Marginal costing

What are the different types of costs?

- Direct costs
- Indirect cost
- Variable costs
- Fixed costs
- Stepped costs
- Semi-variable costs
- Margin costs

What are direct costs?

Cost identified directly with each output

What is the most common example of direct costs?

Royalties

What are Royalties?

An agreed percentage of sales revenue paid to the owner of a patent on a product

What are indirect costs?

Cost that cannot be identified directly with each unit of output

What are examples of indirect costs?

insurance and office expenses

What are variable costs?

costs that vary with the quantity of output produced

What are examples of variable costs?

Materials, purchases and packaging

What are fixed costs?

Costs that do not vary with the quantity of output produced

What are examples of fixed costs?

rent, salaries and advertising

What are stepped costs?

Costs that are fixed up to a certain level of output, beyond which they increase to a higher level of fixed costs

Why may stepped costs be due?

To the need for additional premises or employers

What are semi-variable costs?

Cost where part of it is fixed and part of it is variable

What are examples of semi-variable costs?

Telephone expenses (rental fixed calls variable)

What is margin cost?

Cost of producing one extra unit, it is the sum of the variable costs producing the extra unit

What are direct costs generally the same as?

Variable costs

What are indirect costs generally the same as?

Fixed costs

What is the formula for contribution per unit?

Selling price - variable cost per unit

What is the formula for Total contribution?

Contribution per unit x number of units sold

What is total contribution also equal to?

Revenue - Variable costs

What is the break-even point?

The level of sales where revenue is exactly equal to total costs, the level of profit is zero.

What is the formula for break-even point?

Fixed costs / contribution per unit

How can break-even be expressed in revenue?

By multiplying it by the selling price

What is the formula for margin of safety?

actual level of sales - break even point

What is the formula for contribution sales ratio?

Contribution per unit / Selling price

When is the contribution per sales ratio especially useful in calculating break-even point in revenue?

When a range of products are sold at different prices but with the same gross profit margin.

What is the formula for contribution sales ratio to calculate the break-even point in revenue?

Fixed costs / Contribution sales ratio

What can break-even analysis be used to do?

- Assess the viability of a new business- how likely it is to achieve the level of sales needed to break even
- Set sales targets to help achieve the business' objectives
- Evaluate changes to the business
- Support applications for bank loans

What are the limitations of break-even analysis?

- Assumptions about costs and sales prices may be incorrect
- Fixed costs eventually increase if the business is to produce more than certain levels of output i.e. stepped costs
- Assumptions about how likely a business is to achieve the target level of sales may be incorrect

How are profit statements, contribution statements and marginal cost statements to be presented?

£
Revenue 320,000
Variable costs 180,000
Contribution 140,000
Fixed costs 95,000
Profit 45,000

What is marginal cost?

the cost of producing one extra unit

What business decisions can marginal costs be used to help?

- Make or buy decisions
- Acceptance of additional work
- Price setting
- Optimum use of scarce resources
- Closure of a loss-making line or production department
- Target profit

What is a 'make or buy decision'?

That a business must make decide whether they are going to make the product themselves (in-house) or buy it from a supplier.

How many rules are there for 'make or buy decisions'?

3

What is rule 1 for 'make or buy decisions'?

If marginal cost of producing product in-house is lower than what would be paid to a supplier, business should make product itself and vice versa.

What is rule 2 for 'make or buy decisions'?

If marginal cost of making the product in-house plus contribution from lost work is lower than price that would be paid to supplier, business should make the product itself and vice versa.

What is rule 3 for 'make or buy decisions'?

Non-financial aspects should also be considered, such as quality of products and reliability of other supplier and staffing issues.

What does acceptance of additional work mean?

Deciding whether to accept orders at lower-than-usual selling prices

What conditions must the acceptance of work meet to be acceptable?

1) The selling price of the products is greater than their marginal costs
2) Business must have enough spare capacity to complete the work without incurring additional fixed costs or being prevented from producing goods that would be sold at the normal price
3) Customer will not then sell the goods to other firms at a price below that changed by the original business

What may be difficult to maintain even if the requirements for the acceptance of additional work is met?

Difficult to maintain normal prices for other customers if they become aware of the lower prices being offered to this customer.

Why might a business sell some of its outputs at prices below marginal cost?

To attract normal customers who will subsequently buy others at normal prices

What is cost plus pricing?

Calculating selling prices by applying a percentage mark-up to the cost of the products that are being sold

What is the formula for selling price?

Cost price + Mark up

What can the formula for selling price also be based on?

- Marginal costing
- Absorption costing

What must businesses consider when price setting?

- The prices of similar products that are available from competitors
- How much customers are willing to pay
- Whether the selling price will generate enough revenue for the business to be profitable

What are scarce resources?

Activities or assets that limit output because there is a finite limit to them

What are examples of scarce resources?

The availability of labour hours, machine houses or materials

When a business makes more than one product how will profit be maximized?

By producing as many as possible of the product with the highest contribution per unit of scarce resource.

If there is a limited number of labour hours, what is the formula for contribution per unit of scarce resource?

Contribution per unit / Number of labour hours needed per unit of production

What is an optimum production plan?

Shows the combination of products that will deliver the highest overall profit for the business

When should a business continue to operate a loss-making line or production department?

As long as it is making a positive contribution

What is a positive contribution?

When the revenue for that section is greater than the variable costs (marginal costs)

What is the only exception for closing the loss-making section?

If it would allow the business to operate another line or production department that would generate a higher contribution

What is target profit?

Calculating the level of sales or amount of revenue needed to achieve a target level of profit

What is the formula for target profit?

(Fixed costs + Target profit) / Contribution per unit

What is the formula for contribution sales ratio used to calculate target profit?

Contribution per unit / Selling price

What is the formula for revenue needed to achieve a target profit figure?

Fixed costs + Target profit / Contribution sales ratio