Break Even Sales and the Margin of Safety - Essay Example

1142630 FM Question Part a The number of Racey that JxCorp should make in order to break even during the year is shown in Table which is shown below. Calculation of Break Even Sales   Units Cost per unit (£) Total (£) Sales 28 25,000 700,000 Variable Costs:   Direct labour 28 10,000 280,000 Material 28 6,000 168,000   448,000 Contribution 252,000 Fixed costs:   Salaries 80,000 Administration and Marketing 20,000 Premises running costs 100,000 Vehicle and equipment maintenance costs 52,000 Total fixed costs 252,000 Profit/Margin Safety     0 Table 1 The calculations indicate that JxCorp should sell 28 units of Racey in order to break even. Break even sales revenue is £700,000. This covers variable costs and fixed costs leaving no profit. The margin of safety measures how far from the break even point a company is operating (Eldenburg and Wolcott 2005). It is measured in units, pounds and percentage (Horngren et al 2011). The margin of safety if JxCorp produces 30 units of Racey is shown in Table 2 below. Calculation of Margin of Safety   Units Cost per unit (£) Total (£) Sales 30 25,000 750,000 Variable Costs:   Direct labour 30 10,000 300,000 Material 30 6,000 180,000   480,000 Contribution 270,000 Fixed costs:   Salaries 80,000 Administration and Marketing 20,000 Premises running costs 100,000 Vehicle and equipment maintenance costs 52,000 Total fixed costs 252,000 Margin of Safety     18,000 Table 2 The information in Table 2 shows the calculation of the margin of safety if JxCorp produced 30 units of Racey. The margin safety assuming 30 units are produced is £18,000. The sales revenue from selling 30 units is £750,000. Part b The estimated profit and loss assuming 50 units of the product could be sold s calculated in Table 3 below. Estimated Annual Profit and Loss Assuming Sale of 50 Units of Racey   Units Cost per unit (£) Total (£) Sales 50 25,000 1,250,000 Variable Costs:   Direct labour 50 10,000 500,000 Material 50 6,000 300,000   800,000 Contribution 450,000 Fixed costs:   Salaries 80,000 Administration and Marketing 20,000 Premises running costs 100,000 Vehicle and equipment maintenance costs 52,000 Total fixed costs 252,000 Profit/Margin of Safety     198,000 Table 3 The calculations shown in Table 3 above indicate that the estimated annual profit or loss assuming 50 units of Racey were sold is £198,000. Part c The main advantages of break even analysis are detailed as follows. i. It indicates the lowest amount, in this case of Racey that needs to be produced to cover variable and fixed costs so that a loss is avoided. ii. It can predict the effects of changes in price and costs. iii. It shows how changes in business activity will affect profits. That is, it allows for what if analysis. Break even analysis does not take into consideration changes in the scale of production. An increase in the scale of production could likely result in changes to both fixed and variable cost. Increasing the scale may lead to increased fixed cost. Additionally, buying more raw materials could result in a lower cost per unit. Furthermore, producing more of an item could lead to higher hourly rate for labour as overtime may be necessary. Overtime is normally charged at a higher rate of time and a half. Break even analysis, assumes that the quantity of Racey that is produced will be sold. It may not be possible for JxCorp to sell all the products produced. Profit is calculated on the quantity of goods sold and not the quantity of goods expected to be sold. Additionally, JxCorp may not be selling Racey to one customer. Other customers may demand a lower price per unit. Break-even analysis breaks down as it assumes there is only one market for the product and all units are sold at the same price. It does not take into consideration that JxCorp may have to sell Racey to different customers at different prices. It uses only one selling price to determine how changes in volume sold will affect profits. It is common practice to sell goods at different prices to different customers. Question 2 Part a The weighted cost of capital is the weighted average of the components of capital (Brigham and Ehrhardt 2005). In this case, the components are equity and debt. The calculation of the weighted cost of capital WACC is shown in Table 4 below. Calculation of WACC   Cost (£) Return/Interest (%) WACC Equity 200,000 15   Debt 200,000 9       Formula:   WACC = Wd rd(1-T)+We re =   11.0% Table 4 The calculations in Table 4 indicate that WACC is 11%. The weight of each component is 50% (0.5). The symbol Wd represents the weight of Debt and We the weight of equity. The symbol rd represents the interest rate on the debt which is 9% and re the return on equity which is 15%. The corporation tax rate, T is 22% or 0.22. Part b The capital allowance calculation for years 1 to 4 is shown in Table 5 below. Calculation of Capital Allowances for Projects A and B Year Cost/WDV bf (£) Rate (%) Annual Allowance (£) Balancing Allowance (£) 1 400,000 25 100,000   2 300,000   75,000   3 225,000   56,250   4 168,750     168,750 Table 5 The information in Table 5 indicates that capital allowances of £100,000, £75,000, and £56,250 were charged in years 1, 2 and 3 respectively and balancing charge of £168,750 in year 4. The amount was the same for Projects A and B. The calculation of taxation payable is shown in Table 6 below. Calculation of Tax Payable Project A Year Profit before tax Capital allowance Taxable Profit Tax Payable Tax paid 1 75,000 100,000 (25,000) (5,500)   2 125,000 75,000 50,000 5,500   3 150,000 56,250 93,750 20,625 5,500 4 175,000 168,750 6,250 1,375 20,625 5         1,375     Project A Year Profit before tax Cap/Bal allowance Taxable Profit Tax Payable Tax paid 1 125,000 100,000 25,000 5,500   2 125,000 75,000 50,000 11,000 5,500 3 125,000 56,250 68,750 15,125 11,000 4 150,000 168,750 (18,750) (4125) 15,125 Table 6 Table 6 shows the calculation of taxation payable for years 1 to 4 and the amounts actually paid in those years. No tax was payable in year 1 on project A. Instead there was a tax credit of £5,500. This amount was set off against the amount payable for year 2 of £11,000, making the amount payable of £5,500 for year 2. The tax payable for year 3 and 4 were £20,625 and £1,375 respectively. In relation to Project B, the tax payable for years 1, 2 and 3 were £5,500, £11,000 and £15,125 respectively. A tax credit of £15,125 was due to the company for year 4. Part c Net present value (NPV) is the difference between the present values of cash inflow and outflow (Titman et al 2011). Cash inflows are discounted using WACC. The NPV criterion is to select projects with positive NPV’s is positive and reject those with negative NPV’s. Table 7 shows the calculation of NPV for Projects A and B. Calculation of Net Present Value (NPV) Project A Year Cash Flow (£) PV Factor (11%) PV Cash Flow (£) 0 (400,000) 1 (400,000) 1 75,000 0.90090 67,568 2 125,000 0.81162 101,453 3 150,000 0.73119 109,679 4 175,000 0.65873 115,278 NPV (6,024)     Project B Year Cash Flow (£) PV Factor (11%) PV Cash Flow (£) 0 (400,000) 1 (400,000) 1 125,000 0.90090 112,613 2 125,000 0.81162 101,453 3 125,000 0.73119 91,399 4 150,000 0.65873 98,810 NPV 4,273 Table 7 The information in Table 7 indicates that Project A has a negative NPV while Project B has a positive NPV. The NPV criterion suggests that Project B should be accepted and Project A rejected. The discounted payback provides information on how long it will take for the project to pay back the initial investment from discounted cash flows (Titman et al 2011). Table 8 below provides the information for both projects. Calculation of Payback Period   Project A Project B Year Discounted Inflow/(Outflow) Cumulative Total Discounted Inflow/(Outflow) Cumulative Total 0 (400,000) (400,000) (400,000) (400,000) 1 67,568 (332,432) 112,613 (287,387) 2 101,453 (230,979) 101,453 (185,934) 3 109,679 (121,300) 91,399 (94,535) 4 115,279 (6,021) 98,810 4,275 Table 8 The information in Table 8 indicates that Project B will be able to pay back the initial investment in the four year period while Project A will not. The results from the calculation of both NPV and the discounted payback period indicate that Project B should be selected and Project A rejected. Part d The use of discounting in investment appraisal assumes that the discount rate remains the same throughout the life of the project. Only one discount factor is used in the calculation of NPV. This is a very simplistic assumption. The discounted payback period does not only assume the same discount rate applies throughout the project but it does not consider cash flows after the project period. Cash will still continue to flow and these should be taken into consideration. Question 3 A thorough financial analysis Babs Holdings plc for the years’ 2010and 2011 involves determining the company’s profitability and liquidity. It is also important to assess the efficiency with which the company’s assets and working capital are managed. Calculation of investment ratios will provide information on whether shareholders are receiving a fair return on their investments. Information on profitability ratio is shown in Table 9 below. Profitability Ratio for Bab’s Holding Plc   2011 2010 Profit margin (%):         Profit/Sale revenue   6.77%   1.86% Profit 19,300,000     5,000,000 Sales 285,000,000     268,400,000           Table 9 The information n Table 9 shows that the company’s profitability improved in 2011. Profits increased by 6.8% in 2011 compared to 1.9% in 2010. This is a major improvement. Further analysis of the figures indicates that the reduction in operating expenses from 104.3mn to 100.8mn had a major impact on this change. The figures relating to the company’s liquidity is shown in Table 10 below. Liquidity Ratios   2011 2010 Current Ratio 1.483651 1.1911967 Current assets to Current liabilities 1.48 to 1 1.19 to 1 Current assets 108,900,000 86,600,000   Current liablities 73,400,000 72,700,000           Acid Test Ratio 0.820163488 0.53094911 current assets - stock to current liabilities 0.82 to 1 0.53 to 1 Ca - stock 60,200,000 38,600,000   Current liabilities 73,400,000 72,700,000             Table 10 The information in Table 10 shows that the company’s liquidity improved in 2011. The current assets ratio indicates whether the company is able to pay debts as they fall due. While the figure may indicate that it can, the acid test ratio is a better measure. It takes into account the fact that inventories are not easily converted to cash. The information shown by the acid test ratio indicates that the company will have problems paying debts as they fall due. The improvement shown in 2011 needs to continue into the future References BPP Learning Media Ltd. (2008). ACCA Paper F7 Financial Reporting Study Text. 3rd ed. London: BPP Learning Media Ltd Brigham, E.F and Ehrhardt, M.C. (2005). Financial Management: Theory and Practice. 11th ed. USA:Thomson South-Western Eldenburg, L.G and Wolcott, S.K. (2005). Cost Management: Measuring, Monitoring and Motivating Performance. 1st ed. USA: John Wiley & Sons. Horngren, C.T., Datar, S.M and Rajan, M. (2011). Cost Accounting: A Managerial Emphasis. 14th ed. USA: Prentice Hall Titman, S., Martin, J.D and Keown, A.J. (2011). Financial Management: Principles and Applications. 11th ed. USA: Pearson Education, Inc. Read More