Accounting for Decision Making - Essay Example

? Break-even Analysis and Planning ACC501 - Accounting for Decision Making Break-even for the two strategies at each level of output Strategy Fixed Cost = $20,000,000 Selling Price = $170 Variable Cost = $35 Break-even level of output = (Keiso, 1999) Break-even level of output = = 148,148 units. Break-even level of sales = Break-even units*Selling Price (Keiso, 1999) = 148148.15*170 = $25,185,185 Strategy #2 Fixed Cost = $25,000,000 Selling Price = $200 Variable Cost = $35 Break-even level of output = = = 151,515 units Break-even level of sales = Break-even units*Selling Price = 151515.15*200 = $30,303,030 Desired Target of Profitability The company's desired profitability target is $4 million. According to the break-even level of sales, the company must exceed the above revenue levels according to both strategies in order to be able to make profits. If the output levels, as given in the table, are taken into consideration for calculation of optimal revenue which exceeds breakeven and offers the firm with its target profitability level, the following table would provide the relevant answers to base our analysis with. Strategy 1   Selling Price = $170 Estimated demand (units) Estimated Revenue ($) Profit ($) 150,000 $25,500,000 $314,815 180,000 $30,600,000 $5,414,815 200,000 $34,000,000 $8,814,815 Hence, if the company undertakes strategy 1, as can be seen in the table above, output levels of above 180,000 units would allow the firm to fulfill and exceed its target profitability level. This range of output also fulfills the break-even level of output therefore the firm is satisfying its desired profitability level. (Keiso, 1999) If the second strategy is taken under consideration, the following financial data pertaining to the revenue and profitability associated with the different levels of output are as follows which would help determine whether the firm is likely to reach its target profitability level. As can be seen from the table, the same case applies for the second strategy which is that output levels exceeding 180,000 units, allows the firm to fulfill and exceed it target profitability level of $4m. Hence it can be concluded that both strategies, at an output level of 180,000 units and more, allow the firm to achieve and exceed its profitability target. This level of output also has the highest probability of consumer demand levels hence the firm will benefit from undertaking this level of production and fulfilling its profitability targets. (Keiso, 1999) Margin of Safety Margin of Safety: Budgeted/Actual Sales - Breakeven Sales (Keiso, 1999) Margin of Safety (%) : MOS/(Budgeted/Actual Sales) (Keiso, 1999) Strategy 1     Estimated demand (units) Breakeven Sales (units) Margin of Safety (units) Margin of Safety (%) 150,000 148,148.15 1,852 1.23% 180,000 148,148.15 31,852 17.70% 200,000 148,148.15 51,852 25.93% Strategy 2     Estimated demand (units) Breakeven Sales (units) Margin of Safety (units) Margin of Safety (%) 150,000 151515.15 -1,515 -1.01% 180,000 151515.15 28,485 15.82% 200,000 151515.15 48,485 24.24% As stated above, the margin of safety can be expressed in either units or a percentage of the total estimated sales. These figures are important for key decision making for managers because it shows the extent by which the projected sales exceed the break-even sales. The margin of safety is an important measure of risk as it shows the amount of sales which a firm can afford to vary without incurring a loss. The higher the number, the more beneficial it is for the firm since the company would be able to withstand fluctuations in sales. A drop in the levels of sales, lower than the margin of safety would alarm the management since it would cause losses for that particular period for the firm. (Keiso, 1999) Decision The decision of whether the company should go ahead with the new product should include many other ratio and cash flow analysis and evaluations so that the management, even though they cannot avoid any risks, are able to come up with more suitable decisions. However, based on the calculations and information above, both strategies, whilst exceeding the break-even level of sales, allows the firm to maintain and exceed its profitability level. Hence the firm will be successful in terms of profitability if sales meet the targeted figures. Also, the estimated demand of 180,000 units shows the greatest probability of occurring and allows the firm to earn profits and cover its costs effectively; hence investment in the new product can prove to be feasible if these estimates are turned into reality. The margin of safety at this level of output and for both strategies also provides a safe level for the firm; therefore, keeping all these factors in mind, the management should undertake investment in the new product since it is likely to benefit the firm in the long run. Type of Analysis While break-even analysis proves to be useful for a single product or mix of similar products, for large firms with many different products, it is rather difficult in terms of calculations, analysis and comparisons for managers to undertake this type of analysis since it would prove to be quite time consuming and costly for the firm. Production and sales levels tend to vary in reality and demand tends to fluctuate due to the constant changes in market conditions hence for large firms with wide arrays of products, the use of a break-even analysis is rather difficult and costly in terms of time and money as this form of an analysis does not take into consideration the changes in market conditions, which are bound to take place as sales and estimated demand levels are based on forecasts rather than facts. It can also result in too much data which can be difficult to effectively analyze and information overload can lead to important data being omitted from the conclusion of the final decision. (Brigham, 2004) The same conclusion for the usefulness of the Margin of Safety to a large firm with many products can be derived as it is associated with the break-even analysis and so it is difficult for such calculations to be based for many different products as calculation complexities, time consumption and costs will have to be incurred by the management and this is something which cannot be afforded hence other forms of analysis will prove to be more feasible for such firms whereas single product firms or those with a limited mix of products would greatly benefit from these analysis. (Brigham, 2004) Return on Investment & Residual Income The Return On Investment formula is: (Brigham, 2004) The ROI is basically measure of performance which is used by managers to evaluate the efficiency of an investment or a number of different investments. These calculations can be easily manipulated by managers to suit their own purposes however, for firms dealing with different products, this is an effective means of analysis and for Pringly Division it is a useful measure for evaluation since they are debating on the matter of launching a new product hence the gains from the investment in this will allow the management to effectively analyze the practicability of undertaking the new product investment. Strategy 1 Estimated demand (units) Fixed Cost Variable Cost Total Cost Sales Revenue Profit ROI 150,000 $20,000,000 $5,250,000 $25,250,000 $25,500,000 $250,000 0.99% 180,000 $20,000,000 $6,300,000 $26,300,000 $30,600,000 $4,300,000 16.35% 200,000 $20,000,000 $7,000,000 $27,000,000 $34,000,000 $7,000,000 25.93% Strategy 2 Estimated demand (units) Fixed Cost Variable Cost Total Cost Sales Revenue Profit ROI 150,000 $25,000,000 $5,250,000 $30,250,000 $30,000,000 -$250,000 -0.83% 180,000 $25,000,000 $6,300,000 $31,300,000 $36,000,000 $4,700,000 15.02% 200,000 $25,000,000 $7,000,000 $32,000,000 $40,000,000 $8,000,000 25.00% As can be seen above, the ROI proved to be a useful tactic in determining the returns on investment for different output levels being generated for the launch of the new product according to both the different strategies as being undertaken into consideration by the firm. Residual Income is another method of analysis which is calculated using the formula: Operating Income - (Operating Assets * Target Rate of Return) This refers to the net operating income which is earned above the minimum target return which is set by the firm. (Investopedia, 2013) In this case, the minimum target set by the firm of returns was a profit of $4m. hence all the earnings above this levels shall be part of the residual income and the greater the level of income which exceeds the firm's targets, the more beneficial the firm and its investors would be hence this is a useful analysis in this case of Pringly Division as well. References Books Brigham, E., and Houston, J. (2004). Fundamentals of financial management. Mason, Ohio: Thomson/South-Western. Fridson, M. (1995). Financial statement analysis. New York: Wiley. Harrison, W., and Horngren, C. (2001). Financial accounting. Upper Saddle River, NJ: Prentice Hall. Van Horne, J. (1977). Fundamentals of financial management. Englewood Cliffs, N.J.: Prentice-Hall. Weygandt, J., and Kieso, D., et al. (1999). Principles of financial accounting. New York: Wiley. Websites Managerial Accounting. Accounting Explained. Irfanullah Jan. Margin of Safety (MOS). Retrieved: May 8, 2013. http://accountingexplained.com/managerial/cvp-analysis/margin-of-safety eHow. Tyler Lacoma. The Cons of Brean-Even Analysis. Retrieved: May 8, 2013. http://www.ehow.com/info_8702817_cons-breakeven-analysis.html Investopedia. Residual Income. Retrieved: May 8, 2013. http://www.investopedia.com/terms/r/residualincome.asp Investopedia. Return of Investment - ROI. Retrieved: May 8, 2013. http://www.investopedia.com/terms/r/returnoninvestment.asp Ready Ratios. Residual Income (RI). Retrieved: May 8, 2013. http://www.readyratios.com/reference/analysis/residual_income_ri.html Read More