You are on page 1of 31

TOPICS

1. Margna costng
2. Margna cost
3. Reatonshp b/w margna costng and economes of scae
4. Reevance of margna prvate and soca costs n margna
cost theory
5. Features of margna costng system
6. Advantages of margna costng system
7. Dsadvantages of margna costng system
8. Margna costng as a management accountng too
9. Eements of decson makng
10.Reevant costs of decson makng
11.Basc decson makng ndcators n margna costng
o Proft voume rato
o Cash voume proft anayss
o Break-even anayss
o Margn of safety
o Shut down pont
12.Cash poston and forecast
13.Proft and oss forecast
14.Proft pannng
o
MARGINAL COSTING AS A COSTING SYSTEM
Margna Costng s a type of fexbe standard costng that
separates fxed costs from proportona costs n reaton to the
output quantty of the ob|ects. In partcuar, Margna Costng s a
comprehensve and sophstcated method of pannng and
montorng costs based on resource drvers. Seectng the resource
drvers and separatng the costs nto fxed and proportona
components ensures that cost fuctuatons caused by changes n
operatng eves, as defned by margna anayss, are accuratey
predcted as changes n authorzed costs and ncorporated nto
varance anayss.
Ths form of nterna management accountng has become wdey
accepted n busness practce over the ast 50 years. Durng ths
tme, however, the demands paced on costng systems by cost
management requrements have changed radcay.
MARGINAL COST
In economcs and fnance, marginal cost s the change n tota cost
that arses when the quantty produced changes by one unt. It s
the cost of producng one more unt of a good.
|1|
Mathematcay, the
margna cost (MC) functon s expressed as the frst dervatve of
the tota cost (TC) functon wth respect to quantty (O). Note that
the margna cost may change wth voume, and so at each eve of
producton, the margna cost s the cost of the next unt produced.
A typca Margna Cost Curve
In genera terms, margna cost at each eve of producton ncudes
any addtona costs requred to produce the next unt. If producng
addtona vehces requres, for exampe, budng a new factory, the
margna cost of those extra vehces ncudes the cost of the new
factory. In practce, the anayss s segregated nto short and ong-
run cases, and over the ongest run, a costs are margna. At each
eve of producton and tme perod beng consdered, margna costs
ncude a costs whch vary wth the eve of producton, and other
costs are consdered fxed costs.
A number of other factors can affect margna cost and ts
appcabty to rea word probems. Some of these may be
consdered market faures. These may ncude nformaton
asymmetres, the presence of negatve or postve externates,
transacton costs, prce dscrmnaton and others.
RELATION BETWEEN MARGINAL COST AND ECONOMIES OF
SCALE
Producton may be sub|ect to economes of scae (or
dseconomes of scae). Increasng returns to scae are sad to
exst f addtona unts can be produced for ess than the
prevous unt, that s, average cost s fang.
Ths can ony occur f average cost at any gven eve of
producton s hgher than the margna cost.
Conversey, there may be eves of producton where margna
cost s hgher than average cost, and average cost w rse for
each unt of producton after that pont. Ths type of
producton functon s generay known as dmnshng
margna productvty: at ow eves of producton, productvty
gans are easy and margna costs fang, but productvty
gans become smaer as producton ncreases; eventuay,
margna costs rse because ncreasng output (wth exstng
capta, abour or organzaton) becomes more expensve. For
ths generc case, mnmum average cost occurs at the pont
where average cost and margna cost are equa (when
potted, the two curves ntersect); ths pont w not be at the
mnmum for margna cost f fxed costs are greater than zero.
Short an long r!n marginal costs an "conomi"s o#
scal"
The former takes as unchanged, for exampe, the capta equpment
and overhead of the producer, any change n ts producton
nvovng ony changes n the nputs of abour, materas and energy.
The atter aows a nputs, ncudng capta tems (pant,
equpment, budngs) to vary.
A ong-run cost functon descrbes the cost of producton as a
functon of output assumng that a nputs are obtaned at current
prces, that current technoogy s empoyed, and everythng s beng
but new from scratch. In vew of the durabty of many capta
tems ths textbook concept s ess usefu than one whch aows for
some scrappng of exstng capta tems or the acquston of new
capta tems to be used wth the exstng stock of capta tems
acqured n the past. Long-run margna cost then means the
addtona cost or the cost savng per unt of addtona or reduced
producton, ncudng the expendture on addtona capta goods or
any savng from dsposng of exstng capta goods. Note that
margna cost upwards and margna cost downwards may dffer, n
contrast wth margna cost accordng to the ess usefu textbook
concept.
Economes of scae are sad to exst when margna cost accordng
to the textbook concept fas as a functon of output and s ess than
the average cost per unt. Ths means that the average cost of
producton from a arger new but-from-scratch nstaaton fas
beow that from a smaer new but-from-scratch nstaaton. Under
the more usefu concept, wth an exstng capta stock, t s
necessary to dstngush those costs whch vary wth output from
accountng costs whch w aso ncude the nterest and
deprecaton on that exstng capta stock, whch may be of a
dfferent type from what can currenty be acqured n past years at
past prces. The concept of economes of scae then does not appy.
E$t"rnaliti"s
Externates are costs (or benefts) that are not borne by the partes
to the economc transacton. A producer may, for exampe, poute
the envronment, and others may bear those costs. A consumer may
consume a good whch produces benefts for socety, such as
educaton; because the ndvdua does not receve a of the
benefts, he may consume ess than effcency woud suggest.
Aternatvey, an ndvdua may be a smoker or acohoc and
mpose costs on others. In these cases, producton or consumpton
of the good n queston may dffer from the optmum eve.
%"it& N"gati'" "$t"rnaliti"s o# (ro!ction
N"gati'" E$t"rnaliti"s o# Pro!ction
Much of the tme, prvate and soca costs do not dverge from one
another, but at tmes soca costs may be ether greater or ess than
prvate costs. When margna soca costs of producton are greater
than that of the prvate cost functon, we see the occurrence of a
negatve externaty of producton. Productve processes that resut
n pouton are a textbook exampe of producton that creates
negatve externates.
Such externates are a resut of frms externazng ther costs onto
a thrd party n order to reduce ther own tota cost. As a resut of
externazng such costs we see that members of socety w be
negatvey affected by such behavor of the frm. In ths case, we
see that an ncreased cost of producton on socety creates a soca
cost curve that depcts a greater cost than the prvate cost curve.
In an equbrum state we see that markets creatng negatve
externates of producton w overproduce that good. As a resut,
the socay optma producton eve woud be ower than that
observed.
Positi'" "$t"rnaliti"s o# (ro!ction
Postve Externates of Producton
When margna soca costs of producton are ess than that of the
prvate cost functon, we see the occurrence of a postve externaty
of producton. Producton of pubc goods are a textbook exampe of
producton that create postve externates. An exampe of such a
pubc good, whch creates a dvergence n soca and prvate costs,
ncudes the producton of educaton. It s often seen that educaton
s a postve for any whoe socety, as we as a postve for those
drecty nvoved n the market.
Examnng the reevant dagram we see that such producton
creates a soca cost curve that s ess than that of the prvate curve.
In an equbrum state we see that markets creatng postve
externates of producton w under produce that good. As a resut,
the socay optma producton eve woud be greater than that
observed.
Social costs
Of great mportance n the theory of margna cost s the dstncton
between the margna private and social costs. The margna prvate
cost shows the cost assocated to the frm n queston. It s the
margna prvate cost that s used by busness decson makers n
ther proft maxmzaton goas, and by ndvduas n ther
purchasng and consumpton choces. Margna soca cost s smar
to prvate cost n that t ncudes the cost functons of prvate
enterprse but also that of socety as a whoe, ncudng partes that
have no drect assocaton wth the prvate costs of producton. It
ncorporates a negatve and postve externates, of both
producton and consumpton.
Hence, when decdng whether or how much to buy, buyers take
account of the cost to socety of ther actons if prvate and soca
margna cost concde. The equaty of prce wth soca margna
cost, by agnng the nterest of the buyer wth the nterest of the
communty as a whoe s a necessary condton for economcay
effcent resource aocaton.
Oth"r cost "#initions in marginal costing
Fi$" costs are costs whch do not vary wth output, for
exampe, rent. In the ong run a costs can be consdered
varabe.
)aria*l" cost aso known as, operating costs, prime costs, on
costs and direct costs, are costs whch vary drecty wth the
eve of output, for exampe, abour, fue, power and cost of
raw matera.
Social costs o# (ro!ction are costs ncurred by socety, as
a whoe, resutng from prvate producton.
A'"rag" total cost s the tota cost dvded by the quantty
of output.
A'"rag" #i$" cost s the fxed cost dvded by the quantty
of output.
A'"rag" 'aria*l" cost are varabe costs dvded by the
quantty of output.
What is Marginal Costing+
It s a costng technque where ony varabe cost or drect cost w be
charged to the cost unt produced.
Margna costng aso shows the effect on proft of changes n voume/type
of output by dfferentatng between fxed and varabe costs.
Saent Ponts:
Margna costng nvoves ascertanng margna costs. Snce
margna costs are drect cost, ths costng technque s aso known
as drect costng;
In margna costng, fxed costs are never charged to producton.
They are treated as perod charge and s wrtten off to the proft and
oss account n the perod ncurred;
Once margna cost s ascertaned contrbuton can be computed.
Contrbuton s the excess of revenue over margna costs.
The margna cost statement s the basc document/format to
capture the margna costs.

F"at!r"s o# Marginal Costing S,st"m-
It s a method of recordng costs and reportng profts;
A operatng costs are dfferentated nto fxed and varabe costs;
Varabe cost C"charged to product and treated as a product cost
whst
Fxed cost treated as perod cost and wrtten off to the proft and oss
account
Disa'antag"s O# Marginal Costing
Margna cost has ts mtaton snce t makes use of hstorca
data whe decsons by management reates to future events;
It gnores fxed costs to products as f they are not mportant
to producton;
Stock vauaton under ths type of costng s not accepted by
the Inand Revenue as tCs gnore the fxed cost eement;
It fas to recognze that n the ong run, fxed costs may
become varabe;
Its oversmpfed costs nto fxed and varabe as f t s so
smpy to demarcate them;
ItCs not a good costng technque n the ong run for prcng
decson as t gnores fxed cost. In the ong run, management
must consder the tota costs not ony the varabe porton;
Dffcuty to cassfy propery varabe and fxed cost perfecty,
hence stock vauaton can be dstorted f fxed cost s cassfy
as varabe.
MARGINAL COSTING AS A MANAGEMENT ACCO.NTING
TOOL
1. Margna Costng s ceary the core aspect of tradtona
management accountng. Some of the cassca appcatons of
management accountng, however, have begun to ose ther
sgnfcance. The queston thus arses: What s the current roe of
Margna Costng n modern management accountng?
2. Busnesses today frequenty voce ther dsapprova of the
tradtona cost accountng approaches. At the begnnng of the
1990s, these crtcsms were taken up by researchers nvoved wth
the appcatons of cost accountng concepts.
The man thrust of the dssatsfacton wth conventona cost
accountng methods s that they are too hghy deveoped and too
compex, and furthermore are no onger needed n ther current
form snce other toos are now avaabe. Cas for ncreased use of
cost management toos, nvestment anayses, and vaue-based too
concepts are frequenty assocated wth crtcsm of the functonaty
of current cost accountng approaches as management toos. Ths
ne of crtcsm sees tte reevance n tradtona cost accountng
tasks such as montorng the economc producton process or
assgnng the costs of nterna actvtes. At ther current eve of
deta, such tasks are nether necessary nor does ther perceved
pseudo accuracy further the goas of management.
The vewpont of the present author s that cost accountng has by
no means ost ts rght to exst, for t s an easy overooked fact that
the data structure requred by the new toos s aready present n
tradtona cost accountng.
3. To assess the present-day vaue of Margna Costng, the changes
occurrng n the busness word must be anayzed more cosey. We
need frst to ook at how the purposes of cost accountng are
shftng before we can determne ts sgnfcance.
() cost pannng takes precedence over cost contro. The
effort nvoved n pannng and montorng costs s ncreasngy
beng seen as excessve. The charge eved aganst tradtona cost
accountng--that ts compex cost aocatons merey generate a knd
of pseudo precson--ends further credence to ths assessment. An
aternatve ncreasngy beng caed for s to contro costs through
drect actvty/process nformaton (quanttes, tmes, quaty) for
cost management at oca, decentrazed eves nstead of reyng on
deayed and dstorted cost data. In partcuar, emprca U.S.
research on approprate varabes for performance measurement, n
the context of contnuous mprovement and modern managera
concepts, s based on ths vew. The need for exact cost pannng
for proftabty management s thus touched on ex ante.
() cost accountng must be empoyed as a too for cost
contro at an eary stage. The reatve sgnfcance of tradtona cost
accountng as a management accountng too w decne as t s
apped many to feds where costs cannot be heavy nfuenced.
More sgnfcant than nfuencng the current costs of producton wth
cost center controng and authorzed-actua comparsons of the
cost of goods manufactured s tmey and market-based authorzed
cost management. The greatest scope for nfuencng costs s at the
eary product deveopment phase and when settng up the
producton processes. At the same tme, ths s the stage where cost
nformaton s most urgenty needed snce the tme and quantty
standards as defned by Bs of Materas (BOMs) and producton
routngs are st ackng. Ths requres dfferent methods of cost
pannng than those normay provded by Margna Costng.
() the behavoura effect of cost nformaton s startng to
be recognzed. There s a strong current of accountng research n
the U.S. that takes human psychoogca factors nto consderaton.
Ths s resutng n an extenson of cost theory beyond ts pure
mcroeconomc bass. Resuts of theoretca and emprca research
based, for exampe, on the prncpa-agent theory ndcate that
knowedge of the "reevant" costs does not aways ead to the
optmzaton of overa enterprse proftabty. Hence, the
perspectve that formed the bass for the absorpton costng ssue
has changed. Theores accordng to whch cost aocatons can
contan nformaton and ncrease the effcency of the use of
avaabe capacty, or where future aocatons can nfuence ex-ante
decsons, requre emprca research.
4. The shft n the purposes of cost accountng s beng
accompaned by a shft n the man appcatons of standard costng.
Costng soutons for market-orented proftabty management and
fe-cyce-based pannng and montorng shoud be deveoped
further. They shoud be mpemented both n ndrect areas and at
the corporate eve. In addton, cost accountng must be ntegrated
nto performance measurement.
Compettve dynamcs are gvng rse to an ncreasng dfferentaton
of market-based proftabty controng. Ths appes to the
management of the proftabty of products and product nes, as
we as dstrbuton channes and ncreasngy customers, customer
groups, and markets. The nformaton requred for ths purpose can
ony be supped by muteve and mutdmensona marketng
segment accountng based on contrbuton margn accountng.
Long-term cost pannng based on the dea of fecyce costng s
ganng n promnence compared wth short-term standard costng.
Product decsons are ncreasngy based on more than |ust the cost
of goods manufactured and saes costs and now tend to ncude pre-
producton costs (such as deveopment costs) and phasng-out costs
(such as dsposa costs). Product decsons are vewed strategcay.
Whether or not a product s successfu s determned by the
amortzaton of ts overa cost. Furthermore, the cost and revenue
trend forecasts shoud be more dynamc to support the fecyce
prcng pocy. Ths shft n cost and revenue pannng s movng cost
and revenue accountng n the drecton of nvestment-reated
cacuatons.
As management accountng s ncreasngy apped to the growng
share of the costs of ndrect areas, the too requrements ncrease.
After |. G. Mer's and T. E. Vomann's dscovery of the "hdden
factory" as an area whose costs are negected by conventona
producton costng n the U.S., t was ony a sma step to the
dentfcaton of the ost reevance of conventona cost accountng
by H. T. |ohnson and R. S. Kapan and ther ca to deveop
accountng systems separated nto "process contro, product
costng, and fnanca reportng," whch eventuay ed to actvty-
based costng. Improvng the cost transparency of ndrect actvty
areas through Margna Costng requres a thorough understandng
of the output processes. Anayss frequenty shows that even many
support actvtes have a wde range of repettve processes for
whch pannng and cost aocaton usng drvers s worthwhe,
provdng the cost-voume s arge enough. For ths purpose, the
dfferent operatons n the cost centers must be dentfed, for whch
resource consumpton s then panned and tracked. The number of
these operatons s used as the drver. Ths process of costng
operatons usng proportona costs competes wth the attempt to
acheve better cost transparency n ndrect areas wth process
costng toos to aso mprove the pannng and contro of costs that
were prevousy budgeted ony as a ump sum.
Industra producton and marketng are ncreasngy beng handed
by groups of affated companes. To pan and montor the costs of
these actvtes cas for the estabshment of ndependent group
cost accountng. Ths necessty resuts many from the
requrements of nventory vauaton, the costng bass of transfer
prces, and to further the consstency of corporate cost accountng.
Group cost accountng eads to the defnton of ndependent group
cost categores. Margna Costng and ts toos have been deveoped
for ndvdua companes and are the sutabe patform for ths
expanson.
Performance measures are ganng ncreasng promnence n
decentrazed management accountng. Standard U.S. management
books devote a great dea of space to performance measurement n
the broad sense of the word. The concept s broad for the reason
that performance measurement s accompaned by the provson of
decson-support nformaton, the management of busness unts,
and the use of ncentve systems. Usng modeng and emprca
research, the exponents of ths area are deveopng the dea that
monetary factors are not the ony possbe components of
performance measurement.
Snce the 1980s there has been a growng conscousness of the
sgnfcance of contnuousy mprovng the performance capabtes
of the company, resutng n the ncreased mportance of
nonmonetary ndcators. The recent terature on performance
measurement has focused on probems n the foowng areas:
* The usabty of performance nformaton for managers,
* The assessment of teamwork,
* The motvatona effects of performance measurement,
* The strategc dmenson.
The tenor of the recent nvestgatons nto performance
measurement refects the genera crtcsm of management
accountng voced by |ohnson and Kapan n Reevance Lost. It was
recognzed that short-term accountng nformaton s nsuffcent to
evauate and contro company actvtes effectvey. In partcuar, t
was acknowedged that the use of standard costs does not
adequatey take performance mprovements nto consderaton.
Moreover, the conventona aocaton approach based on the
operatng rate encourages hgh utzaton of capacty at any cost,
underestmates the probem of ncreasng numbers of varants, uses
the wrong overhead aocaton base, and fas to apprecate
nterdepartmenta nterreatonshps.
Whe top management benefts most from fnanca success
ndcators that t examnes n monthy or onger ntervas and that
can consst of mutdmensona aggregate fgures, ower
management must necessary be concerned many wth
nonfnanca, operatona, and very short-term data at the day or
shft eve. In concrete terms, measures n the categores of tme,
quantty, and quaty--such as equpment downtme, ead tme,
response tme, degree of utzaton (rato of actua output quantty
to panned output quantty), saes orders, and error rate--are
becomng ncreasngy sgnfcant for controng busness processes.
In the strategc dmenson, the Baanced Scorecard deveoped by
Kapan and Norton--whch nks fnanca and nonfnanca ndcators
from dfferent strategcay reevant perspectves ncudng cause-
effect chans--s the man proposa under consderaton for
performance measurement. The Baanced Scorecard nks strategc
contngences to fnanca measures, ncorporates success factors of
the future, and expcty ncudes monetary and nonmonetary
parameters. The Baanced Scorecard therefore provdes a
framework for systematc mappng and contro of the crtca
success factors for an enterprse. A Baanced Scorecard s a system
that defnes ob|ectves, measures, targets, and ntatves for each of
the four perspectves of fnanca, customer, nterna busness
process, and earnng and growth. Further anayses and experence
n measurng performance can enabe dentfcaton and assessment
of cause-effect reatonshps wthn the four perspectves (such as
the effect of devery tme on customer satsfacton) and between
the perspectves (such as the effect of customer satsfacton on
proftabty). The knowedge so ganed may eventuay ead to a
reformuaton of strategy.
In the context of comprehensve performance measurement, even
short-term costs and fnanca resuts can serve as contro
nstruments for strategc enterprse management, such as a ower
authorzed cost of goods manufactured as a benchmark. Concrete
panned costs and panned resuts must be rgorousy derved from
hgher-eve target factors so that specfc requrements can be
derved n turn when they are broken down nto smaer
organzatona unts for the tme and quantty standards.
Informaton for decson makng The need for a decson arses n
busness because a manager s faced wth a probem and aternatve
courses of acton are avaabe. In decdng whch opton to choose
he w need a the nformaton whch s reevant to hs decson; and
he must have some crteron on the bass of whch he can choose
the best aternatve. Some of the factors affectng the decson may
not be expressed n monetary vaue. Hence, the manager w have
to make 'quatatve' |udgements, e.g. n decdng whch of two
personne shoud be promoted to a managera poston. A
'quanttatve' decson, on the other hand, s possbe when the
varous factors, and reatonshps between them, are measurabe.
Ths chapter w concentrate on quanttatve decsons based on
data expressed n monetary vaue and reatng to costs and
revenues as measured by the management accountant.
El"m"nts o# a "cision
A quanttatve decson probem nvoves sx parts:
a) An o*/"cti'" that can *" 0!anti#i" Sometmes referred to as
'choce crteron' or 'ob|ectve functon', e.g. maxmsaton of proft
or mnmsaton of tota costs.
b) Constraints Many decson probems have one or more
constrants, e.g. mted raw materas, abour, etc. It s therefore
common to fnd an ob|ectve that w maxmse profts sub|ect to
defned constrants.
c) A rang" o# alt"rnati'" co!rs"s o# action under consderaton.
For exampe, n order to mnmse costs of a manufacturng
operaton, the avaabe aternatves may be:
) to contnue manufacturng as at present
) to change the manufacturng method
) to sub-contract the work to a thrd party.
d) For"casting of the ncrementa costs and benefts of each
aternatve course of acton.
e) A((lication of the decson crtera or ob|ectve functon, e.g. the
cacuaton of expected proft or contrbuton, and the rankng of
aternatves.
f) Choic" of preferred aternatves.
R"l"'ant costs #or "cision ma1ing
The costs whch shoud be used for decson makng are often
referred to as "reevant costs". CIMA defnes reevant costs as 'costs
approprate to adng the makng of specfc management decsons'.
To affect a decson a cost must be:
a2 F!t!r": Past costs are rreevant, as we cannot affect them by
current decsons and they are common to a aternatves that we
may choose.
*2 Incr"m"ntal- ' Meanng, expendture whch w be ncurred or
avoded as a resut of makng a decson. Any costs whch woud be
ncurred whether or not the decson s made are not sad to be
ncrementa to the decson.
c2 Cash #lo3- Expenses such as deprecaton are not cash fows
and are therefore not reevant. Smary, the book vaue of exstng
equpment s rreevant, but the dsposa vaue s reevant.
Other terms:
2 Common costs: Costs whch w be dentca for a aternatves
are rreevant, e.g. rent or rates on a factory woud be ncurred
whatever products are produced.
"2 S!n1 costs: Another name for past costs, whch are aways
rreevant, e.g. dedcated fxed assets, deveopment costs aready
ncurred.
#2 Committ" costs- A future cash outfow that w be ncurred
anyway, whatever decson s taken now, e.g. contracts aready
entered nto whch cannot be atered.
O((ort!nit, cost
Reevant costs may aso be expressed as opportunty costs. An
opportunty cost s the beneft foregone by choosng one opportunty
nstead of the next best aternatve.
E$am(l"
A company s consderng pubshng a mted edton book bound n
a speca eather. It has n stock the eather bought some years ago
for $1,000. To buy an equvaent quantty now woud cost $2,000.
The company has no pans to use the eather for other purposes,
athough t has consdered the possbtes:
a) of usng t to cover desk furnshngs, n repacement for other
matera whch coud cost $900
b) of seng t f a buyer coud be found (the proceeds are unkey to
exceed $800).
In cacuatng the key proft from the proposed book before
decdng to go ahead wth the pro|ect, the eather woud not be
costed at $1,000. The cost was ncurred n the past for some reason
whch s no onger reevant. The eather exsts and coud be used on
the book wthout ncurrng any specfc cost n dong so. In usng the
eather on the book, however, the company w ose the
opportuntes of ether dsposng of t for $800 or of usng t to save
an outay of $900 on desk furnshngs.
The better of these aternatves, from the pont of vew of beneftng
from the eather, s the atter. "Lost opportunty" cost of $900 w
therefore be ncuded n the cost of the book for decson makng
purposes.
The reevant costs for decson purposes w be the sum of:
) 'avodabe outay costs', .e. those costs whch w be ncurred ony
f the book pro|ect s approved, and w be avoded f t s not
) the opportunty cost of the eather (not represented by any outay
cost n connecton to the pro|ect).
Ths tota s a true representaton of 'economc cost'.
Now attempt exercse 5.1.
Th" ass!m(tions in r"l"'ant costing
Some of the assumptons made n reevant costng are as foows:
a) Cost behavour patterns are known, e.g. f a department coses
down, the attrbutabe fxed cost savngs woud be known.
b) The amount of fxed costs, unt varabe costs, saes prce and
saes demand are known wth certanty.
c) The ob|ectve of decson makng n the short run s to maxmse
'satsfacton', whch s often known as 'short-term proft'.
d) The nformaton on whch a decson s based s compete and
reabe.
T4E BASIC DECISION MA5ING INDICATORS IN
MARGINAL COSTING
PROFIT VOLUME RATIO
BREAK- EVEN POINT
CASH VOLUME PROFIT ANALYSIS
MARGIN OF SAFETY
INDIFFERENCE POINT
SHUT - DOWN POINT
PROFIT )OL.ME RATIO 6P ) RATIO 2
The proft voume rato s the reatonshp between the Contrbuton
and Saes vaue.
It s aso termed as Contrbuton to Saes Rato
Formua :
P ) Ratio 7 Contri*!tion 8 9::
Sal"s
Signi#icanc" o# P) Ratio
It s consdered to be the basc ndcator of proftabty of
busness.
The hgher the PV Rato, the better t s for the busness. In the
case of the frm en|oyng steady busness condtons over a
perod of years, the PV Rato w aso reman stabe and
steady.
If PV Rato s mproved, t w resut n better profts.
Im(ro'"m"nt o# P) Ratio
By reducng the varabe costs.
By ncreasng the seng prce
By ncreasng the share of products wth hgher PV Rato n the
overa saes mx. (where a frm produces a number of
products)
.s" o# P) Ratio
To compute the varabe costs for any voume of saes
To measure the effcency or to choose a most proftabe ne.
The overa proftabty of the frm can be mproved by
ncreasng the saes/output of product gvng a hgher PV
Rato.
To determne the Break - Even Pont and the eve of output
requred to earn a desred proft.
To decde the most proftabe saes - mx.
BREA5 ; E)EN ANALYSIS
Br"a1<E'"n Anal,sis s a mathematca technque for
anayzng the reatonshp between saes and fxed and
varabe costs. Break-even anayss s aso a proft-pannng
too for cacuatng the pont at whch saes w equa tota
costs.
The break-even pont s the ntersecton of the tota saes and
the tota cost nes. Ths pont determnes the number of unts
produced to acheve breakeven.
The anayss generay assumes nearty (100% varabe or
100% fxed) of costs. If a frms costs were a varabe, the
frm coud be proftabe from the start. If the frm s to avod
osses, ts saes must cover a costs that vary drecty wth
producton and a costs that do not change wth producton
eves.
Fxed costs are those expenses assocated wth the pro|ect
that you woud have to pay whether you sod one unt or
10,000 unts. Exampes ncude genera offce expenses, rent,
deprecaton, nterest, saares, research and deveopment,
and uttes. Varabe costs vary drecty wth the number of
unts that you se. Exampes ncude materas, drect abour,
postage, packagng, and advertsng. Some costs are dffcut
to cassfy. As a genera gudene, f there s a drect
reatonshp between cost and number of unts sod, consder
the cost varabe. If there s no reatonshp, then consder the
cost fxed.
A break-even chart s constructed wth a horzonta axs
representng unts produced and a vertca axs representng
saes and costs. Represent fxed costs by a horzonta ne
snce they do not change wth the number of unts produced.
Represent varabe costs and saes by upward sopng nes
snce they vary wth the number of unts produced and sod.
The break-even pont s the ntersecton of the tota saes and
the tota cost nes. Above that pont, the frm begns to make
a proft, but beow that pont, t suffers a oss. Here s a sampe
break-even chart:
The agebrac equaton for break-even anayss conssts of four
factors. If you know any three of the four, you can sove for
the fourth factor. You cacuate the break-even amount wth
the foowng equaton:
Saes Prce per Unt * Ouantty Sod = Fxed Costs + |Varabe
Costs per Unt * Ouantty Sod|
For exampe, assume you have tota fxed monthy costs of
$1200 and tota varabe costs of $6 per unt. If you coud se
the unts for $10 each, the equaton ndcates that you need to
se 300 unts to break even. If you knew you coud se 400
unts, the equaton woud ndcate that the saes prce woud
need to be $9 per unt to break even.
When managng nventory, you shoud am for the Economic
Or"r =!antit, (EOO). Ths s the eve of nventory that
baances two knds of nventory costs: hodng (or carryng)
costs, whch ncrease wth the amount of nventory ordered,
and order costs, whch decrease wth the amount ordered.
The argest components of hodng costs for most companes
are the cost of space to store the nventory and the cost of
tyng up capta n nventory. Other components ncude the
abour costs assocated wth nventory mantenance and
nsurance costs. Aso ncude deteroraton, spoage, and
obsoescence costs. The costs of more frequent orders ncude
ost dscounts for arger quantty purchases and abour and
suppy costs of wrtng the orders. Addtona costs ncude
payng the bs and processng the paperwork, assocated
teephone and ma costs, and the abour costs of processng
and nspectng ncomng nventory.
EOO s the sze of order that mnmzes the tota of hodng
and orderng costs. The agebrac expresson of EOO s as
foows:
EOO = square root of |2*U*O dvded by H| where U s the
number of unts used annuay, O s the order cost per order,
and H s the hodng cost per unt.
For exampe, assume you use 40,000 unts annuay, t costs
$50 to pace an order, and t costs $20 to hod the raw
materas for one unt. The equaton yeds an amount of 447,
whch s the number of unts you need to order at one tme to
mnmze tota costs.
The reorder pont, or Economic Or"r Point (EOP), tes you
when to pace an order. Cacuatng the reorder pont requres
you to know the ead tme from pacng to recevng an order.
You compute t as foows:
EOP = Lead tme * Average usage per unt of tme
For exampe, assume you need 6400 unts eveny throughout the
year, there s a ead tme of one week, and there are 50 workng
weeks n the year. You cacuate the reorder pont to be 128 unts as
foows.
1 week * |6400 unts / 50 weeks| = 128 unts
You mght aso consder ">!st In Tim"" nventory management, f
avaabe and approprate. "|ust In Tme" aows you to keep mnma
nventory n stock. You ony order when you make a sae. Carefuy
anayze the tme ag. You must be abe to satsfy the customer as
we as keep your nventory nvestment mnmzed.
.s" o# BEP Anal,sis In ca(ital *!g"ting
Break even anayss s a speca appcaton of senstvty anayss. It
ams at fndng the vaue of ndvdua varabes whch the pro|ects
NPV s zero. In common wth senstvty anayss, varabes seected
for the break even anayss can be tested ony one at a tme.
The break even anayss resuts can be used to decde abandon of
the pro|ect f forecasts show that beow break even vaues are key
to occur.
In usng break even anayss, t s mportant to remember the
probem assocated wth senstvty anayss as we as some
extenson specfc to the method:
Varabes are often nterdependent, whch makes examnng
them each ndvduay unreastc.
Often the assumptons upon whch the anayss s based are
made by usng past experence / data whch may not hod n
the future.
Varabes have been ad|usted one by one; however t s
unkey that n the fe of the pro|ect ony one varabe w
change unt reachng the break even pont. Management
decsons made by observng the behavour of ony one
varabe are most key to be nvad.
Break even anayss s a pessmstc approach by essence. The
fgures sha be used ony as a ne of defence n the pro|ect
anayss.
Limitations O# BEP Anal,sis
Break-even anayss s ony a suppy sde (i.e. costs ony)
anayss, as t tes you nothng about what saes are actuay
key to be for the product at these varous prces.
It assumes that fxed costs (FC) are constant
It assumes average varabe costs are constant per unt of
output, at east n the range of key quanttes of saes. (i.e.
nearty)
It assumes that the quantty of goods produced s equa to the
quantty of goods sod (.e., there s no change n the quantty
of goods hed n nventory at the begnnng of the perod and
the quantty of goods hed n nventory at the end of the
perod).
In mut-product companes, t assumes that the reatve
proportons of each product sod and produced are constant
(i.e., the saes mx s constant).
COST )OL.ME PROFIT ANALYSIS
Anayss that deas wth how profts and costs change wth a
change n voume. More specfcay, t ooks at the effects on
profts of changes n such factors as varabe costs, fxed
costs, seng prces, voume, and mx of products sod.
CVP anayss nvoves the anayss of how tota costs, tota
revenues and tota profts are reated to saes voume, and s
therefore concerned wth predctng the effects of changes n
costs and saes voume on proft. It s aso known as
'breakeven anayss'.

By studyng the reatonshps of costs, saes, and net ncome,
management s better abe to cope wth many pannng
decsons. For exampe, CVP anayss attempts to answer the
foowng questons: (1)
What saes voume s requred to break even?
(2) What saes voume s necessary n order to earn a desred
(target) proft? (3) What proft can be expected on a gven
saes voume? (4) How woud changes n
seng prce, varabe costs, fxed costs, and output affect
profts?
(5) How woud a change n the mx of products sod affect the
break-even and target voume and proft potenta?
Cost-voume-proft anayss (CVP), or break-even anayss, s
used to compute the voume eve at whch tota revenues are
equa to tota costs. When tota costs and tota revenues are
equa, the busness organzaton s sad to be "breakng even."
The anayss s based on a set of near equatons for a straght
ne and the separaton of varabe and fxed costs.
Tota varabe costs are consdered to be those costs that vary
as the producton voume changes. In a factory, producton
voume s consdered to be the number of unts produced, but
n a governmenta organzaton wth no assemby process, the
unts produced mght refer, for exampe, to the number of
wefare cases processed.
There are a number of costs that vary or change, but f the
varaton s not due to voume changes, t s not consdered to
be a varabe cost. Exampes of varabe costs are drect
materas and drect abour. Tota fxed costs do not vary as
voume eves change wthn the reevant range. Exampes of
fxed costs are straght-ne deprecaton and annua nsurance
charges.
A the nes n the chart are straght nes: Lnearty s an
underyng assumpton of CVP anayss. Athough no one can
be certan that costs are near over the entre range of output
or producton, ths s an assumpton of CVP.
To hep aevate the mtatons of ths assumpton, t s aso
assumed that the near reatonshps hod ony wthn the
reevant range of producton. The reevant range s
represented by the hgh and ow output ponts that have been
prevousy reached wth past producton. CVP anayss s best
vewed wthn the reevant range, that s, wthn our prevous
actua experence. Outsde of that range, costs may vary n a
nonnear manner. The straght-ne equaton for tota cost s:
Tota cost = tota fxed cost + tota varabe cost
Tota varabe cost s cacuated by mutpyng the cost of a
unt, whch remans constant on a per-unt bass, by
the number of unts produced. Therefore the tota cost
equaton coud be expanded as:
Tota cost = tota fxed cost + (varabe cost per unt number
of unts)
Tota fxed costs do not change.
A fna verson of the equaton s:
Y = a + bx
where a s the fxed cost, b s the varabe cost per unt, x s
the eve of actvty, and Y s the tota cost. Assume that the
fxed costs are $5,000, the voume of unts produced s 1,000,
and the per-unt varabe cost s $2. In that case the tota cost
woud be computed as foows:
Y = $5,000 + ($2 1,000) Y = $7,000
It can be seen that t s mportant to separate varabe and
fxed costs. Another reason t s mportant to separate these
costs s because varabe costs are used to determne the
contrbuton margn, and the contrbuton margn s used to
determne the break-even pont. The contrbuton margn s
the dfference between the per-unt varabe cost and the
seng prce per unt. For exampe, f the per-unt varabe cost
s $15 and seng prce per unt s $20, then the contrbuton
margn s equa to $5. The contrbuton margn may provde a
$5 contribution toward the reducton of fxed costs or a $5
contrbuton to profts. If the busness s operatng at a voume
above the break-even pont voume (above pont F), then the
$5 s a contrbuton (on a per-unt bass) to addtona profts. If
the busness s operatng at a voume beow the break-even
pont (beow pont F), then the $5 provdes for a reducton n
fxed costs and contnues to do so unt the break-even pont s
passed.
Once the contrbuton margn s determned, t can be used to
cacuate the break-even pont n voume of unts or n tota
saes doars. When a per-unt contrbuton margn occurs
beow a frm's break-even pont, t s a contrbuton to the
reducton of fxed costs. Therefore, t s ogca to dvde fxed
costs by the contrbuton margn to determne how many unts
must be produced to reach the break-even pont:
The fnanca nformaton requred for CVP anayss s for
nterna use and s usuay avaabe ony to managers nsde
the frm; nformaton about varabe and fxed costs s not
avaabe to the genera pubc. CVP anayss s good as a
genera gude for one product wthn the reevant range. If the
company has more than one product, then the contrbuton
margns from a products must be averaged together. But,
any cost-averagng process reduces the eve of accuracy as
compared to workng wth cost data from a snge product.
Furthermore, some organzatons, such as nonprofts
organzatons, do not ncur a sgnfcant eve of varabe costs.
In these cases, standard CVP assumptons can ead to
mseadng resuts and decsons.
.SES OF C)P ANALYSIS
a2 B!g"t (lanning. The voume of saes requred to make a proft
(breakeven pont) and the 'safety margn' for profts n the budget
can be measured.
*2 Pricing an sal"s 'ol!m" "cisions?
c2 Sal"s mi$ "cisions, to determne n what proportons each
product shoud be sod.
2 D"cisions that 3ill a##"ct th" cost str!ct!r" an
(ro!ction ca(acit, o# th" com(an,?
T4E BASIC PRINCIPLES OF C)P ANALYSIS
CVP anayss s based on the assumpton of a near tota cost
functon (constant unt varabe cost and constant fxed costs) and
so s an appcaton of margna costng prncpes.
The prncpes of margna costng can be summarsed as foows:
a) Perod fxed costs are a constant amount, therefore f one
extra unt of product s made and sod, tota costs w ony rse
by the varabe cost (the marginal cost) of producton and
saes for that unt.
b) Aso, tota costs w fa by the varabe cost per unt for
each reducton by one unt n the eve of actvty.
c) The addtona proft earned by makng and seng one
extra unt s the extra revenue from ts saes mnus ts varabe
costs, .e. the contrbuton per unt.
d) As the voume of actvty ncreases, there w be an
ncrease n tota profts (or a reducton n osses) equa to the
tota revenue mnus the tota extra varabe costs. Ths s the
extra contrbuton from the extra output and saes.
e) The tota proft n a perod s the tota revenue mnus the
tota varabe cost of goods sod, mnus the fxed costs of the
perod.
MARGIN OF SAFETY
Margn of safety represents the strength of the busness. It enabes
a busness to know that what s the exact amount he/ she has
ganed or oss over or beow break even pont).
Margn of safety = (( saes - break-even saes) / saes) x 100% If P/V
rato s gven then saes/pv rato
In !nit sal"s
If the product can be sod n a arger quantty that occurs at the
breakeven pont, then the frm w make a proft; beow ths pont, a
oss. Break-even quantty s cacuated by:
Tota fxed costs / (seng prce - average varabe costs).
Expanaton - n the denomnator, "prce mnus average
varabe cost" s the varabe proft per unt, or contrbuton
margn of each unt that s sod.
Ths reatonshp s derved from the proft equaton: Proft =
Revenues - Costs where Revenues = (seng prce * quantty
of product) and Costs = (average varabe costs * quantty) +
tota fxed costs.
Therefore, Proft = (seng prce * quantty) - (average varabe
costs * quantty + tota fxed costs).
Sovng for Ouantty of product at the breakeven pont when
Proft equas zero, the quantty of product at breakeven s Tota
fxed costs / (seng prce - average varabe costs).
Frms may st decde not to se ow-proft products, for exampe
those not fttng we nto ther saes mx. Frms may aso se
products that ose money - as a oss eader, to offer a compete ne
of products, etc. But f a product does not break even, or a potenta
product ooks ke t ceary w not se better than the breakeven
pont, then the frm w not se, or w stop seng, that product.
An exampe:
Assume we are seng a product for $2 each.
Assume that the varabe cost assocated wth producng and
seng the product s 60 cents.
Assume that the fxed cost reated to the product (the basc
costs that are ncurred n operatng the busness even f no
product s produced) s $1000.
In ths exampe, the frm woud have to se (1000 / (2.00 -
0.60) = 715) 715 unts to break even. n that case the margn
of safety vaue of NIL and the vaue of BEP s not proftabe or
not ganng oss.
Break Even = FC / (SP - VC)
where FC s Fxed Cost, SP s seng Prce and VC s Varabe Cost
Signi#icanc"-
Up to the BEP, the contrbuton s earned s suffcent ony to
recover the fxed costs. However the beyond the BEP, the
contrbuton s caed the proft
Proft s nothng but the contrbuton earned out of margn of
safety of saes.
The sze of the margn of safety shows the strength of the
busness.
A ow margn of safety ndcates the frm has a arge fxed
expenses and s mor vunerabe to changes.
A hgh margn of safety mpes that a sght fa n saes may
not the busness very much.
Im(ro'"m"nts in margin o# sa#"t,-
The possbe steps for mprove the margn of safety.
Increase n seng prce, provded the demand s neastc so
as to absorb the ncreased prces.
Reducton n fxed expenses
Reducton n varabe expenses
Increasng the saes voume provded capacty s avaabe.
Substtuton or ntroducton of a product mx such that more
proftabe nes are ntroduced.
S4.T DOWN PROBLEMS
Shut down pont ndcates the eve of operaton(saes), beow whch
t s not |ustfabe to pursue producton. For ths purpose fxed
expenses of a busness are cassfed as () avodabe or
dscretonary fxed costs () unavodabe or commtted fxed costs.
The focus of shut down pont cacuaton s to recover the avodabe
fxed costs n the frst pace. By suspendng the operatons, the frm
may save as aso ncur some addtona expendture. The decson s
based on whether contrbuton s more than the dfference between
the fxed expenses ncurred n norma operaton and the fxed
expense ncurred when the pant s shut down.
A frm has to cose down f ts contrbuton s nsuffcent to recover
even the avodabe fxed costs.
Shutdown probems nvove the foowng types of decsons:
a) Whether or not to cose down a factory, department, product ne
or other actvty, ether because t s makng osses or because t s
too expensve to run.
b) If the decson s to shut down, whether the cosure shoud be
permanent or temporary. Shutdown decsons often nvove ong
term consderatons, and capta expendtures and revenues.
c) A shutdown shoud resut n savngs n annua operatng costs for
a number of years n the future.
d) Cosure resuts n reease of some fxed assets for sae. Some
assets mght have a sma scrap vaue, but others, e.g. property,
mght have a substanta sae vaue.
e) Empoyees affected by the cosure must be made redundant or
reocated, perhaps even offered eary retrement. There w be ump
sums payments nvoved whch must be taken nto consderaton.
For exampe, suppose cosure of a regona offce resuts n annua
savngs of $100,000, fxed assets sod off for $2 mon, but
redundancy payments woud be $3 mon. The shutdown decson
woud nvove an assessment of the net capta cost of cosure ($1
mon) aganst the annua benefts ($100,000 per annum).
It s possbe for shutdown probems to be smpfed nto short run
decsons, by makng one of the foowng assumptons
a) Fxed asset saes and redundancy costs woud be neggbe.
b) Income from fxed asset saes woud match redundancy costs and
so these tems woud be sef-canceng.
In these crcumstances the fnanca aspects of shutdown decsons
woud be based on short run reevant costs.
CAS4 POSITION AND FORECAST
The Cash poston and forecast enqury s usuay used by the
Treasurer or whoever s responsbe for ensurng that the
company has adequate funds for expected outgongs.
The Cash Poston nput data s the known baances:
Postngs n cash and bank accounts (any account reevant to
cash management),the unreconced entres n the bank
cearng accounts (uncashed cheques etc), and
any memo records whch may have been manuay entered
(pannng advces) as reevant to a cash poston
cash fows from transactons managed n Treasury
Management
Exampes are:
-bank baances
-outgong checks posted to the bank cearng account
-outgong transfers posted to the bank cearng account
-maturng deposts and oans
-notfed ncomng payments posted to the bank account
-ncomng payments wth a vaue date

G.IDELINES FOR R.NNING T4E CAS4


POSITION OR FORECAST EN=.IRY
9? .n"rstaning th" B!sin"ss R"0!ir"m"nts
Descrbes the nformaton that you shoud gather about your
company's operatons n ths area to adequatey confgure t.
@? Dat"s an th" Cash For"cast
The Cash poston and forecast s a about amounts and dates. The
secton expans how the dates are determned for the varous
nputs.
A? Cash For"cast T"rminolog,
Expans the key terms that are encountered n the confguraton.
Must be read before embarkng on the confguraton secton.
B? Cash For"cast Con#ig!ration
Gudenes on confgurng the Cash Poston and Forecast - presented
n two sectons - essenta and then advanced confguraton.
C? R"lat" Con#ig!ration D Proc"ssing ar"as
Descrbes some of the reated confguraton and processng areas
that mpact or feed data to the cash forecast.
E? Pr"(aring t"st ata
Presents some hnts on preparng test data drecty wthout havng
to run the feeder programs.
PROFIT AND LOSS FORECAST
A Proft and Loss Account s desgned to show the fnanca
performance of a busness over a gven perod (usuay Monthy or
Annuay) and to ndcate whether t s (or, n the case of a P & L
Forecast, f t w) make or ose money.
Wthout Proft there eventuay w be no busness
Proft and Loss s aso essenta n provdng nformaton for Inand
Revenue for Taxaton purposes
Understandng how a Proft and Loss Account works w hep you to
choose the rght tme to buy tems that you need for the busness,
reduce your tax abty (Tax B) and work out how much Tax you
w have to pay.
PROFIT AND PLANNING
Proft pannng s essenta when you want your busness to focus on
enhancng ts proft-makng capabtes. Effectve proft pannng
happens when you determne n advance a set of cear and reastc
goas that your busness or organzaton needs to fuf. Those goas
must be based upon ob|ectve exstng and expected busness
condtons. Antcpatng the changes n your busness envronment s
aso centra to proft pannng.
Gven the centra roe proft pannng can pay n the future
prospects of an organzaton, t mght come as a surprse to earn
that a arge number of busnesses do not usuay have or deveop a
fnanca pan. What s even more amazng s that many of the
busnesses whch do pan for ther fnanca future often |ust repeat
the same procedure over and over every year. They do not take the
tme to ook at how the pan works, or f t s reay workng.
A very sma number of busnesses currenty knows how to practce
and beneft from profcent proft pannng. However, research
ndcates that proft pannng mght be a centra reason behnd the
ncreased saes and profts en|oyed by these few busnesses.
Approprate proft pannng can hep your company en|oy those
benefts too.
Effectve proft pannng can have a deep mpact n the fe of your
organzaton. The professonas at FRS Consutants beeve that
proft pannng s a key eement whch has ed to the success of bg
and sma busnesses ake. That sad, t coud truy ensure
contnuous prosperty for your own busness, as we. FRS
Consutants s a trustworthy frm of honest and experenced
professonas that can ead you to make the best out of proft
pannng. Many godbrcks n the fed are more eager to charge you
premums for ther tme than to dever what you are payng for. At
FRS Consutants we do not shrk our work. We w strve to dever
on tme and prove the vaue of our servce. Other consutng frms
may seem ess expensve than us, but that s not the case. To earn
more or to request a free consutaton pease compete our onne
form.