chapter 35 Flashcards
variable cost
a cost which varies in direct proportion to changes in the level of output
why can direct labour be considered to be a variable cost
if workers are paid a piece rate according to the amount they produce, then direct wages are proportionate to output and these are variable costs. if direct workers are paid a fixed or basic wage regardless of their output, all wages paid to direct labour will not be in relation to output, but we still treat them as being proportionate to production and thus deem them to be variable costs
fixed costs
a cost that remains unchanged within a certain level of activity or output
stepped costs
fixed costs that are only fixed within certain limits and will increase to a higher level when that limit is reached
semi variable cost
a cost that contains an element of both variable and fixed cost within it
marginal cost
the cost of making one extra unit of output
what is marginal cost based on
it is based on the principle that an additional unit of production will result in an increase in the variable costs but not the fixed costs
what is marginal cost of production
the total variable costs of productioin
contribution
the amount of earnings remaining after all direct costs have been subtracted from revenue. it is the difference between the total revenue and total variable costs
contribution per unit
the difference between the selling price and variable cost of a unit of output
contribution per unit formula
selling price per unit - variable costs per unit
marginal cost of sales
the variable costs of production and selling of one extra unit of output. when variable selling expenses are included in the marginal cost it becomes the marginal cost of sales
how does marginal costing help
helps management to decide on pricing policy
contribution to sales ratio (C/S ratio)
the proportion of sales revenue that contributes towards the fixed costs and profit of a business
contribution to sales ratio formula
contribution/ revenue * 100
break even point
the point at which a business makes neither profit nor loss. It is the point at which total contribution is equal to total fixed costs.
margin of safety
the difference between budgeted or actual output and the break- even quantity.
how is break even point useful
It is particularly useful for managers to know the break-even point of a product when making decisions about pricing and production levels.
break even formula
fixed costs/contribution per unit
what does the break even formula calculate
calculates the number of units that must be produced and sold before the fixed costs are covered. At the break-even point, total contribution will equal total fixed costs
margin of safety formula
sales quantity - break even formula
how can knowing the margin of safety help
Knowing a business’s margin of safety can be useful to managers as it helps them to understand the amount by which output could fall short before the business risks making a loss.
break even chart
a diagrammatic representation of the profit or loss to be expected from the sale of a product at various levels of activity.
when does break even point occur
it occurs where the sale line cuts the total cost line and there is neither profit or loss
profit volume chart
a type of break even chart that only shows the profit or loss at each level of output
limitations of break even profits and profit/volume charts
thy assume the variable cost per unit is constant at all levels of output but this is not always true in practice
fixed costs do not always stay the same because some costs may be stepped costs that are only fixed within certain limits
Costs may be semi-variable and are not easily classified as fixed or variable. For break- even to work, the fixed and variable elements must be separated and added in with the appropriate fixed or variable figures.
They assume the selling price is constant at all levels of output. However, for some products more revenue may only be achieved if customers are given discounts from the selling price.
A break-even or profit/volume chart can only be applied to one product at a time.
A chart can be time consuming to prepare.
The charts may mislead people whose accounting knowledge is limited, but trained accountants will know when to make allowances for the charts’ limitations
target profit and marginal costing
If the managers of a business have an amount of profit that they are aiming to achieve, then marginal costing can be used to calculate the sales quantity needed to achieve this level of profit.
target profit calculator
fixed costs + target profit/contribution per unit
positive contribution
the contribution is above zero
when are special orders considered
There are occasions when an individual order may be accepted below the normal selling price. This may be considered when there is spare capacity in the factory and other orders are not affected.
positive contribution and special orders
for special orders, the general rule is that the selling price must exceed the marginal cost of production. This will allow the additional order to make a positive contribution towards the fixed costs and profit of the business
why are special orders useful at below the usual selling price
to maintain production and avoid redundancy among a skilled workforce during period of poor trading
to promote a new product
to dispose of inventory that is slow-moving or no longer useful.
how does marginal costing affect make or buy decisions
A manufacturer may find that it’s more profitable to buy goods from another supplier than make the goods itself. This involves a ‘make or buy’ decision. It may be relevant for goods that are already being produced, or to the introduction of a new product. The decision will be based mainly on whether the cost of buying the goods from another supplier is more or less than the marginal cost of production.
how to use marginal costing to decide whether to make or buy
If the marginal cost of production is above the price quoted by the supplier then buy from the supplier.
If the marginal cost of production is below the price quoted by the supplier then make the good.
limiting factor
anything that limits the quantity of goods that a business may produce
scarce resource
a resource or material that has limited availability
how is marginal costing used to make the best of limited resources
When there is a limited resource, a business making several different products should use the limited resources in a way that produces the most profit. when making the best use of limited resources, the products must be ranked according to the amount of contribution they make from each unit of the scarce resource. Production will then be planned to ensure that the scarce resource is concentrated on the highest- ranking products.
why does marginal costing an absorption costing show two different profits
the two methods of costing: marginal and absorption, will produce different profits, as the closing inventory is valued in two different ways
how do customer affect the final decisions of price
a large or important customer might put pressure on a business to provide goods at special (lower) prices. despite being unprofitable, a business may agree to this in the short term, in the hope or expectation that the customer will make future purchases at a higher price
how do human resources affect the final decisions of price
a business may decide to priorities avoiding staff redundancies. this encourages mangers to accept special orders at low prices or to avoid closing a business unit unless staff can be redeployed to other parts of the business
how do suppliers affect the final decisions of price
if a business has a strong or long standing relationship with a supplier then it might prefer not to make a shift from buying to making a product despite a possible financial gain
benefits of marginal costing
Fixed costs are not included in the cost of production and therefore there is no arbitrary apportionment of fixed costs.
Contribution provides a reliable measure for short-term decision making.
Marginal costing clearly shows the impact on profit of fluctuations in the volume of sales. Under-absorption and over-absorption of overheads are not a problem as there is no need to calculate an overhead absorption rate.
The marginal costing technique can be used with standard costing
limitations of marginal costing
Marginal costing is only useful for short-term decision making. Not all costs can easily be split into fixed costs and variable costs.
Under marginal costing, the fixed costs remain constant and variable costs vary according to the level of output. In reality, the fixed costs do not remain constant and the variable costs do not vary according to the level of output. In the long run, all costs are variable.
Inventory should not be valued using marginal costing for a financial reporting because fixed manufacturing overheads are required by IAS 2.
Marginal costing may encourage selling prices that are too low because fixed costs are not considered; however, fixed costs must be covered in the long term.
Marginal costing is most useful for a business that makes. a single product. A company making several products will have difficulty allocating fixed costs to each product with any degree of accuracy. This will make it difficult to calculate the break-even point for either a single product or the business as a whole.
