Wayne Fiddler

 Report to managers inside the business

 Internal so very sensitive
 Used for planning, controlling and decision
making
 Usually looks at future events
 More subjective (uncertain)
 Financial and non-financial information
 Format will depend upon user needs
 Required whenever the organisation needs it
 Can be done for parts of business
 Not required by law
 Not governed by accounting standards
 Understand why we need to know how
costs behave
 Know the various types of cost behaviour
 Understand the relationships between

costs, output and profits

 Be able to calculate and interpret

breakeven point, margin of safety and

other measures of risk
 Know how costs behave in reality
 Value our inventories of finished
goods
 Set selling price that covers costs
 Decide how to control costs
 Forecast future costs
 Make decisions on product,

department or business
profitability.
Prime costs

Conversion costs
 We tend to classify costs according to the
way that they behave

 We usually look at behaviour in relation to

output

 We ignore inflation etc

Costs which vary in direct proportion to output of
the product –
wages, materials.

Output
 Cost incurred over a particular period of
time - rent, rates, salaries - Not affected by
our level of output - also known as period
costs.

Output
Fixed over a certain range of output but
then step up if output increases by 1 unit
 supervisors salaries, rent if we have to use

another factory.

Output
 Have a fixed element (standing charge) but
then increase in direct proportion to output
- power costs, telephone costs

Output
 Looks just like a semi variable cost line.
 Total cost is made up of fixed costs and

variable cost
 Fixed cost is the y intercept
 Variable cost per unit is the gradient

Output
 Anything that we wish to know the cost of
 Products
 Product lines
 Customers
 Departments
 Direct costs – can be easily traced to a

particular cost object

 Indirect costs – cannot be traced to a

particular cost object – common cost

 Revenue: Amount earned from selling a product
or service
 Revenue will vary directly with output
 We assume that revenue per unit will remain
the same as output increases
 Total revenue will increase

 Contribution = selling price – variable costs

 The amount that contributes towards fixed
costs by selling an extra unit
 Contribution is important for decision making
 Occurs where total costs and total revenue are
the same amount.
 The business will break even and will make
neither profit or loss

 BE point in units= Total fixed costs

Contribution per unit

 BE point in revenue = Total fixed costs

Contribution to sales
ratio
Cost/Revenues
£s
Sales Revenue £s

Profit Total Costs £s

Break-even point

Fixed Costs £s
Loss

Volume
0
 Contribution to sales ratio = Contribution
Sales
 Margin of safety
 The difference between the break even

point and current or expected output

 Usually shown as a percentage
 MoS = Actual output – Breakeven output

Actual output
Cost/Revenues
£s
Sales Revenue £s

Total Costs £s

Margin of
safety

Volume
0
 Contribution per unit
 £20-£12 = £8

 Break even point in units

 £40,000/8
 =5,000 units

 Break even point in revenue (£)

 5,000*£20 = £100,000

 Contribution to sales ratio

 8/20 = 40%

 BE point in revenue
 Fixed costs / contribution to sales ratio
 £40,000/40% = £100,000

 Margin of safety
 (7000-5000)/7000 = 28.6%
 Ashfield Ltd Per 7,000
unit units
£ £
Revenue 20 140,000
Variable cost 12 84,000
Contribution 8 56,000
Fixed costs 40,000
Profit 16,000
Output necessary to achieve profit of £20,000
= (£40,000+£20,000)/8
 This is the benefit foregone by taking the
next best option
 Arises when resources are scarce

 Order of 3000 units

 Within capacity
 Makes contribution of £15-£12 = £3
 Additional profit of 3,000*£3 = £9,000
 Therefore accept the order
 As long as existing customers don’t find out
 Order of 5,000 units
 Makes contribution of 5,000*£4 = £20,000

 But we don’t have capacity

 We can
 Work overtime
 Reduce output of products to existing

customers
 Make part of order
 Outsource to another producer
 Overtime
 We make 3000 units in capacity
 We need overtime to make extra 2,000 units
 Generates contribution of 2,000*£4 = £8,000

 Reduce output to current customers

 We currently earn contribution of (£20 - £12(
= £8
 New order would earn contribution of £4
 We would lose 2,000*£4 = £8,000
 Make part of order
 Produce up to capacity
 Make remining order next period

 Outsource
 Frees up our capacity
 We lost control of output and quality

 Will existing customers find out

 Likelihood of repeat business
 Margin of safety
 Likelihood of maintaining output
 Likelihood of costs changing
 Likelihood of costs going up or prices

coming down
 Potential benefits of capital investment
 Composition of costs
£s Sales Revenue £s

Total Costs £s

Break-even point

Fixed Costs £s

Volume
0
£s Sales Revenue

Break-Even Total Cost

Point

Fixed Costs

Volume
0
Operating (cost) gearing is to do with the ratio of fixed
costs to variable costs, and affects the business risk of
the firm.

Operating gearing = contribution

profit before interest & tax
As a firm expands or modernises it tends to
replace direct labour (variable cost) with
equipment, such as an automated production
line (fixed cost) thus increasing the cost gearing
ratio.

This is likely to lead to a higher break-even point

as the fixed cost is increased, and a smaller
slope in the total cost line as the unit variable
cost is reduced.

Increasing operating gearing increases both the

risk and the potential profit of the business.
Questions that can be answered:
How many units must we sell to break even?
What is the effect of changes in selling

prices?
Can we justify extra advertising spend?
What would be the effect of changes in

variable costs?
Can we sell extra products to different

customers?
Single product or constant sales mix
Only volume causes and revenue changes
Stock volumes remain the same (we sell what we
make)
Unit selling price and unit variable cost remain
constant
All costs can be accurately divided into their fixed
and variable components
Only applies over a relevant range of output.
 Weighted contribution
 40%*£12+60%*£10 = £10.80
 Break even point is £30,000/£10.80 =2,777 units
 So we make 40% of 2,777 of A = 1,111 units
 And 60% of 2,777 of B = 1,666 units

 OR
 40% of fixed costs for A = £12,000
 60% of fixed costs for B = £18,000
 Break even point for A = £12,000/£12 = 1,000 units
 Break even point for B = £18,000/£10 = 1,800 units
 But can we split the fixed costs?
 Current profit
 A = 4000*12£48,000
 B = 6000*10 £60,000 so £108,000
 Less fixed costs £30,000
 Profit £78,000

 Either (10,000-2777)/10000 = 72%

 For A = (4000-1111)/4000 = 72%

 For B = (6000-1666)/6000 = 72%

 Why is it the same?

 Are we setting the right selling price?
 How do we calculate breakeven point if we

make more than one product?

 Which fixed costs do we include in the

calculation?
 Do we need to split fixed costs to calculate

separate break even points for each

product?
 How would we analyse risk using margin of

safety?
 Total cost
£
Total
revenue

Variable cost

Fixed cost

Output