Profitability at Hardhat Limited: The Relationships between Revenues - Essay Example

Profitability at Hardhat Limited: The Relationships between Revenues The budgeting committee of Hardhat Limited, has to analyze the profitability and the effect of change in prices of production inputs on our profits for the coming year. Profit planning can be done through the cost-volume and profit analysis(hereafter, CVP analysis). It can be clearly understood by everybody that profit is a functions of cost, volume and selling price and the cost-volume and profit analysis is a great management tool to show the inter-relationship between these ingredients1. 2Profitability analysis involves examining the relationships between revenues, costs, and profits. Performing profitability analysis requires an understanding of selling prices and the behavior of activity cost drivers. (Activity cost driver is often referred to as cost driver when the context is clear that we are discussing activity, rather than structural or organizational, cost drivers.) Profitability analysis is widely used in the economic evaluation of existing or proposed products or services. Typically, it is performed before decisions are finalized in the operating budget for a future period. This report shows the analysis done to find out the changes in the profit when the costs increase and how much of sales is requires to achieve the targeted profits and also the selling price that is required to achieve the targeted profit. For the CVP analysis it is assumed that the total costs can be segregated into fixed and variable costs, the fixed cost remains constant during the relevant period, variable cost per unit remains constant during the period of consideration and the selling price will also be constant irrespective of the volume sold during the year 2007/ 2008. It is also assumed that the production and sales volume will remain constant. With these assumptions as the background, the calculation on the effect of profit is calculated when there is change in selling price, sales volume and cost of resources are made and submitted. INCOME STATEMENT From the projected income statement for 2006/ 2007 and the anticipated changes for 2007/ 2008 the following income statements are prepared: (amounts in £) Particulars Year 2006/ 2007 Year 2007/ 2008 Change Total amount Per unit Total amount Per unit Units Sold 100000 130000 30 % increase Selling Price 100 100 - Sale Value 10000000 13000000 Material Cost * 3000000 30 4680000 36 20% increase Labour Cost* 2000000 20 2730000 21 5% increase Variable Overheads* 960000 9.6 1372800 10.56 10% increase Contribution (A) 4040000 40.4 4217200 32.44 Selling Expenses 1500000 1620000 8 % increase Administrative Expenses 1000000 1060000 6 % increase Fixed Overheads 40000 42000 5 % increase Total Fixed Cost (B) 2540000 2722000 Profit (A – B) 1500000 1495200 Note: materials, labor and overheads are in the ratio 3:2:1 in cost of goods sold Fixed overheads is £ 40,000 in 2006/ 2007 It is mentioned that the expected sales, variable costs an fixed costs will change in the year of 2007/ 2008. The reason for the increase in fixed cost is the increase in the selling expenses due to expected increase in sales volume and the increase in administration costs are due to expected increase in salaries. Hence, we have to find out, the relative sales volume to earn the target profits and the new selling price when the sales volume increases by 10% and 20%. These analyses help to understand the triangular relationship between the costs, volume of sales and profits. Understanding of this relationship helps to make managerial decisions and to devise marketing strategies. From the information provided the variable cost and the fixed costs are segregated to calculate the contribution. Contribution per unit is the difference between the selling price and the variable cost per unit. Contribution is not profit. Contribution means the amount that is obtained by the sale of each unit towards recovery of the fixed costs. In other words, it tells us the amount that is contributed towards the recovery of the fixed costs, in every sales transaction. When we are doing CVP analysis for Hardhat Limited, we have to know the number of units we have sell to recover the fixed costs and to earn the required profits. for this analysis, determination of contribution is very crucial. Hence, contribution is calculated in the above table by adding all the variable costs and subtracting ti from the sales revue and the contribution per unit is obtained by calculating the difference between the selling price of one unit and the variable cost per unit. ESTIMATION OF SELLING PRICE TO EARN THE TARGET PROFIT The targeted profit set by our managing Director is £2,000,000. To attain this profit there are two options, one is to increase the price or to increase the sales volume. But increasing the selling price is not the first option. If the selling price in increased we may lose our market shares. To increase the sales volume will be the best option towards achieving the strategic market share. To increase the sale volume the selling expenses may increase which is shown in the projected income statement. But an analysis is needed to know how much should be the selling price in order to achieve the target profit. Profit = Sales revenue – total cost Sales revenue = profit + total cost Selling price x no. of units sold = profit + total cost Selling price = profit + total cost / no. of units sold Here, expected profit = £ 2000,000 total cost = total variable cost + total fixed cost Total variable cost = 8782800 Total fixed cost = 2722000 Total cost = 11504800 Selling price = (2000000 + 11504800) / 130000 = 103.88 It is shown from the calculation that, the company has to sell 130000 units at a price of £ 103.88. But increase in prices is not an option that is preferred very much because it is feared that it might have a long term impact on the strategic competitive position of the company. It is felt that, if the company raises its prices it may give short term profits, but it can give advantage to the competitors and can affect the company in the long run. Hence, it is important to analyze how many units have to be sold at the current price to earn the targeted profits. to find out how many units have to be sold at the current selling price to earn the targeted profits, we have to again use the contribution per unit. Contribution per unit = Selling price – variable cost per unit It is also called as the V/V ratio, (Khan, 2004), i.e., the ratio which shows the ratio between the variable costs and volume of sales. V/ V ratio = variable cost / sales revenue The use of this ratio is to understand in each sales, how much is contributed towards the recovery of the fixed costs., which is the breakeven point. Breakeven point is the level of sales where all the fixed costs are recovered and beyond the breakeven point, the contribution per unit is our profits, until the breakeven point the contribution is just recovering our fixed costs. Breakeven point is calculated by the following formula: BEP(in amount) = Fixed costs / P/ V ratio Here, P/ V ratio is the relationship between contribution margin per unti and selling price per unit. It can be represented as follows: P/ V ratio = contribution margin per unit/ selling price per unit The former ratio, V/ V ratio tells us the relationship between sales volume and variable cost and the latter P/ V ratio is the relationship between contribution and selling price. Contribution is the difference between selling price and variable cost, in other words the V/ V ratio. Hence, it can be denoted that V/ V ratio + P/ V ratio = 1 or 100% This analysis is very useful to understand the following calculation. Breakeven point = Fixed costs/ P/V ratio. But in our case we have to find out the number of units that are required to earn the targeted profit. Profits are realized only when we cross the Break even point which is shown in the following graph: Y V B BEP T F O X The above, is the graphical representation of Break even point. The graph has three line in it, the TF is the fixed cost line which does not change with the change in sales, the variable cost line, OV is the sales line and the total cost line, TB which is the combination of variable and fixed costs. hence, it starts from T and not O. the point where the sales line crosses the total cost line is the break even pint. Before the breakeven point every sales transaction gives us contribution to recover the total costs and after the sales line crosses the total cost line, then the company earns profits. Breakeven point = Fixed costs/ contribution per unit But here we have to find out the sales required to earn the targeted profit, i.e. the sales we have to calculate is after the breakeven point. In the formula the numerator should have the amount to be recovered. If it is breakeven point the numerator is the fixed costs which have to be recovered and in this case it is the fixed costs plus the targeted profit. Hence, the formula will be, Sales required = (total fixed cost + targeted profit)/ contribution per unit = (2722000 + 2000000)/ 32.44 = 145561 units The company has to sell 145561 units at the current selling price of £ 100 to earn the targeted profits. the expected sales for 2007/ 2008 is 130000 units and the additional units to be sold to earn the targeted profits are 15561 units. The management should analyze whether it is possible to sell these units in order to achieve the targeted profits. if it is possible then the selling price need not be increased and can be maintained at the current level. Another aspect of analysis is the effect of the change in selling price on the profit. To have a more clear picture the effect of change in selling price on the profit when the sales volume increases by 10 % and 20%. PARTICULARS 10% INCREASE IN SALES 20% INCREASE IN SALES UNITS SOLD 110000 120000 SALES REVENUE(103.88 x no. of units) 11427138.46 12465969.23 MATERIAL COST(36 per unit) 3960000 4320000 LABOUR (21 per unit) 2310000 2520000 VARIABLE OVERHEADS (10.56 per unit) 1161600 1267200 CONTRIBUTION (36.32 per unit) 3995538.46 4358769.23 SELLING EXPENSES 1620000 1620000 ADMINISTRATIVE EXPENSES 1060000 1060000 FIXED OVERHEADS 42000 42000 TOTAL FIXED COST 2722000 2722000 PROFIT 1273538.46 1636769.23 In this table it is taken as there is change in sales volume by 10% and 20%. The other costs both fixed and variable costs are assumed to be the same as in the normal sales level. Hence, the contribution per unit will be same, except for change in profits. FUTURE DECISIONS The results from the calculations above will hold good only when the assumptions are true. The validity of the analysis depends on the validity of the assumption. It is assumed that the costs are either perfectly variable with the output or it is absolutely fixed for a range of production levels over a particular period of time. This assumption may not be true in real life situations. The variable cost is assumed to have perfectly linear relationship with the output. But we all know that the variable cost per unit can increase as the production increases to full capacity. This may be due to less efficiency of the human resource. Hence, a study on the nonlinear relationship between total costs and volume in the economic reality should be undertaken. Also , a sensitivity analysis about the change in cost of factors of production at various levels and the change in profit levels should be done to have more reliable results. Also an analysis of trend in the variations of the price in the short run should be done to predict the future behavior of prices. In future the company should try to control its fixed costs. An increase in fixed cost will increase the amount to be recovered and hence, it will increase the number of units to be sold to achieve the targeted profits. Hence, it will be advisable to introduce cost control measures at Hardhat Company. This analysis will help the company to fix the selling price which can give a strategic advantage in the long run. The strategy of raising finance from short term profits for financing acquisitions may give an advantage but the increase in prices can have effects on the perception of the consumers. It can affect the brand image and in future new competition may arise in the market. We all know that markets are contestable. When a company in an industry has no competition an has considerable profits, it is likely to attract new competition. CONCLUSION From the analysis, it is evident that if there is an increase in the price, the targeted profits can be achieved easily. But the committee has to discuss the effects of the increase in selling price and has to decide the best option. To achieve the target profit, we can also increase the sales volume and the marketing budget has to be increased. It should also be taken up by the Budget Committee to decide whether the company can manage to sell another15561 units more. The plans required to increase the sales should be formulated. However, analysis is crucial for making this type of decision3. It is essential that the Committee should have more in-depth study into the estimated sales in order to make decisions about the future. In this aspect, it is essential that we should prioritize our objectives. Either to achieve maximum short term profits, raise money for acquisition, acquire our competitor and move ahead, or to continue with our tight cost and low price strategy and drive the competitor out of the industry. We all know markets are contestable, and hence, any new competitor can enter the industry and can claim a share in our profits. Negligible competition and heavy profits will attract new players into the industry. So, the latter option of holding a tight cost structure and keeping the price low will act as barriers of entry to avoid new competition. When a new competitor enters the market he can survive only when he can match our cost structure, which is highly unlikely for a new entrant. Hence, in the long run, this approach will be very significant to strengthen our competitive position and will be instrumental to achieve the market leader status in the long run. REFERENCES 1. Khan, M. Y and Jain, P. K (2003) Financial Management, 4th ed, New Delhi, Tata McGraw Hill publication 2. Morse, W. J Davis, J. R and Hartgraves, AI (2000) Management Accounting: A Strategic Approach, 2nd ed, Cincinnati, South Western Publishing 3. Brannon, L and McCabe, A (2001) “Time Restricted Sales Appeals” Conrnell Hotel and Restaurant Administration Quarterly, August/ September, pp 47-53 Read More