marginal-costing decisin making- - for merge

7/30/2019 Marginal-Costing Decisin Making- - For Merge

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TOPICS

1. Marginal costing

2. Marginal cost

3. Relationship b/w marginal costing and economies of scale

4. Relevance of marginal private and social costs in marginal

cost theory

5. Features of marginal costing system

6. Advantages of marginal costing system

7. Disadvantages of marginal costing system

8. Marginal costing as a management accounting tool

9. Elements of decision making

10. Relevant costs of decision making

11. Basic decision making indicators in marginal costing

o Profit volume ratio

o

Cash volume profit analysis

o Break-even analysis

o Margin of safety

o Shut down point

12. Cash position and forecast

13. Profit and loss forecast

14. Profit planning

o

MARGINAL COSTING AS A COSTING SYSTEM


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Marginal Costing is a type of flexible standard costing that

separates fixed costs from proportional costs in relation to the

output quantity of the objects. In particular, Marginal Costing is a

comprehensive and sophisticated method of planning and

monitoring costs based on resource drivers. Selecting the resourcedrivers and separating the costs into fixed and proportional

components ensures that cost fluctuations caused by changes in

operating levels, as defined by marginal analysis, are accurately

predicted as changes in authorized costs and incorporated into

variance analysis.

This form of internal management accounting has become widely

accepted in business practice over the last 50 years. During this

time, however, the demands placed on costing systems by cost

management requirements have changed radically.

MARGINAL COST

In economics and finance, marginal cost is the change in total costthat arises when the quantity produced changes by one unit. It isthe cost of producing one more unit of a good.[1] Mathematically, themarginal cost (MC) function is expressed as the first derivative ofthe total cost (TC) function with respect to quantity (Q). Note that

the marginal cost may change with volume, and so at each level ofproduction, the marginal cost is the cost of the next unit produced.

A typical Marginal Cost Curve
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In general terms, marginal cost at each level of production includesany additional costs required to produce the next unit. If producingadditional vehicles requires, for example, building a new factory, themarginal cost of those extra vehicles includes the cost of the newfactory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At eachlevel of production and time period being considered, marginal costsinclude all costs which vary with the level of production, and othercosts are considered fixed costs.

A number of other factors can affect marginal cost and itsapplicability to real world problems. Some of these may be

considered market failures. These may include informationasymmetries, the presence of negative or positive externalities,transaction costs, price discrimination and others.

RELATION BETWEEN MARGINAL COST AND ECONOMIES OFSCALE

Production may be subject to economies of scale (ordiseconomies of scale). Increasing returns to scale are said toexist if additional units can be produced for less than theprevious unit, that is, average cost is falling.

This can only occur if average cost at any given level ofproduction is higher than the marginal cost.

Conversely, there may be levels of production wheremarginal cost is higher than average cost, and average costwill rise for each unit of production after that point. This typeof production function is generally known as diminishingmarginal productivity: at low levels of production, productivitygains are easy and marginal costs falling, but productivitygains become smaller as production increases; eventually,marginal costs rise because increasing output (with existing

capital, labour or organization) becomes more expensive. Forthis generic case, minimum average cost occurs at the pointwhere average cost and marginal cost are equal (whenplotted, the two curves intersect); this point will notbe at theminimum for marginal cost if fixed costs are greater than zero.

Short and long run marginal costs and economies of scale

The former takes as unchanged, for example, the capital equipmentand overhead of the producer, any change in its productioninvolving only changes in the inputs of labour, materials and energy.

The latter allows all inputs, including capital items (plant,equipment, buildings) to vary.
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A long-run cost function describes the cost of production as afunction of output assuming that all inputs are obtained at currentprices, that current technology is employed, and everything is beingbuilt new from scratch. In view of the durability of many capitalitems this textbook concept is less useful than one which allows for

some scrapping of existing capital items or the acquisition of newcapital items to be used with the existing stock of capital itemsacquired in the past. Long-run marginal cost then means theadditional cost or the cost saving per unit of additional or reducedproduction, including the expenditure on additional capital goods orany saving from disposing of existing capital goods. Note thatmarginal cost upwards and marginal cost downwards may differ, incontrast with marginal cost according to the less useful textbookconcept.

Economies of scale are said to exist when marginal cost accordingto the textbook concept falls as a function of output and is less thanthe average cost per unit. This means that the average cost ofproduction from a larger new built-from-scratch installation fallsbelow that from a smaller new built-from-scratch installation. Underthe more useful concept, with an existing capital stock, it isnecessary to distinguish those costs which vary with output fromaccounting costs which will also include the interest anddepreciation on that existing capital stock, which may be of adifferent type from what can currently be acquired in past years atpast prices. The concept of economies of scale then does not apply.

Externalities

Externalities are costs (or benefits) that are not borne by the partiesto the economic transaction. A producer may, for example, pollutethe environment, and others may bear those costs. A consumer mayconsume a good which produces benefits for society, such aseducation; because the individual does not receive all of thebenefits, he may consume less than efficiency would suggest.Alternatively, an individual may be a smoker or alcoholic andimpose costs on others. In these cases, production or consumption

of the good in question may differ from the optimum level.

[edit] Negative externalities of production
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Negative Externalities of Production

Much of the time, private and social costs do not diverge from oneanother, but at times social costs may be either greater or less thanprivate costs. When marginal social costs of production are greater

than that of the private cost function, we see the occurrence of anegative externality of production. Productive processes that resultin pollution are a textbook example of production that createsnegative externalities.

Such externalities are a result of firms externalizing their costs ontoa third party in order to reduce their own total cost. As a result ofexternalizing such costs we see that members of society will benegatively affected by such behavior of the firm. In this case, wesee that an increased cost of production on society creates a social

cost curve that depicts a greater cost than the private cost curve.

In an equilibrium state we see that markets creating negativeexternalities of production will overproduce that good. As a result,the socially optimal production level would be lower than thatobserved.

Positive externalities of production

Positive Externalities of Production

When marginal social costs of production are less than that of theprivate cost function, we see the occurrence of a positive externality

of production. Production ofpublic goods are a textbook example ofproduction that create positive externalities. An example of such apublic good, which creates a divergence in social and private costs,includes the production ofeducation. It is often seen that educationis a positive for any whole society, as well as a positive for thosedirectly involved in the market.

Examining the relevant diagram we see that such productioncreates a social cost curve that is less than that of the private curve.In an equilibrium state we see that markets creating positive

externalities of production will under produce that good. As a result,
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the socially optimal production level would be greater than thatobserved.

Social costs

Of great importance in the theory of marginal cost is the distinctionbetween the marginalprivate and social costs. The marginal privatecost shows the cost associated to the firm in question. It is themarginal private cost that is used by business decision makers intheir profit maximization goals, and by individuals in theirpurchasing and consumption choices. Marginal social cost is similarto private cost in that it includes the cost functions of privateenterprise but also that of society as a whole, including parties thathave no direct association with the private costs of production. Itincorporates all negative and positive externalities, of both

production and consumption.

Hence, when deciding whether or how much to buy, buyers takeaccount of the cost to society of their actions ifprivate and socialmarginal cost coincide. The equality of price with social marginalcost, by aligning the interest of the buyer with the interest of thecommunity as a whole is a necessary condition for economicallyefficient resource allocation.

Other cost definitions in marginal costing

Fixed costs are costs which do not vary with output, forexample, rent. In the long run all costs can be consideredvariable.

Variable cost also known as, operating costs,prime costs,on costs and direct costs, are costs which vary directly withthe level of output, for example, labour, fuel, power and costof raw material.

Social costs of production are costs incurred by society, asa whole, resulting from private production.

Average total cost is the total cost divided by the quantityof output.

Average fixed cost is the fixed cost divided by the quantityof output.

Average variable cost are variable costs divided by thequantity of output.
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Disadvantages Of Marginal Costing

Marginal cost has its limitation since it makes use of historicaldata while decisions by management relates to future events;

It ignores fixed costs to products as if they are not importantto production;

Stock valuation under this type of costing is not accepted bythe Inland Revenue as its ignore the fixed cost element;

It fails to recognize that in the long run, fixed costs maybecome variable;

Its oversimplified costs into fixed and variable as if it is so

simply to demarcate them;

Its not a good costing technique in the long run for pricingdecision as it ignores fixed cost. In the long run, managementmust consider the total costs not only the variable portion;

Difficulty to classify properly variable and fixed cost perfectly,hence stock valuation can be distorted if fixed cost is classifyas variable.

Features of Marginal Costing System:

It is a method of recording costs and reporting profits;

All operating costs are differentiated into fixed and variable costs;

Variable cost charged to product and treated as a product costwhilst

Fixed cost treated as period cost and written off to the profit and lossaccount


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MARGINAL COSTING AS A MANAGEMENT ACCOUNTING

TOOL

1. Marginal Costing is clearly the core aspect of traditional

management accounting. Some of the classical applications ofmanagement accounting, however, have begun to lose their

significance. The question thus arises: What is the current role of

Marginal Costing in modern management accounting?

2. Businesses today frequently voice their disapproval of the

traditional cost accounting approaches. At the beginning of the

1990s, these criticisms were taken up by researchers involved with

the applications of cost accounting concepts.

The main thrust of the dissatisfaction with conventional costaccounting methods is that they are too highly developed and too

complex, and furthermore are no longer needed in their current

form since other tools are now available. Calls for increased use of

cost management tools, investment analyses, and value-based tool

concepts are frequently associated with criticism of the functionality

of current cost accounting approaches as management tools. This

line of criticism sees little relevance in traditional cost accounting

tasks such as monitoring the economic production process or

assigning the costs of internal activities. At their current level ofdetail, such tasks are neither necessary nor does their perceived

pseudo accuracy further the goals of management.

The viewpoint of the present author is that cost accounting has by

no means lost its right to exist, for it is an easily overlooked fact that

the data structure required by the new tools is already present in

traditional cost accounting.

3. To assess the present-day value of Marginal Costing, the changesoccurring in the business world must be analyzed more closely. We

need first to look at how the purposes of cost accounting are

shifting before we can determine its significance.

(i) cost planning takes precedence over cost control. The

effort involved in planning and monitoring costs is increasingly

being seen as excessive. The charge levied against traditional cost

accounting--that its complex cost allocations merely generate a kind

of pseudo precision--lends further credence to this assessment. An

alternative increasingly being called for is to control costs through


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direct activity/process information (quantities, times, quality) for

cost management at local, decentralized levels instead of relying on

delayed and distorted cost data. In particular, empirical U.S.

research on appropriate variables for performance measurement, in

the context of continuous improvement and modern managerialconcepts, is based on this view. The need for exact cost planning

for profitability management is thus touched on ex ante.

(ii) cost accounting must be employed as a tool for cost

control at an early stage. The relative significance of traditional cost

accounting as a management accounting tool will decline as it is

applied mainly to fields where costs cannot be heavily influenced.

More significant than influencing the current costs of production

with cost center controlling and authorized-actual comparisons of

the cost of goods manufactured is timely and market-based

authorized cost management. The greatest scope for influencing

costs is at the early product development phase and when setting

up the production processes. At the same time, this is the stage

where cost information is most urgently needed since the time and

quantity standards as defined by Bills of Materials (BOMs) and

production routings are still lacking. This requires different methods

of cost planning than those normally provided by Marginal Costing.

(iii) the behavioural effect of cost information is starting tobe recognized. There is a strong current of accounting research in

the U.S. that takes human psychological factors into consideration.

This is resulting in an extension of cost theory beyond its pure

microeconomic basis. Results of theoretical and empirical research

based, for example, on the principal-agent theory indicate that

knowledge of the "relevant" costs does not always lead to the

optimization of overall enterprise profitability. Hence, the

perspective that formed the basis for the absorption costing issue

has changed. Theories according to which cost allocations cancontain information and increase the efficiency of the use of

available capacity, or where future allocations can influence ex-ante

decisions, require empirical research.

4. The shift in the purposes of cost accounting is being

accompanied by a shift in the main applications of standard costing.

Costing solutions for market-oriented profitability management and

life-cycle-based planning and monitoring should be developed

further. They should be implemented both in indirect areas and atthe corporate level. In addition, cost accounting must be integrated


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into performance measurement.

Competitive dynamics are giving rise to an increasing differentiation

of market-based profitability controlling. This applies to the

management of the profitability of products and product lines, aswell as distribution channels and increasingly customers, customer

groups, and markets. The information required for this purpose can

only be supplied by multilevel and multidimensional marketing

segment accounting based on contribution margin accounting.

Long-term cost planning based on the idea of lifecycle costing is

gaining in prominence compared with short-term standard costing.

Product decisions are increasingly based on more than just the cost

of goods manufactured and sales costs and now tend to include pre-

production costs (such as development costs) and phasing-out costs

(such as disposal costs). Product decisions are viewed strategically.

Whether or not a product is successful is determined by the

amortization of its overall cost. Furthermore, the cost and revenue

trend forecasts should be more dynamic to support the lifecycle

pricing policy. This shift in cost and revenue planning is moving cost

and revenue accounting in the direction of investment-related

calculations.

As management accounting is increasingly applied to the growingshare of the costs of indirect areas, the tool requirements increase.

After J. G. Miller's and T. E. Vollmann's discovery of the "hidden

factory" as an area whose costs are neglected by conventional

production costing in the U.S., it was only a small step to the

identification of the lost relevance of conventional cost accounting

by H. T. Johnson and R. S. Kaplan and their call to develop

accounting systems separated into "process control, product

costing, and financial reporting," which eventually led to activity-

based costing. Improving the cost transparency of indirect activityareas through Marginal Costing requires a thorough understanding

of the output processes. Analysis frequently shows that even many

support activities have a wide range of repetitive processes for

which planning and cost allocation using drivers is worthwhile,

providing the cost-volume is large enough. For this purpose, the

different operations in the cost centers must be identified, for which

resource consumption is then planned and tracked. The number of

these operations is used as the driver. This process of costing

operations using proportional costs competes with the attempt toachieve better cost transparency in indirect areas with process


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costing tools to also improve the planning and control of costs that

were previously budgeted only as a lump sum.

Industrial production and marketing are increasingly being handled

by groups of affiliated companies. To plan and monitor the costs ofthese activities calls for the establishment of independent group

cost accounting. This necessity results mainly from the

requirements of inventory valuation, the costing basis of transfer

prices, and to further the consistency of corporate cost accounting.

Group cost accounting leads to the definition of independent group

cost categories. Marginal Costing and its tools have been developed

for individual companies and are the suitable platform for this

expansion.

Performance measures are gaining increasing prominence in

decentralized management accounting. Standard U.S. management

books devote a great deal of space to performance measurement in

the broad sense of the word. The concept is broad for the reason

that performance measurement is accompanied by the provision of

decision-support information, the management of business units,

and the use of incentive systems. Using modelling and empirical

research, the exponents of this area are developing the idea that

monetary factors are not the only possible components of

performance measurement.

Since the 1980s there has been a growing consciousness of the

significance of continuously improving the performance capabilities

of the company, resulting in the increased importance of

nonmonetary indicators. The recent literature on performance

measurement has focused on problems in the following areas:

* The usability of performance information for managers,

* The assessment of teamwork,

* The motivational effects of performance measurement,

* The strategic dimension.

The tenor of the recent investigations into performance

measurement reflects the general criticism of management

accounting voiced by Johnson and Kaplan in Relevance Lost. It wasrecognized that short-term accounting information is insufficient to


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evaluate and control company activities effectively. In particular, it

was acknowledged that the use of standard costs does not

adequately take performance improvements into consideration.

Moreover, the conventional allocation approach based on the

operating rate encourages high utilization of capacity at any cost,underestimates the problem of increasing numbers of variants, uses

the wrong overhead allocation base, and fails to appreciate

interdepartmental interrelationships.

While top management benefits most from financial success

indicators that it examines in monthly or longer intervals and that

can consist of multidimensional aggregate figures, lower

management must necessarily be concerned mainly with

nonfinancial, operational, and very short-term data at the day or

shift level. In concrete terms, measures in the categories of time,

quantity, and quality--such as equipment downtime, lead time,

response time, degree of utilization (ratio of actual output quantity

to planned output quantity), sales orders, and error rate--are

becoming increasingly significant for controlling business processes.

In the strategic dimension, the Balanced Scorecard developed by

Kaplan and Norton--which links financial and nonfinancial indicators

from different strategically relevant perspectives including cause-

effect chains--is the main proposal under consideration forperformance measurement. The Balanced Scorecard links strategic

contingencies to financial measures, incorporates success factors of

the future, and explicitly includes monetary and nonmonetary

parameters. The Balanced Scorecard therefore provides a

framework for systematic mapping and control of the critical

success factors for an enterprise. A Balanced Scorecard is a system

that defines objectives, measures, targets, and initiatives for each of

the four perspectives of financial, customer, internal business

process, and learning and growth. Further analyses and experiencein measuring performance can enable identification and assessment

of cause-effect relationships within the four perspectives (such as

the effect of delivery time on customer satisfaction) and between

the perspectives (such as the effect of customer satisfaction on

profitability). The knowledge so gained may eventually lead to a

reformulation of strategy.

In the context of comprehensive performance measurement, even

short-term costs and financial results can serve as controlinstruments for strategic enterprise management, such as a lower


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authorized cost of goods manufactured as a benchmark. Concrete

planned costs and planned results must be rigorously derived from

higher-level target factors so that specific requirements can be

derived in turn when they are broken down into smaller

organizational units for the time and quantity standards.

Information for decision making The need for a decision arises inbusiness because a manager is faced with a problem and alternativecourses of action are available. In deciding which option to choosehe will need all the information which is relevant to his decision; andhe must have some criterion on the basis of which he can choosethe best alternative. Some of the factors affecting the decision maynot be expressed in monetary value. Hence, the manager will haveto make 'qualitative' judgements, e.g. in deciding which of twopersonnel should be promoted to a managerial position. A

'quantitative' decision, on the other hand, is possible when thevarious factors, and relationships between them, are measurable.

This chapter will concentrate on quantitative decisions based ondata expressed in monetary value and relating to costs andrevenues as measured by the management accountant.

Elements of a decision

A quantitative decision problem involves six parts:

a) An objective that can be quantified Sometimes referred to as'choice criterion' or 'objective function', e.g. maximisation of profitor minimisation of total costs.

b) Constraints Many decision problems have one or moreconstraints, e.g. limited raw materials, labour, etc. It is thereforecommon to find an objective that will maximise profits subject todefined constraints.

c) A range of alternative courses of action under consideration.For example, in order to minimise costs of a manufacturing

operation, the available alternatives may be:

i) to continue manufacturing as at presentii) to change the manufacturing methodiii) to sub-contract the work to a third party.

d) Forecasting of the incremental costs and benefits of eachalternative course of action.

e) Application of the decision criteria or objective function, e.g. thecalculation of expected profit or contribution, and the ranking ofalternatives.


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f) Choice of preferred alternatives.

Relevant costs for decision making

The costs which should be used for decision making are often

referred to as "relevant costs". CIMA defines relevant costs as 'costsappropriate to aiding the making of specific management decisions'.

To affect a decision a cost must be:

a) Future: Past costs are irrelevant, as we cannot affect them bycurrent decisions and they are common to all alternatives that wemay choose.

b) Incremental: ' Meaning, expenditure which will be incurred oravoided as a result of making a decision. Any costs which would beincurred whether or not the decision is made are not said to beincremental to the decision.

c) Cash flow: Expenses such as depreciation are not cash flowsand are therefore not relevant. Similarly, the book value of existingequipment is irrelevant, but the disposal value is relevant.

Other terms:

d) Common costs: Costs which will be identical for all alternatives

are irrelevant, e.g. rent or rates on a factory would be incurredwhatever products are produced.

e) Sunk costs: Another name for past costs, which are alwaysirrelevant, e.g. dedicated fixed assets, development costs alreadyincurred.

f) Committed costs: A future cash outflow that will be incurredanyway, whatever decision is taken now, e.g. contracts alreadyentered into which cannot be altered.

Opportunity cost

Relevant costs may also be expressed as opportunity costs. Anopportunity cost is the benefit foregone by choosing one opportunityinstead of the next best alternative.

Example

A company is considering publishing a limited edition book bound ina special leather. It has in stock the leather bought some years ago

for $1,000. To buy an equivalent quantity now would cost $2,000.


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THE BASIC DECISION MAKING INDICATORS IN

MARGINAL COSTING

PROFIT VOLUME RATIO

BREAK- EVEN POINT

CASH VOLUME PROFIT ANALYSIS

MARGIN OF SAFETY

INDIFFERENCE POINT

SHUT DOWN POINT

PROFIT VOLUME RATIO (P V RATIO )

The profit volume ratio is the relationship between the Contribution

and Sales value.

It is also termed as Contribution to Sales Ratio

Formula :

P V Ratio = Contribution X 100

Sales

Significance of PV Ratio

It is considered to be the basic indicator of profitability of

business.

The higher the PV Ratio, the better it is for the business. In the

case of the firm enjoying steady business conditions over a

period of years, the PV Ratio will also remain stable and

steady.

If PV Ratio is improved, it will result in better profits.


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Improvement of PV Ratio

By reducing the variable costs.

By increasing the selling price

By increasing the share of products with higher PV Ratio in the

overall sales mix. (where a firm produces a number of

products)

Use of PV Ratio

To compute the variable costs for any volume of sales

To measure the efficiency or to choose a most profitable line.

The overall profitability of the firm can be improved byincreasing the sales/output of product giving a higher PV

Ratio.

To determine the Break Even Point and the level of output

required to earn a desired profit.

To decide the most profitable sales mix.

BREAK EVEN ANALYSIS

Break-Even Analysis is a mathematical technique foranalyzing the relationship between sales and fixed andvariable costs. Break-even analysis is also a profit-planningtool for calculating the point at which sales will equal totalcosts.

The break-even point is the intersection of the total sales andthe total cost lines. This point determines the number of unitsproduced to achieve breakeven.

The analysis generally assumes linearity (100% variable or100% fixed) of costs. If a firms costs were all variable, thefirm could be profitable from the start. If the firm is to avoidlosses, its sales must cover all costs that vary directly withproduction and all costs that do not change with productionlevels.

Fixed costs are those expenses associated with the projectthat you would have to pay whether you sold one unit or10,000 units. Examples include general office expenses, rent,depreciation, interest, salaries, research and development,

and utilities. Variable costs vary directly with the number ofunits that you sell. Examples include materials, direct labour,


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postage, packaging, and advertising. Some costs are difficultto classify. As a general guideline, if there is a directrelationship between cost and number of units sold, considerthe cost variable. If there is no relationship, then consider thecost fixed.

A break-even chart is constructed with a horizontal axisrepresenting units produced and a vertical axis representingsales and costs. Represent fixed costs by a horizontal linesince they do not change with the number of units produced.Represent variable costs and sales by upward sloping linessince they vary with the number of units produced and sold.

The break-even point is the intersection of the total sales andthe total cost lines. Above that point, the firm begins to makea profit, but below that point, it suffers a loss. Here is asample break-even chart:

The algebraic equation for break-even analysis consists of fourfactors. If you know any three of the four, you can solve forthe fourth factor. You calculate the break-even amount withthe following equation:

Sales Price per Unit * Quantity Sold = Fixed Costs + [VariableCosts per Unit * Quantity Sold]

For example, assume you have total fixed monthly costs of$1200 and total variable costs of $6 per unit. If you could sellthe units for $10 each, the equation indicates that you need tosell 300 units to break even. If you knew you could sell 400units, the equation would indicate that the sales price wouldneed to be $9 per unit to break even.

When managing inventory, you should aim for the EconomicOrder Quantity (EOQ). This is the level of inventory that

balances two kinds of inventory costs: holding (or carrying)


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costs, which increase with the amount of inventory ordered,and order costs, which decrease with the amount ordered.

The largest components of holding costs for most companies

are the cost of space to store the inventory and the cost oftying up capital in inventory. Other components include thelabour costs associated with inventory maintenance andinsurance costs. Also include deterioration, spoilage, andobsolescence costs. The costs of more frequent orders includelost discounts for larger quantity purchases and labour andsupply costs of writing the orders. Additional costs includepaying the bills and processing the paperwork, associatedtelephone and mail costs, and the labour costs of processingand inspecting incoming inventory.

EOQ is the size of order that minimizes the total of holdingand ordering costs. The algebraic expression of EOQ is asfollows:

EOQ = square root of [2*U*O divided by H] where U is thenumber of units used annually, O is the order cost per order,and H is the holding cost per unit.

For example, assume you use 40,000 units annually, it costs$50 to place an order, and it costs $20 to hold the rawmaterials for one unit. The equation yields an amount of 447,which is the number of units you need to order at one time tominimize total costs.

The reorder point, or Economic Order Point (EOP), tells youwhen to place an order. Calculating the reorder point requiresyou to know the lead time from placing to receiving an order.

You compute it as follows:

EOP = Lead time * Average usage per unit of time

For example, assume you need 6400 units evenly throughout the

year, there is a lead time of one week, and there are 50 workingweeks in the year. You calculate the reorder point to be 128 units asfollows.

1 week * [6400 units / 50 weeks] = 128 units

You might also consider Just In Time inventory management, ifavailable and appropriate. Just In Time allows you to keep minimalinventory in stock. You only order when you make a sale. Carefullyanalyze the time lag. You must be able to satisfy the customer aswell as keep your inventory investment minimized.

Use of BEP Analysis In capital budgeting


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Break even analysis is a special application of sensitivity analysis. Itaims at finding the value of individual variables which the projectsNPV is zero. In common with sensitivity analysis, variables selectedfor the break even analysis can be tested only one at a time.

The break even analysis results can be used to decide abandon ofthe project if forecasts show that below break even values are likelyto occur.

In using break even analysis, it is important to remember theproblem associated with sensitivity analysis as well as someextension specific to the method:

Variables are often interdependent, which makes examiningthem each individually unrealistic.

Often the assumptions upon which the analysis is based aremade by using past experience / data which may not hold inthe future.

Variables have been adjusted one by one; however it isunlikely that in the life of the project only one variable willchange until reaching the break even point. Managementdecisions made by observing the behaviour of only onevariable are most likely to be invalid.

Break even analysis is a pessimistic approach by essence. Thefigures shall be used only as a line of defence in the projectanalysis.

Limitations Of BEP Analysis

Break-even analysis is only a supply side (i.e. costs only)analysis, as it tells you nothing about what sales are actuallylikely to be for the product at these various prices.

It assumes that fixed costs (FC) are constant It assumes average variable costs are constant per unit of

output, at least in the range of likely quantities of sales. (i.e.linearity)

It assumes that the quantity of goods produced is equal to the

quantity of goods sold (i.e., there is no change in the quantityof goods held in inventory at the beginning of the period andthe quantity of goods held in inventory at the end of theperiod).

In multi-product companies, it assumes that the relativeproportions of each product sold and produced are constant(i.e., the sales mix is constant).


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COST VOLUME PROFIT ANALYSIS

Analysis that deals with how profits and costs change with a

change in volume. More specifically, it looks at the effects onprofits of changes in such factors as variable costs, fixedcosts, selling prices, volume, and mix of products sold.

CVP analysis involves the analysis of how total costs, totalrevenues and total profits are related to sales volume, and istherefore concerned with predicting the effects of changes incosts and sales volume on profit. It is also known as'breakeven analysis'.

By studying the relationships of costs, sales, and net income,management is better able to cope with many planningdecisions. For example, CVP analysis attempts to answer thefollowing questions: (1)What sales volume is required to break even?(2) What sales volume is necessary in order to earn a desired(target) profit? (3) What profit can be expected on a givensales volume? (4) How would changes inselling price, variable costs, fixed costs, and output affectprofits?(5) How would a change in the mix of products sold affect thebreak-even and target volume and profit potential?

Cost-volume-profit analysis (CVP), or break-even analysis, isused to compute the volume level at which total revenues areequal to total costs. When total costs and total revenues are

equal, the business organization is said to be "breaking even."The analysis is based on a set of linear equations for a straightline and the separation of variable and fixed costs.

Total variable costs are considered to be those costs that varyas the production volume changes. In a factory, production

volume is considered to be the number of units produced, butin a governmental organization with no assembly process, the


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units produced might refer, for example, to the number ofwelfare cases processed.

There are a number of costs that vary or change, but if thevariation is not due to volume changes, it is not considered tobe a variable cost. Examples of variable costs are directmaterials and direct labour. Total fixed costs do not vary asvolume levels change within the relevant range. Examples offixed costs are straight-line depreciation and annual insurancecharges.

All the lines in the chart are straight lines: Linearity is anunderlying assumption of CVP analysis. Although no one canbe certain that costs are linear over the entire range of outputor production, this is an assumption of CVP.

To help alleviate the limitations of this assumption, it is alsoassumed that the linear relationships hold only within therelevant range of production. The relevant range isrepresented by the high and low output points that have been

previously reached with past production. CVP analysis is bestviewed within the relevant range, that is, within our previousactual experience. Outside of that range, costs may vary in anonlinear manner. The straight-line equation for total cost is:

Total cost = total fixed cost + total variable cost

Total variable cost is calculated by multiplying the cost of aunit, which remains constant on a per-unit basis, bythe number of units produced. Therefore the total cost

equation could be expanded as:

Total cost = total fixed cost + (variable cost per unit numberof units)

Total fixed costs do not change.

A final version of the equation is:

Y = a + bx

where a is the fixed cost, b is the variable cost per unit,xisthe level of activity, and Yis the total cost. Assume that the
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fixed costs are $5,000, the volume of units produced is 1,000,and the per-unit variable cost is $2. In that case the total costwould be computed as follows:

Y= $5,000 + ($2 1,000) Y= $7,000

It can be seen that it is important to separate variable andfixed costs. Another reason it is important to separate thesecosts is because variable costs are used to determine thecontribution margin, and the contribution margin is used todetermine the break-even point. The contribution margin isthe difference between the per-unit variable cost and theselling price per unit. For example, if the per-unit variable costis $15 and selling price per unit is $20, then the contributionmargin is equal to $5. The contribution margin may provide a$5 contribution toward the reduction of fixed costs or a $5contribution to profits. If the business is operating at a volumeabove the break-even point volume (above point F), then the$5 is a contribution (on a per-unit basis) to additional profits. Ifthe business is operating at a volume below the break-evenpoint (below point F), then the $5 provides for a reduction infixed costs and continues to do so until the break-even point ispassed.

Once the contribution margin is determined, it can be used tocalculate the break-even point in volume of units or in total

sales dollars. When a per-unit contribution margin occursbelow a firm's break-even point, it is a contribution to thereduction of fixed costs. Therefore, it is logical to divide fixedcosts by the contribution margin to determine how many unitsmust be produced to reach the break-even point:

The financial information required for CVP analysis is forinternal use and is usually available only to managers insidethe firm; information about variable and fixed costs is not

available to the general public. CVP analysis is good as ageneral guide for one product within the relevant range. If thecompany has more than one product, then the contributionmargins from all products must be averaged together. But,any cost-averaging process reduces the level of accuracy ascompared to working with cost data from a single product.Furthermore, some organizations, such as nonprofitsorganizations, do not incur a significant level of variable costs.In these cases, standard CVP assumptions can lead tomisleading results and decisions.

USES OF CVP ANALYSIS
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a) Budget planning. The volume of sales required to make a profit(breakeven point) and the 'safety margin' for profits in the budgetcan be measured.

b) Pricing and sales volume decisions.

c) Sales mix decisions, to determine in what proportions eachproduct should be sold.

d) Decisions that will affect the cost structure andproduction capacity of the company.

THE BASIC PRINCIPLES OF CVP ANALYSIS

CVP analysis is based on the assumption of a linear total costfunction (constant unit variable cost and constant fixed costs) andso is an application of marginal costing principles.

The principles of marginal costing can be summarised as follows:

a) Period fixed costs are a constant amount, therefore if oneextra unit of product is made and sold, total costs will only riseby the variable cost (the marginal cost) of production andsales for that unit.

b) Also, total costs will fall by the variable cost per unit foreach reduction by one unit in the level of activity.

c) The additional profit earned by making and selling oneextra unit is the extra revenue from its sales minus its variablecosts, i.e. the contribution per unit.

d) As the volume of activity increases, there will be anincrease in total profits (or a reduction in losses) equal to thetotal revenue minus the total extra variable costs. This is theextra contribution from the extra output and sales.

e) The total profit in a period is the total revenue minus thetotal variable cost of goods sold, minus the fixed costs of theperiod.

MARGIN OF SAFETY

Margin of safety represents the strength of the business. It enablesa business to know that what is the exact amount he/ she has

gained or loss over or below break even point).


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Margin of safety = (( sales - break-even sales) / sales) x 100% If P/Vratio is given then sales/pv ratio

In unit sales

If the product can be sold in a larger quantity that occurs at thebreakeven point, then the firm will make a profit; below this point, aloss. Break-even quantity is calculated by:

Total fixed costs / (selling price - average variable costs).

Explanation - in the denominator, "price minus average

variable cost" is the variable profit per unit, or contribution

margin of each unit that is sold.

This relationship is derived from the profit equation: Profit =

Revenues - Costs where Revenues = (selling price * quantityof product) and Costs = (average variable costs * quantity) +

total fixed costs.

Therefore, Profit = (selling price * quantity) - (average variable

costs * quantity + total fixed costs).

Solving for Quantity of product at the breakeven point when

Profit equals zero, the quantity of product at breakeven is

Total fixed costs / (selling price - average variable costs).

Firms may still decide not to sell low-profit products, for examplethose not fitting well into their sales mix. Firms may also sellproducts that lose money - as a loss leader, to offer a complete lineof products, etc. But if a product does not break even, or a potentialproduct looks like it clearly will not sell better than the breakevenpoint, then the firm will not sell, or will stop selling, that product.

An example:

Assume we are selling a product for $2 each. Assume that the variable cost associated with producing and

selling the product is 60 cents. Assume that the fixed cost related to the product (the basic

costs that are incurred in operating the business even if noproduct is produced) is $1000.

In this example, the firm would have to sell (1000 / (2.00 -0.60) = 715) 715 units to break even. in that case the marginof safety value of NIL and the value of BEP is not profitable ornot gaining loss.

Break Even = FC / (SP VC)

where FC is Fixed Cost, SP is selling Price and VC is Variable Cost


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Significance:

Up to the BEP, the contribution is earned is sufficient only torecover the fixed costs. However the beyond the BEP, thecontribution is called the profit

Profit is nothing but the contribution earned out of margin ofsafety of sales.

The size of the margin of safety shows the strength of thebusiness.

A low margin of safety indicates the firm has a large fixedexpenses and is moir vulnerable to changes.

A high margin of safety implies that a slight fall in sales maynot the business very much.

Improvements in margin of safety:

The possible steps for improve the margin of safety.

Increase in selling price, provided the demand is inelastic soas to absorb the increased prices.

Reduction in fixed expenses Reduction in variable expenses Increasing the sales volume provided capacity is available. Substitution or introduction of a product mix such that more

profitable lines are introduced.

SHUT DOWN PROBLEMS

Shut down point indicates the level of operation(sales), below whichit is not justifiable to pursue production. For this purpose fixedexpenses of a business are classified as (i) avoidable ordiscretionary fixed costs (ii) unavoidable or committed fixed costs.

The focus of shut down point calculation is to recover the avoidable

fixed costs in the first place. By suspending the operations, the firmmay save as also incur some additional expenditure. The decision isbased on whether contribution is more than the difference betweenthe fixed expenses incurred in normal operation and the fixedexpense incurred when the plant is shut down.

A firm has to close down if its contribution is insufficient to recovereven the avoidable fixed costs.

Shutdown problems involve the following types of decisions:


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a) Whether or not to close down a factory, department, product lineor other activity, either because it is making losses or because it istoo expensive to run.

b) If the decision is to shut down, whether the closure should be

permanent or temporary. Shutdown decisions often involve longterm considerations, and capital expenditures and revenues.

c) A shutdown should result in savings in annual operating costs fora number of years in the future.

d) Closure results in release of some fixed assets for sale. Someassets might have a small scrap value, but others, e.g. property,might have a substantial sale value.

e) Employees affected by the closure must be made redundant orrelocated, perhaps even offered early retirement. There will be lumpsums payments involved which must be taken into consideration.For example, suppose closure of a regional office results in annualsavings of $100,000, fixed assets sold off for $2 million, butredundancy payments would be $3 million. The shutdown decisionwould involve an assessment of the net capital cost of closure ($1million) against the annual benefits ($100,000 per annum).

It is possible for shutdown problems to be simplified into short rundecisions, by making one of the following assumptions

a) Fixed asset sales and redundancy costs would be negligible.b) Income from fixed asset sales would match redundancy costs andso these items would be self-cancelling.

In these circumstances the financial aspects of shutdown decisionswould be based on short run relevant costs.

CASH POSITION AND FORECAST

The Cash position and forecast enquiry is usually used by theTreasurer or whoever is responsible for ensuring that thecompany has adequate funds for expected outgoings.


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The Cash Position input data is the known balances:

Postings in cash and bank accounts (any account relevant to

cash management),the unreconciled entries in the bankclearing accounts (uncashed cheques etc), and

any memo records which may have been manually entered(planning advices) as relevant to a cash position

cash flows from transactions managed in TreasuryManagement

Examples are:

-bank balances -outgoing checks posted to the bank clearing account -outgoing transfers posted to the bank clearing account -maturing deposits and loans -notified incoming payments posted to the bank account -incoming payments with a value date

GUIDELINES FOR RUNNING THE CASH

POSITION OR FORECAST ENQUIRY1. Understanding the Business Requirements

Describes the information that you should gather about yourcompany's operations in this area to adequately configure it.

2. Dates and the Cash Forecast

The Cash position and forecast is all about amounts and dates. Thesection explains how the dates are determined for the various

inputs.

3. Cash Forecast Terminology

Explains the key terms that are encountered in the configuration.Must be read before embarking on the configuration section.

4. Cash Forecast Configuration

Guidelines on configuring the Cash Position and Forecast -presented in two sections - essential and then advancedconfiguration.


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5. Related Configuration / Processing areas

Describes some of the related configuration and processing areas

that impact or feed data to the cash forecast.

6. Preparing test data

Presents some hints on preparing test data directly without havingto run the feeder programs.

PROFIT AND LOSS FORECAST

A Profit and Loss Account is designed to show the financialperformance of a business over a given period (usually Monthly orAnnually) and to indicate whether it is (or, in the case of a P & LForecast, if it will) make or lose money.

Without Profit there eventually will be no business

Profit and Loss is also essential in providing information for InlandRevenue for Taxation purposes

Understanding how a Profit and Loss Account works will help you tochoose the right time to buy items that you need for the business,reduce your tax liability (Tax Bill) and work out how much Tax youwill have to pay.

PROFIT AND PLANNING

Profit planning is essential when you want your business to focus on

enhancing its profit-making capabilities. Effective profit planninghappens when you determine in advance a set of clear and realisticgoals that your business or organization needs to fulfil. Those goalsmust be based upon objective existing and expected businessconditions. Anticipating the changes in your business environment isalso central to profit planning.

Given the central role profit planning can play in the futureprospects of an organization, it might come as a surprise to learnthat a large number of businesses do not usually have or develop a

financial plan. What is even more amazing is that many of thebusinesses which do plan for their financial future often just repeat


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the same procedure over and over every year. They do not take thetime to look at how the plan works, or if it is really working.

A very small number of businesses currently knows how to practiceand benefit from proficient profit planning. However, research

indicates that profit planning might be a central reason behind theincreased sales and profits enjoyed by these few businesses.Appropriate profit planning can help your company enjoy thosebenefits too.

Effective profit planning can have a deep impact in the life of yourorganization. The professionals at FRS Consultants believe thatprofit planning is a key element which has led to the success of bigand small businesses alike. That said, it could truly ensurecontinuous prosperity for your own business, as well. FRSConsultants is a trustworthy firm of honest and experiencedprofessionals that can lead you to make the best out of profitplanning. Many goldbricks in the field are more eager to charge youpremiums for their time than to deliver what you are paying for. AtFRS Consultants we do not shirk our work. We will strive to deliveron time and prove the value of our service. Other consulting firmsmay seem less expensive than us, but that is not the case. To learnmore or to request a free consultation please complete our onlineform.

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