Question 19.9: Marginal costing example Looking ahead to the financial year...
Marginal costing example
Looking ahead to the financial year ending 31 March 2005, the directors of Problems
Limited are faced with a budgeted loss of £10 000. This is based on the following data:
| Budgeted number of units: 10 000 | |
| £000 | |
| Sales revenue | 100 |
| Less: Variable costs | \underline{80} |
| Contribution | 20 |
| Less: Fixed costs | \underline{30} |
| Budgeted loss | \underline{\underline{(10)}} |
The directors would like to aim for a profit of £20 000 for the year to 31 March 2005.
Various proposals have been put forward, none of which require a change in the budgeted level of fixed costs. These proposals are as follows:
1 Reduce the selling price of each unit by 10 per cent.
2 Increase the selling price of each unit by 10 per cent.
3 Stimulate sales by improving the quality of the product, which would increase the variable cost of the unit by £1.50 per unit.
Required:
(a) For each proposal calculate:
(i) the break-even position in units in value terms;
(ii) the number of units required to be sold in order to meet the profit target.
(b) State which proposal you think should be adopted.
Problems Limited
(a) (i) and (ii)
| Workings: | £ |
| Profit target | 20000 |
| Fixed costs | \underline{30000} |
| Total contribution required | \underline{\underline{50000}} |
The budgeted selling price per unit is £10 (£100 000/10 000). The budgeted variable cost per unit is £8 (£80 000/10 000).
The budgeted outlook compared with each proposal may be summarized as follows:
| Per unit: | Budgeted | Proposal | Proposal | Proposal |
| position | 1 | 2 | 3 | |
| £ | £ | £ | £ | |
| Selling price | 10 | 9 | 11 | 10.00 |
| Less: Variable costs | \underline{8} | \underline{8} | \underline{8} | \underline{9.50} |
| (a) Unit contribution | \underline{\underline{2}} | \underline{\underline{1}} | \underline{\underline{3}} | \underline{\underline{0.50}} |
| (b) Total contribution required to break even (= fixed costs) | \underline{£30 000} | \underline{£30 000} | \underline{£30 000} | \underline{£30 000} |
| (c) Total contribution required to meet the profit target | \underline{£50 000} | \underline{£50 000} | \underline{£50 000} | \underline{£50 000} |
| Number of units to break even [(b)/(a)] | \underline{\underline{15000}} | \underline{\underline{30000}} | \underline{\underline{10000}} | \underline{\underline{60000}} |
| Number of units to meet the profit target [(c)/(a)] | \underline{\underline{25000}} | \underline{\underline{50000}} | \underline{\underline{16667}} | \underline{\underline{100000}} |
(b) Comments:
1 By continuing with the present budget proposals, the company would need to sell 15 000 units to break even, or 25 000 units to meet the profit target. Thus in order to break even the company needs to increase its unit sales by 50% (\frac{£15 000 -10 000}{10 000} \times 100) and by 150% (\frac{£25 000 -10 000}{10 000} \times 100) to meet the profit target.
2 A reduction in selling price of 10% per unit would require unit sales to increase by 200% (\frac{£30000 -10 000}{10 000} \times 100) in order to break even, and by 400% (\frac{£50000 -10 000}{10 000} \times 100) to meet the profit target.
3 By increasing the selling price of each unit by 10%, the company would only have to sell at the budgeted level to break even, but its unit sales would have to increase by 66.7% (\frac{£16 667 -10 000}{10 000} \times 100) to meet the profit target.
4 By improving the product at an increased variable cost of £1.50 per unit, the company would require a 500% (\frac{£60 000 -10 000}{10 000} \times 100) increase in unit sales to break even, or a 900% (\frac{£100 000 -10 000}{10 000} \times 100) to meet the profit target.
Conclusion:
It would appear that increasing the selling price by 10% would be a more practical solution for the company to adopt. In the short run at least, it will break even, and there is the possibility that sales could be sufficient to make a small profit. In the long run this proposal has a much better chance of meeting the profit target than do the others. Some extra stimulus would be needed, however, to lift sales to this level over such a relatively short period of time. It is not clear, why an increase in price would increase sales, unless the product is one that only sells at a comparatively high price, such as cosmetics and patent medicines. It must also be questioned whether the cost relationships will remain as indicated in the exhibit over such a large increase in activity. In particular, it is unlikely that the fixed costs will remain entirely fixed if there were to be a 66.7% increase in sales.