‘The 3 types of costs: Fixed: Cost that stays fixed regardless of volume activity. Number of units produced 1,000 2,000 3,000 (Volume of activity) Cost (£) 30,000 30,000, 30,000 Variable: Cost that varies accordingly with volume activity, Number of units produced | 7,000 2,000 3,000 (Volume of activity) Cost (£) 70,000 [20,000 | 30,000 Semi-variable costs: Has a mix of fixed and variable (ex. Utility bills) Davos Lid collected data relating to its electricity cost and volume of activity over several ‘quarters and found the following: Lowest quarterly activity Highest quarterly activity Volume of activiy 100,000 units 180,000 units Total electricity cost £80,000 £120,000 We can see that an increase in activity of 80,000 units (that is, from 100,000 to 180,000 Units) led to an increase in total electricity cost of £40,000 (that is from £80,000 to £120,000). As itis assumed that this increase is caused by an increase in variable cost, the variable cost per unit of output must be £40,000/80,000 ~ £0.50 per unit. The breakdown in total electricity cost for the highest and lowest quarters will therefore be as follows: Lowest quarterly activity Highest quartery activity Volume of activity 100,000 units 120,000 unite £ B Variable cost 100,000 x £0.50 000 180,000 x £0.50 20,000 Fixed cost (balancing figure) 30,000 30,000 Total electricity cost 000 20,000‘The Break-even point (BEP): The break even point is when total revenue Total revenue = Sales volume x Sales price Total costs = Fixed costs + Variable Costs To find the number of units sold to achieve BEP: To find the number of units sold to achieve Target Profit: BREAK - EVEN CHART‘THe bottom formula is known as the contribution per unit. Margin of safety: The extent to which the planned level of output is above the break even point MOS (%) = Q left for sale after BEQ / Q Expected level of sales If both options offer the same return on profit, but significantly different MOS% numbers, itis recommended to go with the option with a higher MOQ to mitigate risk. However this factor can always change depending on a company’s attitude towards risk Operating Gearing The relationship between contribution and fixed costs is known as Operating Gearing, ‘An activity with relatively high fixed costs compared with its variable costs is said to have High Operating Gearing. When operating gearing is high, then a relatively small change in sales will have a much bigger impact on profit. Increasing the level of operating gearing makes profits more sensitive to changes in the volume of activity. Profit grows much more with a higher operating gear. Without the machine With the machine Volume (number of baskets) 500 1,000 1,500, 500 1,000 1,500, e 4 s £ g £ Contributions* 1,000 2,000 3,000 3.500 7,000 10,500 Fixed cost (600) (600) (500) (3,000) (3,000) 3,000) Proft 500 1,500 2.500 500 4,000 7,500 * £2 per basket without the machine and £7 per basket with it Profit grows much more with the machine as it has a high operating gearing‘The economist’s view of Break Even Analysis (BEA) & Weaknesses of BEA: Lines between variable costs and volume of output: * Economists say that this relationship can't always be a straight line due to economies of scale as well as diseconomies of scale Relationship between revenues and volume of output. * Economists say that this line can't always be straight due to the fact that sometimes in order to achieve higher sales volume, selling prices may have to decrease. ‘The economist’s view ofthe break-even chart ‘The three main weaknesses of the break-even anal: Non-linear relationships ‘© BEP is used to forecast. Difference between both approaches (simplistic linear vs sophisticated non linear) in most cases is not very significant. Stepped fixed costs ‘© Could be included in analysis, but difficult to implement and fixed costs are likely to be at different points, roduct businesses ‘© Asserious weakness in BE analysis as different products may have different prices and different impacts on the BEP.Marginal analysi For decisions involving} ‘* Small variations in existing practice © Limited time periods Fixed costs are irrelevant as they do not vary with decision outcomes. However, they do vary with the variable costs which makes them relevant. Variable cost per unit is also referred to as marginal cost. The types of deci ions that make us use the marginal analysis ‘© Accepting/rejecting special contracts Cottage Industries Ltd has spare capacity in that it has spare baskets makers. An overseas retail chain has offered the business an order for 300 baskets at a price of £13 each. Without considering any wider issues, should the Lesscaddiienal cost per unk business accept the order? Sales price: £14 Variable costs: £12, Fixed costs £500 After calculating the Contribution per unit, the calculation shows a profit of £1 per unit. 300 baskets would generate the business £300 pounds in profit therefore they should accept the offer. General factors to consider before deci order: ing on whether to accept or reject the -Selling spare capacity off too cheaply -Loss of customer goodwill -Indication of lack of demand -Potential use of lower price to enter new markets £ Additional revenue per unit 13 12 | Additional contribution per unit 4© Efficient use of scarce resources Product name Bi4 BI7 B22 |Selling price per unit [25 20 23 Variable cost per unit [10 8 12 Weekly demand 25 20 30 Machine time per unit |4hours 3 hours [4 hours Machine time is limited to 148 hours per week. Which combination of products should be manufactured to make the highest profit? Calculate the contribution per unit for each product. Then calculate the contribution per hour as shown below. Product name Bia B17, B22 Selling price per unit 25 20 23 ‘Variable cost per unit 40 8 12 {Contribution per unit 15 12 a> Machine time per unit hours} hours) 4 hours| Contribution per 76( eau eas machine hour (=£15/4h)| (=£12/3h)| (=£11/4h) Order of priority a 1 3 Using this information we could determine which is the most efficient to produce using the contribution per unit method. Therefore the optimal solution would be to produce: 20 units of B17 (20x3) = 60 hours 22 units of B14 (2x4) = 88 hours 18 hours¢ Make-or-buy decisions (outsourcing) A company needs a component for one of its products. It can subcontract the production at a cost of £35 per component. It can produce the component internally for total variable costs of £28 per unit. The company has spare capacity. Should the company make the product internally or subcontract externally? Based on the following the company should resort to producing internally as it is cheaper considering that it has spare capacity. Assume the same situation except the company has no spare capacity. It can only produce this component by reducing the output of another component. The other component makes a contribution of £15. Assuming this case however, the company should resort to outsourcing as they have no spare capacity and they would have to reduce output of components which make up for an additional £15 making it more expensive hence, outsourcing would be a better resort. Considerations for make or buy decisions: -Majorly depends on intemal and external conditions/ offer. -Loss of control of the qui -Potential unreliability of supply -Expertise of specialists -Consider the opportunity cost of marginal contribution.* Closing or continuation decisions -Decision made based on the three above categories in marginal analysis. Total Sports equipment Sports clothes General clothes £000 £000 £000 £000 Sales revenue 534 254 183 97 Variable cost 44) (167) 17) 0) Contribution 190 87 66 37 Fixed cost (rent and soon) (138) (48) (46) (46) Profit/(loss) 52 41 20 9) ‘The most logical decision here is to close down general clothing and continue with the others as they generate profit