Marginal Costing and Break-Even Analysis - Essay Example

Name………………………………………………………………xxxxxx Tutor………………………………………………………………. xxxxxx Institution……………………………………………………………xxxxxx Title………………………………………………………… ………xxxxxx Course……………………………………………………………….xxxxxx @2010 Introduction In this report, we are going to determine whether the introduction of a new energy drink is worth making by analysis the profitability and costs to be incurred. This analysis can only be made possible by use of marginal costing, the break-even analysis, balance sheet and income statement forecasts and budgets. The determination of the optimum level of production will also be carried out. In cost accounting, all these aspects are commonly used by the managers in the planning and control process. A good plan should have a sense of direction, objective and smart. The control process entail proper budgeting and making comparison between actual results and the estimated results. The new energy drink will be parked in plastic bottles of 300ml in capacity. Plastics bottles can be recycled for reuse thus economical. Marginal costing Marginal costs in economics and finance refers to the change in the total cost as a result of a change by one unit in the quantity produced. Therefore, marginal costs are considered as a variable cost since it varies with the level of production. Variable costs are vey important in decision making unlike the fixed costs. Marginal cost is made up of various cost elements such as direct labor, direct materials, direct expenses and the variable overheads. Direct costs are costs that can easily be identified. For instance, it is easy to identify the cost of materials used to package the new energy drink. Note that marginal costing is not a costing method but a technique that is used by the managers in planning and decision making process. The term marginal costing is sometimes referred to as the contribution approach or direct costing. Contribution is an approach that has resulted from marginal costing. It is the difference between sales revenue and the direct costs. In our case, we want to find out how the marginal costing statement for the new soft drink would look like. Below is the statement of marginal costing: Marginal costing statement $ 000' Sales revenue 20,000 Less: marginal cost of sales Opening stock - Add production cost @25 5,000 Total production cost 5,000 Less: closing stock - Marginal cost of production 5,000 Add: selling, administration and distribution costs 1,000 (6,000) Contribution 14,000 Less: fixed costs (4,000) Marginal costing profit 10,000 Looking from the statement above, the fixed costs have been excluded because such costs are assumed to be incurred whether production takes place or not. There is also the production cost, which is made up of the direct labor costs, direct material costs and the direct expenses. The selling, administration and distribution costs are part of the variable overhead costs. Notice that the opening stocks, closing stocks and the production costs are valued at the unit variable cost or marginal cost. Not that fro the above format, marginal three main features characterize costing. We have the inventories that are valued at the marginal cost. Then there is the contribution given by the sales less the variable costs and then the sharp distinction between the variable and fixed costs. The question that is the new soft drink worth producing should come into mind. If the marginal costing profit is a negative meaning a loss, then the new soft drink is not worth producing. On the other hand, if it is a marginal profit, then it worth producing thus the investors should be presented with the statement to show the viability of the new product. Ours is a marginal profit thus the soft drink is worth producing. The reason why marginal costing is most preferred than absorption costing is because it is easy to use and understand and it eliminates the fixed costs, which are irrelevant in decision-making process. It also helps in planning the breakeven and profitability analysis. There are several disadvantages of marginal costing. To begin with, it is difficult to separate the variable costs with the fixed costs and this fact may lead to misleading results. Marginal costing leads to the understatement of stocks and the work in progress since the fixed costs are excluded. This definitely affects transparency of the financial statements as they fail to reflect a true and fair view. Another disadvantage associated with marginal costs is that the data may be rendered unrealistic especially in cases where the levels of production fluctuate highly. The assumption that the variable costs per unit, the fixed costs and sales price are constant is not realistic because they usually vary. In the long term, the best method to be used in profit planning is the absorption costing rather than the marginal costing. Finally, in marginal costing only consider the contribution as the profit but this is not suitable in budgetary control process since contribution does not take into account the fixed costs. Break even analysis In cost accounting, the breakeven analysis is the point where the total revenue equals the total costs of production. Total revenue = Total costs Total revenue= selling price per unit * total units sold Total costs = Fixed costs + variable costs variable costs = variable cost per unit* quantity produced X * S = FC + V* X X = FC/ (S-V) Let: X = quantity produced and sold FC = Fixed costs S = selling price per unit V = variable cost per unit x = 4,000,000/ (30-25) x = 800,000 units At the break-even point, the profit is zero and you find out that the total revenue at least cover all the fixed costs. All the units produced are assumed to have been sold therefore no opening stocks or closing stocks. Looking at the break-even units calculated above of 800,000 we have assumed that the unit-selling price per bottle of the energy drink is $30 while the variable unit cost is $25. The break-even analysis assumes that the fixed costs are constant that is why we used $4,000,000. Therefore, at that level of production, there will be no profits and the revenue received will have covered all fixed costs. Break even analysis also determines the break-even sales given by the formulae shown below: Break even sales = FC /(C/S) Therefore break even sales = 4,000,000/ (5/30) = 24,000,000 Break even analysis is also used in determining the margin of safety. In cost accounting, margin of safety is used to measure the strength of business by measuring the exact amount that has been gained or lost on reaching the break-even point. It is given by the difference between the expected sales and the break even sales. Margin of safety = expected sales revenue - break even sales Margin of safety = 32 million- 24 million = $8 million In the above analysis, we have assumed that the expected sales revenue from sale of the energy drinks would be $32 million to give us a margin of safety of $8 million. The break-even analysis has several limitations. To begin with, it assumes that the fixed costs ar constant but this is not practical in the real business world since you may find out that some of these fixed costs vary with the level of production. It assume that all quantity produced is sold thus no opening inventories or closing inventories. This fact is also not practical since sales are influenced by factors such as economy, seasonal, political and cultural. For instance, the sale of a product may go down if there is political instability in a country. The forces of demand and supply also affect the quantity sold. For instance, there are seasons when a product is highly on demand than others. Therefore, such realistic facts make that assumption vague. The other critic of break-even analysis is that it only considers the costs but tells nothing about the sales. A reliable model of cost accounting should take into account both the costs and sales. Break even analysis does not take into account any changes that may be brought about by the technology. Technology is very important in the production process nowadays and it determines the quality of a product, the costs to be incurred and many more. Finally, when it comes to companies producing multiple products, it assumes break-even analysis assumes that the sales mix is constant meaning that the relative proportion of each product produced and sold is constant. Forecasting the financial statements Forecasting of the financial statements is very important as it helps the financial managers plan the firm’s financial needs. It also helps them in identifying and solving potential problems early in advance. The accuracy of these statements is limited by the assumptions that have been used in creating them Sales forecasts The first step in preparation of financial statement forecasts is by preparing the sales forecast (Brigham and Daves, 2009). This is because the sales affect the current assets and liabilities. For instance, an increase in sales will lead to reduction in inventories or affect the accounts receivables. The forecasting of sales is the hardest duty one can ever do since sales depend on specific factors such as the industry, economy and season. When it comes to the industry factors, it becomes very essential to observe the trends so that one can quantify the impact on the company. Such trends may be competition in the industry. The economic factors involve the economic cycles such as recessions and boom. Such economic factors not only affect the sales but also other financial statement forecasts. For seasons, you find out that there is a particular time of the year when a certain product is largely on demand. Therefore, it is good to take into consideration this factor as it affects the sales forecasts and also the financial statements forecasts. Sales can be estimated weekly, monthly or quarterly. The best way to carry out sales forecasts is by the use of the regression analysis but the easiest way is by using the moving average method. The average moving model takes the sales of each quarter then divided by the number of months in each quarter. In our analysis, we will use quarters as shown below: Estimated sales 1st quarter 2nd quarter 3rd quarter 4th quarter 4 million 6 million 10million 12 million Each quarter has duration of three months. The first quarter is from the month of January to march, the second from April to June, the third from July to September and the fourth quarter from October to December. Using the moving average method, we took the total sales of each quarter divided by three. It has been assumed that the sales will increase gradually in each quarter an indication that the product is now familiar with the consumers and more markets are being penetrated. The increase in sales means that marketing strategies such as personal selling, media and promotions have been used to target the customers. Estimations are referred to as forecasts and some of the forecasts. For example, there are cash budget, income statement and balance sheet forecasts. a) Cash budget A cash budget shows the cash receipts and cash expenditures of a business (Brigham and Daves, 2009). Such a budget can be prepared either quarterly or yearly for short-term planning needs. They are especially needed when a firm wants to borrow money from a financial institution. This is because such institutions need that budget to help in determining on whether the company or borrower is in a position to settle the debt in future. It is usually uncertain that one may experience surpluses or deficit in business, therefore the cash budgets are just used to foresee the future. Cash budgeting should be carried out as a continuous process so that timely comparisons between the estimated cash budget and the actual cash budget can easily be made. The continuous process ensures consistency, which is a very important element when it comes to planning and decision-making. It is very important to check on the reasonableness of the budget to determine whether the method used in forecasting is reliable. The cash budget as noted before involves cash only. Below is an estimated cash budget for the new energy drink. CASH BUDGET ESTIMATED STATEMENT OF CASH RECIEPTS AND PAYMENTS FOR THE YEAR ENDED 31ST DECEMBER 2010 1st quarter 2nd quarter 3rd quarter 4th quarter 000' 000' 000' 000' Estimated cash balance at the beginning of the period 2,000 6,800 13,550 24,800 Estimated cash Inflows: cash sales 4,000 6,000 10,000 12,000 collections on credit sales 2,000 4,000 6,000 10,000 Bank loans 1,000 - - - Total inflows 9,000 16,800 29,550 46,800 Estimated Cash outflows: payments to suppliers (1,500) (2,000) (3,000) (4,000) payments to operating and other expenses (500) (1,000) (1,500) (2,000) payment of bank loan plus interest (250) (250) (250) (250) Estimated cash balance at the end of the period 6,750 13,550 24,800 40,550 The above cash budget has been prepared on a quarterly basis and it seems the results reflected are favorable meaning that there will be no cash deficits to be experienced if the new product is to be introduced. You also notice that the closing balance of quarter is the beginning balance of another quarter. The cash balances are referred to as reserves and are very important especially when carrying out the planning process. The cash balance held at the beginning of each quarter highly depends on the estimated future cash flows and should be large enough to enable the company meet its operating costs. Holding such a reserve enables the management to cope with adversities and they will not be forced to borrow cash to meet their needs. The amount held as a cash reserve varies from company to company. For instance, some companies hold a substantial amount of cash together with highly liquid investments that can easily be converted into cash. Others prefer maintaining small amounts of the cash reserve and when it gets finished, they make borrowing from the bank. b) Forecast income statement The income statement forecast shows future estimates of company’s results regarding all the operating activities. The income statement thus takes into account all revenues but excludes the sources of income. The best way to forecast the income statement is by use of the sales percentage method. PROFORMA INCOME STATEMENT FOR THE YEAR ENDING 31ST DEC 2010 $ 000' Sales 32,000 less: cost of sales (24,000) 8,000 gross profit margin 25% less expenses (3,200) 4,800 net profit margin 15% In the calculations above, we have assumed that the gross profit margin is 25% of the total sales revenue to come up with the cost of sales, which is a balancing figure. Then to get the estimated expenses, we calculated the net profit first using the net profit margin of 15% on sales. The got the difference between the gross profit and the net profit. c) Balance sheet forecast In preparing the forecasted balance sheet, the accounts that greatly vary with the sales such as the inventories, accounts payable and accounts receivables are prepared first (Brigham and Daves, 2009). Other accounts such as long-term borrowings may be driven by the discretion of the management and not sales. However, there are accounts that may relate with the sales in the end. For instance, the fixed assets may grow at a faster rate than the sales. The most used ways in forecasting the balance sheet current accounts is by use of ratios, percent of sales and the regression analysis. For our analysis, since the product is new the percentage of sales method plus it is easy to use compared to ratios and the regression analysis. Below is the balance sheet forecast using the percentage of sales method for the year: PROFORMA BALANCE SHEEET AS AT 31ST DEC 2010 $ Assumption 000' CURRENT ASSETS inventories 19,200 60% of sales accounts receivables 6,400 20% of sales cash 25,600 80% of sales 51,200 EQUITY AND LIABILITIES accounts payables 3,200 10% of sales long term loan 1,000 stock 30,000 external finances 12,200 Retained earnings 4,800 51,200 In the above analysis, we have assumed percentages on sales for the current account balances since they greatly vary with sales. The amount of forecasted external finances can easily be calculated using a simple method. That is by taking the difference between the forecasted used and forecasted sources. This approach is not accurate tough. The use of ratio can best be used in forecasting the external finances. On the other hand, stock may be forecasted by first determining the capital requirements of the company. Conclusion We have analyzed the marginal profit, the break-even analysis and the financial statement forecasts as part of the planning process. The results regarding the cost and profitability of the new energy drink seem to be favorable therefore; it is upon the investors to make up a decision on whether to allow the new energy drink to be produced. However, looking into the results the investors should be convinced that the new product is viable. The only thing left is to kick start the production process and strategically position the product into the market. If the investors are not fully convinced, then they should be asked on which areas they feel are not satisfying so that changes can be made before the production takes place. It is vital to listen to any of their opinions to come up with a consensus and avoid conflicts. Reason being it is their money that will be used and they have any rights whatsoever to know how their funds are to be used and what returns are they to get out of that. Apart from making profits, a company has the obligation of maximizing the investor’s wealth. Reference Eugene Brigham and Philip Daves (2009). Intermediate financial management. Cengage learning. Read More