Accounting L7: Marginal costing and short-term decision making

Relevant Costs for Decision Making

• Relevant Costs and Revenues: These are costs and revenues that differ for each option available to the decision maker.

• Sunk Costs: Past costs; irrelevant to current decisions as they have already been incurred.

• Future Costs and Revenues: Changes under different options make them relevant costs.

• Opportunity Costs: Value of the benefit sacrificed when one action is chosen over another (e.g., studying vs. working).

Example of Relevant Costs

• A consortium plans to build a football stadium on land that could be developed as a hotel complex. The relevant analysis includes:

  • Future costs and revenues of the stadium.

  • Opportunity costs of not building the hotel (estimated profit from the hotel).

Cost Behaviour Patterns

• Types of Costs:

  • Variable Costs: Costs that change with the level of production (e.g., handlebar cost for bicycles).

  • Fixed Costs: Costs that remain unchanged over varying levels of production (e.g., plant leasing costs).

  • Semi-variable and Semi-fixed Costs: Costs that contain fixed and variable components.

Example Calculation

• For Royal Bicycles:

1. Handlebar cost for 1,000 bicycles at €52 each = €52,000

2. Handlebar cost for 3,500 bicycles = €182,000

• Variable cost per unit fixed at €52, but total variable costs increase with production.

Fixed Costs Analysis

• Plant leasing costs of €94,500 remain unchanged over different output:

  • Cost per bicycle at:

    • 1,000 bicycles: €94.50

    • 3,500 bicycles: €27.00

• Fixed costs of €94,500 remain constant, affecting the fixed cost per unit.

Marginal Costing

• Marginal Cost: Cost of an additional product unit, considering only variable costs.

• Contribution Margin: Sales revenue – Variable costs

  • Positive contribution indicates a project should be accepted.

  • Profit Calculation: Operating profit = Contribution margin – Fixed costs.

Special Orders Example

• Hi Co.: Selling at £40/unit, special order for 100 units at £30 each:

  • Variable cost: £25/unit

  • Total sales from special order: £3,000

  • Contribution: £500; hence, accept the order.

Further Example - Firelight Ltd

• Producing boxes of fireworks:

  • Selling price: £120/box

  • Variable cost: £35/box.

  • Special Order Calculation:

    • Profit prior to special order: £120,000 revenue - £35,000 variable costs = £25,000 profit.

    • Contribution calculation for special order indicates acceptance.

Decision Making on Discontinuation

• Assessing whether to discontinue a product line:

  • Total Contribution Analysis:

    • Classic: £30

    • Contemporary: £15

    • Modern: £35

• Profit Analysis:

  • Total profits with and without contemporary clocks discussed.

Opportunity Cost Assessment

• If facilities can produce additional items (modern clocks), potential profit from missing out should inform decisions.

Make-or-Buy Decisions

• Cost analysis between manufacturing a component or outsourcing:

  • Example: Circuit board has variable cost of £300, purchase price £350. Prefer “make” if surplus capacity exists, hence, do not outsource.

Optional Reading

• Gowthorpe: Chapter 14