Use with Business Accounting and Finance Second Edition

• Variable costs vary in line with the level of business activity • Fixed costs do not vary with the level of business activity (true only up to a point) • Stepped costs: where the business reaches the level of activity where a fixed cost must increase, the increase is sudden • Semi-variable costs have both fixed and variable elements Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

• In economics, a marginal cost is the cost of one additional item • Marginal costing describes an approach to costing that excludes fixed costs • Contribution refers to the amount that is left over after deducting variable costs from sales Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

The break-even point is the point at which no profit or loss is made in a set of business transactions. For example: Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

• It is important to understand the relationships between the level of business activity, the different types of cost, and profitability • The analysis of the interaction of these factors is Cost-Volume-Profit analysis (CVP Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Add a line for sales revenue Use with Business Accounting and Finance Second Edition

We can work out break-even points using the relationship between sales and costs: Selling price per unit - variable costs per unit = contribution per unit Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Example: Mulberry Piggott Limited Selling price of a raincoat = £ 30 Variable costs = £ 10 per raincoat Expected fixed costs = £ 60 000 How many raincoats must the company sell to break even? Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Mulberry Piggott (continued): target profit = £ 30 000 Use with Business Accounting and

Mulberry Piggott Limited Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe

Mulberry Piggott Limited If projected sales of 4500 are realistic, and break even point is 3000 units, the margin of safety is: Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Decision rule: if an order or a contract at a special price would produce a positive contribution to fixed costs, the order should be accepted BUT there are likely to be other factors relevant to the decision Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

If a business is considering major increases in activity levels it must take into account any likely increases in fixed costs If incremental revenues exceed incremental costs, the project should be accepted Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Example: Spindrift & Schooner Limited Estimated effect of extending a boatyard Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Limiting factors are constraints on sales or production, for example: • a product may require specialist labour for which there is a shortage • a product may require a material that is in short supply Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Example: Crosthwaite and Crosby Limited Cost structures for three products Use with Business Accounting

Example: Crosby and Crosthwaite Limited Product B gives the highest contribution, but labour is scarce. Which product provides the highest contribution per unit of limiting factor? Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

Example: Crosby and Crosthwaite Limited Product A gives the highest contribution per unit of limiting factor Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning

• Assumes that variable costs increase at a steady rate - assumption may not be valid • Very few costs are truly variable • Fixed costs remain fixed only up to a point • Analysis more difficult in multi-product firms • There may be other factors to take into account Use with Business Accounting and Finance Second Edition by Catherine Gowthorpe ISBN 1 -84480 -200 -0 © 2005 Thomson Learning