety.

7.12 Construction of a profit/volume chart A P/V chart is constructed as follows (look at the chart in the example that follows as you read the explanation).

(a) 'P' is on the y axis and actually comprises not only 'profit' but contribution to profit (in monetary value), extending above and below the x axis with a zero point at the intersection of the two axes, and the negative section below the x axis representing fixed costs. This means that at zero production, the firm is incurring a loss equal to the fixed costs.

(b) 'V' is on the x axis and comprises either volume of sales or value of sales (revenue).

(c) The profit-volume line is a straight line drawn with its starting point (at zero production) at the intercept on the y axis representing the level of fixed costs, and with a gradient of contribution/unit (or the C/S ratio if sales value is used rather than units). The P/V line will cut the x axis at the breakeven point of sales volume. Any point on the P/V line above the x axis represents the profit to the firm (as measured on the vertical axis) for that particular level of sales.

FAST FORWARD


78

7.13 Example: P/V chart Let us draw a P/V chart for our example in Paragraph 8.3. At sales of 120,000 units, total contribution will be 120,000 × £(1 – 0.5) = £60,000 and total profit will be £20,000.

A Section A question in the May 2006 exam asked what would happen to the gradient of a line on a P/V chart if fixed costs increased. This highlights that the examiner can set questions on topics that you covered in your earlier studies as P/V charts are not specifically mentioned in the P1 syllabus.

7.14 The advantage of the P/V chart

(a) If the budgeted selling price of the product in our example is increased to £1.20, with the result that demand drops to 105,000 units despite additional fixed costs of £10,000 being spent on advertising, we could add a line representing this situation to our P/V chart.

(b) At sales of 105,000 units, contribution will be 105,000 × £(1.20 – 0.50) = £73,500 and total profit will be £23,500 (fixed costs being £50,000).

(c) The diagram shows that if the selling price is increased, the breakeven point occurs at a lower level of sales revenue (71,429 units instead of 80,000 units), although this is not a particularly large decrease when viewed in the context of the projected sales volume. It is also possible to see that for sales above 50,000 units, the profit achieved will be higher (and the loss achieved lower) if the price is £1.20. For sales volumes below 50,000 units the first option will yield lower losses.

(d) The P/V chart is the clearest way of presenting such information; two conventional breakeven charts on one set of axes would be very confusing.

(e) Changes in the variable cost per unit or in fixed costs at certain activity levels can also be incorporated easily into a P/V chart. The profit or loss at each point where the cost structure changes should be calculated and plotted on the graph so that the profit/volume line becomes a series of straight lines.

For example, suppose that at sales levels in excess of 120,000 units the variable cost per unit increases to £0.60 (perhaps because of overtime premiums that are incurred when production exceeds a certain level). At sales of 130,000 units, contribution would therefore be 130,000 × £(1 - 0.60) = £52,000 and total profit would be £12,000.

Exam focus point


79


80

Question Breakeven chart

Match the following labels to (a), (b), (c) and (d) marked on the breakeven chart below.

Fixed costs Margin of safety Budgeted profit Budgeted variable costs

Answer

Fixed costs (d)

Margin of safety (a)

Budgeted profit (b)

Budgeted variable costs (c)

Question G Limited

G Limited manufactures and sells a single product. The profit statement for May is as follows. £ Sales value 80,000 Variable cost of sales 48,000 Contribution 32,000 Fixed costs 15,000 Profit 17,000

The management accountant has used the data for May to draw the following profit/volume chart.


81

(a) The monetary values indicated on the chart as A, B and C are:

A £

B £

C £

(b) The term used to describe the distance D on the chart is

(c) For the whole of the current year, G Limited budgets to achieve a sales value of £900,000. Assuming that the unit variable costs and selling price achieved will be the same as that achieved during May, and that fixed costs for the year will be £180,000, the profit for the whole year will be

£

(d) The annual margin of safety for G Limited's product is

% of budgeted sales.

Answer

(a) A £17,000 B –£15,000 C £37,500

Workings

A: profit achieved from £80,000 sales revenue = £17,000 B: loss at zero sales revenue = fixed costs = –£15,000 C: breakeven point = £37,500 sales revenue (see below)

C/S ratio = 32/80 = 40%

Breakeven point = ratio C/Scosts fixed

= 0.4

£15,000 = £37,500 sales revenue

(b) The term used to describe the distance D on the chart is the margin of safety. (This is the difference between the sales revenue budgeted or achieved, and the revenue required to break even.)

(c) The profit for the whole year will be £180,000.

Workings

Contribution achieved = sales revenue × C/S ratio = £900,000 × 0.4 = £360,000 Fixed costs £180,000 ∴Profit for whole year £180,000

(d) The annual margin of safety for G Limited's product is 50% of budgeted sales.

Workings

Annual breakeven point = ratio C/Scostsfixed

= 0.4

£18,000 = £450,000 sales revenue

Margin of safety = £900,000 – £450,000 = £450,000 sales revenue = 50% of budgeted sales


82

7.15 Limitations of CVP analysis • It can only apply to a single product or a single mix of a group of products. • A breakeven chart may be time-consuming to prepare. • It assumes fixed costs are constant at all levels of output. • It assumes that variable costs are the same per unit at all levels of output. • It assumes that sales prices are constant at all levels of output. • It assumes production and sales are the same (stock levels are ignored). • It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

8 Relevant costs

Relevant costs are future cash flows arising as a direct consequence of a decision. Relevant costs are:

• Future costs • Opportunity costs • Differential costs • Cash flows • Incremental costs • Avoidable costs

8.1 Relevant costs Decision making should be based on relevant costs.

(a) Relevant costs are future costs.

(i) A decision is about the future; it cannot alter what has been done already. Costs that have been incurred in the past are totally irrelevant to any decision that is being made 'now'. Such costs are past costs or sunk costs.

(ii) Costs that have been incurred include not only costs that have already been paid, but also committed costs (a future cash flow that will be incurred anyway, regardless of the decision taken now).

(b) Relevant costs are cash flows. Only cash flow information is required. This means that costs or charges which do not reflect additional cash spending (such as depreciation and notional costs) should be ignored for the purpose of decision making.

(c) Relevant costs are incremental costs. For example, if an employee is expected to have no other work to do during the next week, but will be paid his basic wage (of, say, £100 per week) for attending work and doing nothing, his manager might decide to give him a job which earns the organisation £40. The net gain is £40 and the £100 is irrelevant to the decision because although it is a future cash flow, it will be incurred anyway whether the employee is given work or not.

8.2 Relevant costs - other terms

Differential cost is 'the difference in total cost between alternatives.' CIMA Official Terminology

For example, if decision option A costs £300 and decision option B costs £360, the differential cost is £60.

Avoidable cost is the 'specific cost of an activity or sector of a business that would be avoided if the activity or sector did not exist.' CIMA Official Terminology

For example a retailing organisation may be considering the closure of one of its shops. Avoidable costs would be those that are saved by closing the shop, for example the rent of the shop premises. Costs such as apportioned head office costs would not be saved by closing the shop, therefore these apportioned costs are not avoidable costs.

FAST FORWARD

Key term

Key term


83

An opportunity cost is 'The value of the benefit sacrificed when one course of action is chosen, in preference to an alternative. The opportunity cost is represented by the foregone potential benefit from the best rejected course of action.' CIMA Official Terminology

8.3 Example: relevant costs Suppose for example that there are three options, A, B and C, only one of which can be chosen. The net profit from each would be £80, £100 and £70 respectively.

Since only one option can be selected option B would be chosen because it offers the biggest benefit.

£ Profit from option B 100 Less opportunity cost (ie the benefit from the most profitable alternative, A) 80 Differential benefit of option B 20

The decision to choose option B would not be taken simply because it offers a profit of £100, but because it offers a differential profit of £20 in excess of the next best alternative.

8.4 Sunk costs

A sunk cost is a past cost which is not directly relevant in decision making.

8.5 Decision accounting

The principle underlying decision accounting is that management decisions can only affect the future. In decision making, managers therefore require information about future costs and revenues which would be affected by the decision under review, and they must not be misled by events, costs and revenues in the past, about which they can do nothing.

Therefore sunk costs, which have been charged already in a previous accounting period or will be charged in a future accounting period although the expenditure has already been incurred (or the expenditure decision irrevocably taken), are irrelevant to decision making.

8.6 Example: sunk costs An example of sunk costs is development costs which have already been incurred. Suppose that a company has spent £250,000 in developing a new service for customers, but the marketing department's most recent findings are that the service might not gain customer acceptance and could be a commercial failure. The decision whether or not to abandon the development of the new service would have to be taken, but the £250,000 spent so far should be ignored by the decision makers because it is a sunk cost.

8.7 Fixed and variable costs

Unless you are given an indication to the contrary, you should assume the following.

• Variable costs will be relevant costs. • Fixed costs are irrelevant to a decision.

This need not be the case, however, and you should analyse variable and fixed cost data carefully. Do not forget that 'fixed' costs may only be fixed in the short term.

Key term

FAST FORWARD

FAST FORWARD


84

8.8 Non-relevant variable costs There might be occasions when a variable cost is in fact a sunk cost. For example, suppose that a company has some units of raw material in stock. They have been paid for already, and originally cost £2,000. They are now obsolete and are no longer used in regular production, and they have no scrap value. However, they could be used in a special job which the company is trying to decide whether to undertake. The special job is a 'one-off' customer order, and would use up all these materials in stock.

In deciding whether the job should be undertaken, the relevant cost of the materials to the special job is nil. Their original cost of £2,000 is a sunk cost, and should be ignored in the decision.

However, if the materials did have a scrap value of, say, £300, then their relevant cost to the job would be the opportunity cost of being unable to sell them for scrap, ie £300.

8.9 Attributable fixed costs There might be occasions when a fixed cost is a relevant cost, and you must be aware of the distinction between 'specific' or 'directly attributable' fixed costs, and general fixed overheads.

(a) Directly attributable fixed costs are those costs which, although fixed within a relevant range of activity level are relevant to a decision for either of the following reasons.

(i) They could increase if certain extra activities were undertaken. For example, it may be necessary to employ an extra supervisor if a particular order is accepted. The extra salary would be an attributable fixed cost.

(ii) They would decrease or be eliminated entirely if a decision were taken either to reduce the scale of operations or shut down entirely.

(b) General fixed overheads are those fixed overheads which will be unaffected by decisions to increase or decrease the scale of operations, perhaps because they are an apportioned share of the fixed costs of items which would be completely unaffected by the decisions. An apportioned share of head office charges is an example of general fixed overheads for a local office or department. General fixed overheads are not relevant in decision making.

8.10 Absorbed overhead Absorbed overhead is a notional accounting cost and hence should be ignored for decision-making purposes. It is overhead incurred which may be relevant to a decision.

Question Relevant costs

The output of a process consists of two joint products, Jointpro A and Jointpro B, and a by-product. Jointpro B could go through a further process in order to increase its sales value. To assist management in making the decision whether to carry out further processing, which ONE of the following is relevant?

A The share of the total processing cost which has been allocated to Jointpro B B The sales value of Jointpro A and the by-product C The physical quantities of all three products at separation point D The cost of further processing Jointpro B and the increase in sales value that will result

Answer

The correct answer is D.

The decision must be based on the incremental costs and revenues to be incurred or earned in the future, as a result of the decision.


85

Option A is incorrect because you should recall from Chapter 9 that the share of the total processing cost which is allocated to a particular product is an arbitrary amount. The decision to further process Jointpro B will not affect the total of the joint process costs.

The sales value of Jointpro A and the by-product, as well as the physical quantities of all products (options B and C) will not be affected by the further processing decision and are therefore not relevant.

8.11 The relevant cost of materials The relevant cost of raw materials is generally their current replacement cost, unless the materials have already been purchased and would not be replaced once used. In this case the relevant cost of using them is the higher of the following.

• Their current resale value • The value they would obtain if they were put to an alternative use

If the materials have no resale value and no other possible use, then the relevant cost of using them for the opportunity under consideration would be nil.

You should test your knowledge of the relevant cost of materials by attempting the following question.

Question Relevant cost of materials

O'Reilly Ltd has been approached by a customer who would like a special job to be done for him, and who is willing to pay £22,000 for it. The job would require the following materials.

Total units Units already Book value of Realisable Replacement Material required in stock units in stock value cost

£/unit £/unit £/unit A 1,000 0 - - 6 B 1,000 600 2 2.50 5 C 1,000 700 3 2.50 4 D 200 200 4 6.00 9

Material B is used regularly by O'Reilly Ltd, and if units of B are required for this job, they would need to be replaced to meet other production demand.

Materials C and D are in stock as the result of previous over-buying, and they have a restricted use. No other use could be found for material C, but the units of material D could be used in another job as substitute for 300 units of material E, which currently costs £5 per unit (of which the company has no units in stock at the moment).

Required

Calculate the relevant costs of material for deciding whether or not to accept the contract.

Answer

(a) Material A is not yet owned. It would have to be bought in full at the replacement cost of £6 per unit.

(b) Material B is used regularly by the company. There are existing stocks (600 units) but if these are used on the contract under review a further 600 units would be bought to replace them. Relevant costs are therefore 1,000 units at the replacement cost of £5 per unit.


86

(c) 1,000 units of material C are needed and 700 are already in stock. If used for the contract, a further 300 units must be bought at £4 each. The existing stocks of 700 will not be replaced. If they are used for the contract, they could not be sold at £2.50 each. The realisable value of these 700 units is an opportunity cost of sales revenue forgone.

(d) The required units of material D are already in stock and will not be replaced. There is an opportunity cost of using D in the contract because there are alternative opportunities either to sell the existing stocks for £6 per unit (£1,200 in total) or avoid other purchases (of material E), which would cost 300 × £5 = £1,500. Since substitution for E is more beneficial, £1,500 is the opportunity cost.

(e) Summary of relevant costs £ Material A (1,000 × £6) 6,000 Material B (1,000 × £5) 5,000 Material C (300 × £4) plus (700 × £2.50) 2,950 Material D 1,500 Total 15,450

8.12 Considering qualitative factors

Qualitative factors should always be considered alongside the quantitative data in any management accounting situation.

8.13 Qualitative factors Qualitative factors in decision making are factors which might influence the eventual decisions but which have not been quantified in terms of relevant income or costs. They may stem from two sources.

• Non-financial objectives

• Factors which might be quantifiable in money terms, but which have not been quantified, perhaps because there is insufficient information to make reliable estimates

8.14 Examples of qualitative factors Qualitative factors that are relevant to a decision will vary according to the circumstances and nature of the decision. Here are some examples.

(a) The availability of cash. An opportunity may be profitable, but there must be sufficient cash to finance any purchases of equipment and build-up of working capital.

(b) Employees. Any decision involving the creation of a new work shift or changes in work procedures or location will require acceptance by employees, and ought to have regard to employee welfare.

(c) Customers. A decision involving one product may have repercussions on customer attitudes towards a range of products. For example, a company which sells a range of garden tools and equipment under a single brand name should consider the effects on demand for the entire brand range if one product (for example a garden rake) is deleted, albeit temporarily, because of a shortage of resources.

(d) Competitors. In a competitive market, some decisions may stimulate a response from rival companies. For example, the decision to focus on relevant costs in order to reduce selling prices and raise demand may not be successful if all competitors take similar action.

FAST FORWARD


87

(e) Suppliers. Some decisions will affect suppliers, whose long-term goodwill may be damaged by a decision to, for example, close a product line temporarily. In some cases, where a company is the supplier's main customer, a decision to reduce demand might drive the supplier out of business.

(f) Changes in cost structure. There is no certainty that cost structures experienced in the past will continue into the future. For example if production volume is reduced because of a shortage of labour, this may reduce the quantity of material purchased and hence bulk discounts may be forgone.

This is by no means an exhaustive list of the qualitative factors that may be relevant to a decision. However, you should now have an idea of the type of factor that may be worthy of mention, and you should be able to adapt your understanding to any situation.

Chapter Roundup

• There are four main groups of accounts in an integrated system

– The resources accounts

– Materials control account or stores control account – Wages (and salaries) control account – Production overhead control account – Administration overhead control account – Selling and distribution overhead control account

– Accounts which record the cost of production items from the start of production work through to cost of sales

– Work in progress control account – Finished goods control account – Cost of sales control account

– Sales account

– Income statement

• To overcome the need to have accounts for cash, payables and so on in the cost books in an interlocking system, a cost ledger control account is used. It represents all the accounts in the financial accounting books which are not included in the corresponding cost accounting books.

• The work in progress control account in a job or batch environment contains the summary totals of the entries in the individual job or batch accounts.

• In a job costing environment, the cost of completed production is transferred direct from work in progress control to the cost of sales account. There is unlikely to be a ledger account for finished goods inventory.

• Cost behaviour is the variability of input costs with activity undertaken.

• Costs which are not affected by the level of activity are fixed costs or period costs.

• A step cost is a cost which is fixed in nature but only within certain levels of activity.

• Variable costs increase or decrease with the level of activity.

• Semi-variable/semi-fixed or mixed costs are costs which are part-fixed and part-variable and which are thus partly affected by a change in the level of activity.

• It is often possible to assume that, within the normal or relevant range of output, costs are either variable, fixed or semi-variable.


88

• The fixed and variable elements of semi-variable costs can be determined by the high-low method or the scattergraph method.

• Cost-volume- profit (CVP)/breakeven analysis is the study of the interrelationships between costs, volume and profits at various levels of activity.

• The C/S ratio (or P/V ratio) is a measure of how much contribution is earned from each £1 of sales.

• Breakeven point = Sales revenue required to break even = ratio C/S

even break torequiredonContributi

= ratio C/Scosts Fixed

• The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. It is sometimes expressed as a percentage of the budgeted sales volume. Alternatively the margin of safety can be expressed as the difference between the budgeted sales revenue and breakeven sales revenue, expressed as a percentage of the budgeted sales revenue.

• The target profit is achieved when sales revenue = variable costs plus fixed costs plus profit. Therefore the total contribution required for a target profit = fixed costs + required profit.

• The breakeven point can also be determined graphically using a breakeven chart. This is a chart which shows approximate levels of profit or loss at different sales volume levels within a limited range.

• A contribution breakeven chart depicts variable costs instead of fixed costs, so that contribution can be read directly from the chart.

• The profit/volume (P/V) chart is a variation of the breakeven chart which illustrates the relationship of costs and profits to sales and the margin of safety.

• Relevant costs are future cash flows arising as a direct consequence of a decision. Relevant costs are:

• Future costs • Differential costs • Cash flows • Avoidable costs • Incremental costs • Opportunity costs

• A sunk cost is a past cost which is not directly relevant in decision making.

• The principle underlying decision accounting is that management decisions can only affect the future. In decision making, managers therefore require information about future costs and revenues which would be affected by the decision under review, and they must not be misled by events, costs and revenues in the past, about which they can do nothing.

• Qualitative factors should always be considered alongside the quantitative data in any management accounting situation.


89

Quick Quiz 1 What is the double entry for the following in an integrated accounts absorption costing system?

(a) Production overhead absorbed in the cost of production (b) Completed work transferred from the production process to inventory

2 The production overhead control account for October looks like this.

PRODUCTION OVERHEAD CONTROL ACCOUNT

$ $ Raw materials control 1,840 Work in progress 55,400 Wages control 7,900 Under-/over-absorbed overhead 1,520 Payables control 47,180 56,920 56,920

Indicate whether the following statements are true or false. True False I Indirect materials issued during October were $1,840

II Direct wages incurred during October were $7,900

III Production overhead incurred during October was $55,400

IV Production overhead for October was over-absorbed

3 Rocky Landscapes undertakes small landscaping jobs on customers' premises.

Three jobs were worked on last period. Details are as follows.

Job P Job Q Job R Total �€ �€ �€ �€ Opening work in progress 1,405 – – 1,450 Direct materials added in period 240 1,640 1,230 3,110 Direct wages incurred in period 920 984 610 2,514 Overhead absorbed 390 370 420 1,180 3,000 2,994 2,260 8,254

Job R was the only incomplete job at the end of the period.

Which of the following ledger entries is correct?

Debit Credit A Work in progress €2,260 Cost of sales €2,260 B Cost of sales €2,260 Work in progress €2,260 C Finished goods €5,994 Work in progress €5,994 D Cost of sales €5,994 Work in progress €5,994

4 In a batch costing system, a separate work in progress account is maintained for each unit in the batch.

True

False


90

5 The costs of operating the canteen at 'Eat a lot Company' for the past three months is as follows.

Month Cost Employees £ 1 72,500 1,250 2 75,000 1,300 3 68,750 1,175

Variable cost (per employee per month) =

Fixed cost per month =

6 Use the following to make up four formulae which can be used to calculate the breakeven point.

Contribution per unit

Contribution per unit

Fixed costs

Fixed costs

Contribution required to break even

Contribution required to break even

C/S ratio

C/S ratio

(a) Breakeven point (sales units) =

or

(b) Breakeven point (sales revenue) =

or

7 The P/V ratio is a measure of how much profit is earned from each £1 of sales.

True

False

8 The margin of safety is the difference in units between the budgeted sales volume and the breakeven sales volume. How is it sometimes expressed?

9 Profits are maximised at the breakeven point.

True

False

10 At the breakeven point, total contribution = …………………………………. .

11 The total contribution required for a target profit = ……………………………………………….. .

12 Give three uses of breakeven charts.


91

13 Breakeven charts show approximate levels of profit or loss at different sales volume levels within a limited range. Which of the following are true?

I The sales line starts at the origin II The fixed costs line runs parallel to the vertical axis III Breakeven charts have a horizontal axis showing the sales/output (in value or units) IV Breakeven charts have a vertical axis showing £ for revenues and costs V The breakeven point is the intersection of the sales line and the fixed cost line

A I and II B I and III C I, III and IV D I, III, IV, and V

14 On a breakeven chart, the distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the ………………………………. .

15 Give seven limitations of CVP analysis.

• ……………………………………………………………………………………………………… • ……………………………………………………………………………………………………… • ……………………………………………………………………………………………………… • ……………………………………………………………………………………………………… • ……………………………………………………………………………………………………… • ……………………………………………………………………………………………………… • ………………………………………………………………………………………………………

16 Name six types of relevant costs

17 A sunk cost is:

A a cost committed to be spent in the current period B a cost which is irrelevant for decision making C a cost connected with oil exploration in the North Sea D a cost unaffected by fluctuations in the level of activity

18 Select the correct word in the following sentences.

(a) For a material item that is regularly used, the relevant cost of using it for a particular order is its original purchase price/current replacement cost.

(b) For a material item that has already been purchased and would not be replaced once used, the relevant cost of using it for a particular order is the higher/lower of its current resale value and its value if put to an alternative use.

19 In week 2, the gross wages of the direct labour work force for Badders Ltd were £17,000. Idle time was recorded as £3,000 in the cost ledger. How would this wages cost be recorded in the cost ledger?

Debit Credit

A Wages and salaries control £17,000 Work in progress £14,000 Production overhead £3,000

B Work in progress £14,000 Wages and salaries control £17,000 Production overhead £3,000

C Work in progress £17,000 Wages and salaries control £17,000

D Wages and salaries control £17,000 Work in progress £17,000


92

Answers to Quick Quiz 1 (a) Dr Work in progress control account Cr Production overhead account

(b) Dr Finished goods control account Cr Work in progress control account

2 I True. Issues of indirect materials are charged to the production overhead control account

II False. Indirect wages incurred were $7,900

III False. Production overhead absorbed was $55,400

IV False. Production overhead for October was under-absorbed because overhead incurred ($56,920) was greater than overhead absorbed ($55,400)

3 D. The completed cost of jobs P and Q is transferred from work in progress to cost of sales. No finished goods inventory is held therefore C is not correct.

4 False. A separate work in progress is maintained for each batch, as well as a work in progress control account which summarises the costs of all batches in progress.

5 Variable cost = £50 per employee per month Fixed costs = £10,000 per month

Activity Cost No employees £ High 1,300 75,000 Low 1,175 68,750 125 6,250

Variable cost per employee = £6,250/125 = £50

For 1,175 employees, total cost = £68,750

Total cost = variable cost + fixed cost £68,750 = (1,175 × £50) + fixed cost ∴Fixed cost = £68,750 – £58,750 = £10,000

6 (a) Breakeven point (sales units) = unit per onContributi

costs Fixed

or unit per onContributi

even break to required onContributi

(b) Breakeven point (sales revenue) = ratio C/ScostsFixed

or ratio C/S

evenbreaktorequired onContributi

7 False. The P/V ratio is a measure of how much contribution is earned from each £1 of sales.

8 As a percentage of the budgeted sales volume.

9 False. At the breakeven point there is no profit.

10 At the breakeven point, total contribution = fixed costs

11 Fixed costs + required profit


93

12 • To plan the production of a company's products • To market a company's products • To give a visual display of breakeven arithmetic

13 C

14 Margin of safety

15 • It can only apply to a single product or a single mix of a group of products. • A breakeven chart may be time-consuming to prepare. • It assumes fixed costs are constant at all levels of output. • It assumes that variable costs are the same per unit at all levels of output. • It assumes that sales prices are constant at all levels of output. • It assumes production and sales are the same (stock levels are ignored). • It ignores the uncertainty in the estimates of fixed costs and variable cost per unit.

16 (a) Future costs (b) Cash flows (c) Incremental costs (d) Differential costs (e) Opportunity costs (f) Avoidable costs

17 B

18 (a) current replacement cost (b) higher

19 B The idle time is recorded as an indirect cost and is therefore charged to production overhead.

Now try the questions below from the Exam Question Bank

Number Level Marks Time

Q2 Examination 5 9 mins

Q3 Examination 5 9 mins