Week 4: Warm Up - Group D:
Kieran Mervyn
Minimum Price
Have a go at the questions below:
● A garage buys a car for £3,000.
● It requires a new engine costing £500 that will take 7 hours
to fit.
● The technicians will be paid £20 per hour to fit the engine.
● The technicians are short of work but the garage wishes
to retain their services.
● The car could instead be sold immediately for £3,500.
Question 1 : What is the minimum price the garage should
charge for the car after the engine has been fitted?
Now have a look at this slightly different question and have a go:
● A garage buys a car for £3,000.
● It requires a new engine costing £500 that will take 7 hours
to fit.
● The technicians will be paid £20 per hour to fit the engine.
● The technicians are busy and are charged out at £60
per hour.
● The car could be sold immediately for £3,500.
Question 2 : What is the minimum price the garage should
charge for the car after the engine has been fitted?
Week 4: Guided
Practice 1 – What
is the Definition
of a Cost?
Introduction
Cost is defined as: The amount of resources, usually measured
in monetary terms, sacrificed to achieve a particular objective.
There are certain types of costs you will need to be aware of during
this course:
● Historic cost – A cost already incurred.
● Opportunity cost – The value of an opportunity forgone.
The relevance of costs
Costs can be classified in terms of relevance, i.e. is the cost we are
looking at as part of our process either relevant to our decision or
can it simply be ignored? We can use the following decision tree
to determine whether a cost is relevant or irrelevant.
The Behaviour of Costs
Costs can be broadly be classified in one of two ways in terms of
behaviour.
● Fixed – Those that stay fixed (the same) when changes
occur to the volume of activity.
● Variable – Those that vary according to the volume of
activity.
Fixed
Attributes of fixed costs
● Do not change with volume of sales (can change over time
or relevant range of volume).
● Remain constant in the short term.
● May be unavoidable (ie salaries or insurance).
● Do not affect current capacity.
● Some can be avoided in the short term but avoidance
jeopardises long-term efficiencies, e.g. training
programmes for staff marketing.
The graph below illustrates how fixed costs change with volume of
activity: you will see that the costs remain constant in the short
term but ‘step up’ at certain volumes of activity. If you consider
that the fixed cost here is, for example, rent, then when an
organisation’s activity reaches a certain level, they may need
additional floor space to house their increased production
requirements.
Variable
Attributes of variable costs
● Change with volume of sales.
● May reduce with higher volumes.
● Cannot generally be avoided.
The graph below shows how variable costs change with activity.
You can see that as activity increases, variable costs increase
proportionally.
Fixed or Variable?
Total Cost of an Activity
Once we can distinguish between these behaviours, we can use
the information to determine the total cost of an activity. Assuming
fixed costs remain constant (i.e. do not ‘step up’), we can see the
cost profile for given volumes of activity looks like the graph below:
Figure 1. Cost profile
Taking this one step further, we can add in our sales revenues to
determine how much of our product we need to sell in order to cover
all of our costs. This is termed our ‘break-even point’. You can see
that below the break-even point, we are in a loss-making position, ie
our sales revenues are lower than our total costs. Above the
break-even point, our revenues are in excess of our costs and
therefore we are making a profit.
Figure 2. Break-even point
How Do We Use This Information?
We can use this information in a number of ways, the main ones
are:
● To make decisions on how much we need to sell to break
even.
● To work out how much profit we make at a given level of
output.
● To see the impact due to changes in selling prices or
costs.
This is known as Cost-Volume-Profit analysis. It is the study of the
effects of output volume on revenue (sales), expenses (costs) and
net income (net profit).
Week 4: Guided
Practice 2 –
Marginal Costing
Introduction
Marginal costing is the relationship between sales, variable costs
and contribution.
Contribution = Sales Revenue – Variable Costs
It is called contribution because it contributes to meeting the fixed
costs of business, and if there is any excess, it contributes to profit.
Contribution relationships
Figure 3 below shows the relationship between contribution, sales
revenue, costs and profit.
Figure 3. Contribution, sales revenue, costs and profit.
Columns A and B together illustrate the definition of contribution:
Contribution (C)= Sales revenue (SR) – Variable cost (VC)
Columns B and C show the relationship between contribution, fixed
costs and profit:
Total contribution (C)= Total fixed costs (FC) + Profit (P)
The marginal cost equation
You can see from the chart above, we can look at contribution in a
number of ways:
Contribution
Contribution = Sales revenue – Variable cost
Contribution + Variable cost = Sales revenue
Contribution = Fixed cost + Profit
Contribution – Fixed cost = Profit
C = SR – VC
SR = C + VC
C = FC + P
P = C – FC
Similarly, we can see from the chart the various relationships that
relate to calculating profit:
Profit
Profit = Total revenue – Total cost
Profit = Total revenue – (Variable costs + Fixed costs)
Profit = (Units sold × Selling price per unit) – [(Units sold × Variable
costs per unit) + Fixed costs]
Profit = Units sold × Contribution per unit – Fixed costs
P = TR – TC
P = TR – (VC + FC)
P = Q × SP – [(Q × VC) + FC]
P = Q (SP – VC) – FC
Reflection
The formulae above show you how to calculate business profits at
certain levels of output.
This can be useful in determining, for example, whether or not to
invest in new machinery or use existing resources for a particular
project. Investing in new machinery (fixed cost) may have the effect
of reducing variable costs and therefore affect your profits at a
given level of output.
Week 4: Guided Practice 3 – Break-even Analysis
Introduction
We can use the marginal costing information we have learned to calculate the break-even
point for any activity.
The break-even point occurs where sales revenue and costs are equal
We can use various formulae to calculate it or we can construct break-even charts.
Calculating the break-even point:
b = fixed costs over (sales revenue per unit - Variable cost per unit)
Example
Assume that a product has a Selling Price (SP) of £6. Variable Costs (VC) are £1 per unit
and Fixed Costs are £50,000 per year.
Question: Calculate the number of units that a firm must sell in order to break even.
Answer:
Break Even (Units)
= Fixed Costs / Contribution per unit
Contribution per unit
= Selling Price per unit – Variable Cost per unit
= SP – VC
= £6 – £1 = £5
Break Even = £50,000 / £5 = 10,000 units
Sales to Break Even = B/E units × Selling Price
= 10,000 × £6
= £60,000
We can use break-even analysis in a number of ways to assist with our decision making.
Some of the ways we can use break-even analysis are shown below:
Margin of Safety Achieving a target profit Sensitivity Analysis
The distance between the break-even level of output and the expected level of output is the
margin of safety, ie the degree to which sales can fall before a loss-making situation is
reached.
Margin of Safety = Expected sales – Breakeven sales
The margin of safety is sometimes expressed as a percentage of the budgeted sales
volume.
Example
In this example, we are expecting to make sales of £80,000 and in order to break even, we
need to make sales of £60,000.
Working out:
Margin of Safety (sales) = Expected Sales – Break-Even Sales
= £20,000 drop in sales before a loss is incurred
Margin of Safety (%)
Expected percentage drop before a loss is incurred
£80,000 – £60,000 = £20,000
£20,000/£80,000 = 0.25
Therefore 25% drop in sales before loss is incurred.
Weaknesses of Break-even Analysis
If target profit is £20,000, fixed cost is £50,000, contribution per unit is £5 and selling price is
£6, find the sales (in units and £).
Break Even = Fixed Cost + Target Profit / Contribution per unit
=£50,000 + £20,000 / £5 = 14,000 units
In £ = B/E units × Selling Price
= 14,000 × £6
= £84,000
Sensitivity analysis is a 'what-if' technique that examines how a result will change if the
original predicted data are not achieved or if an underlying assumption changes, eg:
What will happen to operating income if volume declines by 5%?
What will happen to operating income if variable costs increase by 10% per unit?
Sensitivity analysis broadens management’s perspectives about possible outcomes.
Marginal Analysis and Decision Making
Figure 4 shows the four key areas of decision making that managers can use marginal
analysis for:
four key areas of decision making that managers can use marginal analysis
Week 4: Guided Practice 4 – Full Costing
Introduction
Up to now we have been looking at marginal costing, i.e. what is the effect of producing ‘one
more’ unit of output. We have also highlighted that in a multi-product business, it can be
difficult to ascertain the fixed cost associated with one particular product. Full costing
attempts to make this easier by taking a fair share of the overheads consumed in the
production process to arrive at the full cost associated with a particular production job.
Example
See the following example from the recommended textbook – Marine Suppliers Ltd (p. 255).
Marine Suppliers Ltd undertakes a range of work, including making sailing boats on a
made-to-measure basis. The business expects the following to arise during the next month:
Direct labour cost £120,000
Direct labour time 6,000 hours
Indirect labour cost £19,000
Depreciation of machinery £8,000
Rent £10,000
Heating, lighting and power £2,000
Machine time 2,000 hours
Indirect materials £1,500
Other miscellaneous indirect
Production cost elements (overheads)
£1,200
Direct materials cost £36,000
The business has received an enquiry about a sail. It is estimated that this particular sail will
take 6 direct labour hours to make and will require 20 square metres of sailcloth, which costs
£25 per square metre.
The business normally uses a direct labour hour basis of charging indirect cost (overheads)
to individual jobs.
Question: What is the full (absorption) cost of making the sail?
We need to derive the full cost of the sail, including the direct costs and a fair share of the
indirect costs or overheads.
Diagram showing the full cost of a sail. The calculation being direct labour plus direct
overheads plus a proportion of the overheads, calculated on e.g. a labour hour basis
Step 1
Work out the direct costs: £
Direct materials (£20 x £25) 500.00
Direct labour (6 x (£120,000/6,000)) 120.00
£620.00
Step 2
Add up all of the indirect costs (overheads).
In this case, they total £41,700 as shown in Atrill and McLaney (2022), p. 256.
Step 3
Calculate an overhead recovery rate per labour hour (or machine hour, or square metre,
whatever is appropriate). In this case, direct labour hours is used.
£41,700 / 6,000 hours = £6.95 per direct labour hour.
Step 4
Add together the direct and indirect
Costs to give the full cost of the job. £
Direct costs 620.00
Indirect cost (6 x £6.95) 41.70
£661.70
Atrill, P. and McLaney, E. (2022). Accounting and Finance for Non-specialists. 12th ed.
London: Pearson Education.
Week 4: Challenge Activity - Group D: Kieran Mervyn
Challenge Brief
Question
A spinning mill produces three types of yarns: A, B and C. These yarns require the use of
two machines: X and Z.
Estimates for next year: Products mix
Yarn AYarn BYarn C
Sales (units) 3,100 4,500 6,250
Selling price per unit (PU) ($/unit) 31 38 23
Material cost (PU) ($/unit) 9 12 13
Variable production cost 5 7 8
Time required PU on 'X' machines (hours) 1.3 1.1 0.9
Time required PU on 'Z' machines (hours) 0.7 0.8 0.7
Fixed costs for next year are expected to be $72,000.
The business has an annual capacity of 12,000 hours for machine X and 10,500 hours for Z.
Which products should the business plan to make next year?