1. Marginal costing and breakeven
analysis

After completing this topic you should be
able to




Describe the main purposes of marginal
costing
Construct a marginal cost statement and
associated profit statement
Conduct breakeven analysis
Independent study

Study Chapter 17
1

2. The story so far ...


Cost accounting is the process of
collecting, processing and presenting
financial and quantitative data within an
entity to ascertain the cost of the cost
centres and cost units’ (Collis and Hussey,
2007, p. 213)
Revenue expenditure can be divided into
direct costs (eg direct materials) and
indirect costs (eg production overheads)
Business Accounting
2

3. Marginal costing


One problem with methods of total costing
is that the classification of revenue
expenditure into direct costs and indirect
costs ignores their different behaviours
when production or sales activity varies
An alternative is to use marginal costing,
where the main purpose is to provide
detailed cost information for planning and
short-term decisions in a business where
Business Accounting
3

4. Classifying costs by behaviour

Costs and expenses are classified
according to their behaviour when activity
levels fluctuate


A variable cost is ‘an item of revenue
expenditure that varies directly with changes in
the level of production or sales activity’ (Collis
and Hussey, 2007, p. 292)
A fixed cost is ‘an item of revenue expenditure
that is unaffected by changes in the level of
production or sales Accounting (Collis and Hussey,
Business activity’
4

5. Exercise 1
Variable and fixed costs

Ros expects the production costs will be as
follows







Mineral water (in bulk)
Bottles, lids and labels
Rent and rates
Electricity (lighting, heating and power)
Wages (for the bottling operative)
Depreciation on the bottling machine
Required
Business Accounting
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6. Solution 1
Variable and fixed costs
Cost
Direct Indirect

Mineral water (in bulk)

Bottles, lids and labels

Rent and rates

Electricity (lighting, heating and power)
?

Wages (for the bottling operative)
?

Depreciation of machinery
Note
• Electricity and wages may have variable elements
• If we compare this with our classification into direct and indirect
costs, we can conclude that product direct costs are always
variable costs and, in the short term, indirect costs are likely to
be fixed costs
Business Accounting
6

7. 
Calculatingcosts are charged to the
contribution
Only the variable
cost units


The variable cost per unit is known as the
marginal cost
The difference between the sales value and
the variable costs is known as the
contribution and is based on the assumption
that the sales value and variable costs will be
constant
Sales value – Variable costs = Contribution

Business Accounting
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8. Exercise 2
Marginal cost statement


A marginal cost statement allows you to calculate the
contribution per unit and net profit or loss over the
accounting period
Cotswold Coolers plans to produce and sell 1,000 units of
mineral water per week


The selling price will be £3.20 per unit and variable costs per unit
will be mineral water £0.30; bottle, lid and label £0.75. Fixed costs
will be £850 per week.
Required

Complete the marginal cost statement for 1 unit and the
associated weekly profit statement based on 1,000 units

9. Pro forma
Cotswold Coolers
Marginal cost statement
1 unit
£
Sales
Variable costs
Mineral water
Bottle, lid and label
Contribution
Fixed costs
Net profit/(loss)
0.30
0.75 (
£
3.20
)?
?
Business Accounting
1,000 units
£
?
? (
£
?
)?
?
(850)
?
9

10. Solution 2
Cotswold Coolers
Marginal cost statement
Sales
Variable costs
Mineral water
Bottle, lid and label
Contribution
Fixed costs
Net profit/(loss)
1 unit
£
£
3.20
0.30
0.75
(1.05)
2.15
1,000 units
£
£
3,200
300
750
(1,050)
2,150
(850)
1,300
Notes
• The contribution per unit will be £2.15
• Total contribution from selling 1,000 units will be £2,150, which will
cover the fixed costs of £850 and provide a net profit of £1,300
10

11. Techniques based on marginal
costing
 The information in a marginal cost statement
forms the basis of two widely used
techniques for making short-term decisions


Breakeven analysis and contribution analysis
We are going to start with breakeven
analysis, which can be used for




Setting the minimum selling price
Setting the minimum level of activity
Planning the level of activity to generate a
required profit
Business Accounting
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12. Breakeven analysis


The purpose of breakeven analysis is to identify the
breakeven point (BEP), which is ‘the level of activity at
which there is neither a profit nor a loss, as measured by
volume of production or sales, percentage of production
capacity or level of sales revenue’ (Collis and Hussey,
2007, p. 296)
In other words, the breakeven point is where

Total contribution = total fixed costs or

Total revenue = total costs
Business Accounting
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13. Exercise 3
Breakeven point in units


Ros expects the total fixed costs for 1 week
will be £850 and we know from the
marginal cost statement that the
contribution per unit will be £2.15
Required

Calculate the breakeven point in units using the
formula:
Fixed costs
Contribution per unit
Business Accounting
13

14. Solution 3
Breakeven point in units
Formula
Workings
Fixed costs
£850
= 395.34883
Contribution per unit £2.15
or 395 units
• Interpretation
- Cotswold Coolers will break even when 395 units are sold
- This is the minimum level of activity, where the business
covers the total cost but makes neither a profit nor a loss
NB Round to the nearest whole number (no split bottles!) This
is not an exact science and the results must be interpreted in
the knowledge that the figures are based on budgeted/planned
figures, which are estimates
Business Accounting
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15. Breakeven point in sales value or
% of capacity
Once you’ve found the breakeven point (BEP) in units, you
can use it to find the BEP in sales value or % of capacity
Formula
Workings
BEP in units × Selling price 395 × £3.20 = £1,264 sales value
BEP in units × 100
Capacity in units
395 × 100
1,000
= 39.5%
or 40% of capacity
• Interpretation
- Cotswold Coolers will break even when sales revenue
reaches £1,264, which is 40% of their production capacity
Business Accounting
15

16. Exercise 4
Level of activity to achieve a target profit

Same information from the marginal cost
statement



Total fixed costs will be Rs 850 per week
Contribution will be Rs 2.15 per unit
Required

Calculate the level of activity required to achieve a
target profit of Rs 500 using the formula:
Fixed costs + Target profit
Contribution per unit

17. Solution 4
Level of activity to achieve a target profit
Formula
Workings
Total fixed costs + Target profit Rs 850 + Rs 500 = 627.9
Rs 2.15
Contribution per unit
or 628 units
• Interpretation
- Bisleri will achieve a profit of Rs 500 when the
business has sold 628 units
- The contribution made by the sale of 628 units will
exceed the total fixed costs by Rs 500, which is profit
Business Accounting
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18. Margin of safety

The formula for the margin of safety is
Selected level of activity – Breakeven point

Our selected level of activity is where the business will
make a profit of Rs 500, so inserting the figures:
628 – 395 = 233 units

Interpretation


Bisleri could miss the sales target of 628 units by as many as 233
units before the level of activity drops below the breakeven point
of 395 units and the business starts making a loss
All this information can be shown graphically ...

19. Breakeven graph
Costs/Sales (Rs)
Sales revenue
PROFIT
Rs1,350
Rs1,264
Rs 850
0
Profit Rs 500
Breakeven point
LOSS
Variable costs
Fixed costs
←→ Margin of safety 233 units
395 628
Activity level (units)

20. Conclusions


Breakeven analysis is based on marginal
costing and provides detailed cost
information in a business where production
and/or sales levels fluctuate
It is based on the assumption that sales
value and variable costs are constant and
that variable costs vary with changes in the
level of activity whilst fixed costs do not, but
in the longer term
Business Accounting
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