Numeric Example of Breakeven Point Analysis - Coursework Example

Breakeven Table of Contents Introduction 3 Breakeven analysis 4 Type of cost 4 Total revenue 5 Contribution margin 6 Marginal safety 6 Breakeven point 7 Numeric example of breakeven point analysis 8 Conclusion 10 Reference 11 Introduction Often it is found that a company is failing to generate profit despite having sufficient revenue. Such situations are examined with the help of break even analysis. When the cash generated by business is less than the total cost, it becomes difficult to retain the business operations resulting in closure of the firm. Therefore, it is very important for a company to undertake a break even analysis for determining the feasibility of business. The concept of breakeven analysis is as old as business itself. For years on end, business people have used break even analysis as a business analytical tool while deciding the feasibility of a new venture. The breakeven point is also taken into consideration by the management for finalising the marketing budget and other vital expenses for a particular month, quarter or year. Breakeven analysis is also necessary for new entrants to determine the total capital requirement for starting a business. In reality, majority of the companies need approximately 18 months to reach a point from where they can start making profit. Until then, the company needs extra capital (working capital) to run the business. Breakeven analysis is one such vital tool that assists in understanding when the business will start generating profit, how much extra working capital should be arranged and how much money should be allocated for marketing and other vital activities. The given project will attempt to discuss breakeven analysis in depth to understand how it is conducted, what are the factors that should be used while determining the breakeven point. The concept will be discussed with help of a numeric example so one can understand the real life application of this analytical tool in the decision making process. Breakeven analysis “Breakeven point is the point of zero profit” (Hansen, Mowen & Guan, 2007, p.591). In simple words it can be said that breakeven point is a sales volume at which the revenue earned by a firm equals the cost incurred within a specific time period. While developing the business plan for a new venture, the management takes into account different types of costs that will be incurred in the business process. The management then decides the profit margin on the products and hence the final selling price per unit is determined. Considering the total cost as well as the selling price per unit, the management determines the minimum sales so that the company can pay for all the expenses without making any profit. There are two commonly used approaches to determine the breakeven point; it can be breakeven point in units and another one is breakeven point in sales volume. Breakeven in units explains the number of units that must be sold at the predetermined selling price to cover the fixed and variable cost (Vickers, 2005, p.163). In the similar manner, breakeven point determined in terms of revenue to be generated so as to cover the cost incurred in the process of production is called breakeven point in amount. Before understanding the process of conducting breakeven point analysis some important concepts should be taken into account. Type of cost To determine the amount of units to be sold or the total revenue to be earned in order to achieve the breakeven point, one must take into account different types of cost. The cost component can be differentiated into two distinct parts; fixed cost and variable cost. Fixed cost is indifferent of the number of units produced hence with more production per unit fixed cost declines. On the other hand, variable cost is the specific cost that varies with change in production volume. Unlike fixed cost, per unit variable cost remains fixed. Apart from these two types of cost, semi variable cost possesses the characteristic of both variable cost as well as fixed cost. For simplicity of calculation, the semi variable cost has been decomposed into fixed component as variable components. Together fixed and variable cost resemble the total cost of production. At breakeven point, a company should incur enough revenue to pay back the total cost. Total revenue “Total revenue is the amount which the firm receive for the sales of its output” (Mankiw, 2008, p.244). For a company the total revenue reflects the amount incurred by selling the products at a predetermined selling price. Practically, the total revenue is the total number of units sold multiplied by number of units produced (Carbaugh, 2010, p.61). Contribution margin Contribution margin can be defined as “the sales revenue less the variable costs of production” (Vickers, 2005, p.155). While calculating the breakeven in units, contribution is derived as margin contributed to each of the unit sold. It is often calculated as selling price per unit less the variable cost per unit. An organisation should always generate a positive contribution so that the business remains feasible. This contribution represents total of fixed cost as well as the profit of the company (Finkler & Ward, 1999, p.288). Marginal safety Marginal safety is defined as the amount by which the actual volume of sales incurred within a specific time frame exceeds the breakeven sales. In other words, it is the spread between anticipated sales volume and the sales at the breakeven point; hence it resembles the strength of the business. A high margin of safety means the company can make profit even if there is a fall in the sales. Whereas low margin of profit means that the company possess high fixed cost of production and profit cannot be reduced until the sales volume is increased either by increasing per unit selling price or the total unit sold. It is calculated as actual sales less breakeven sales. Breakeven point After undertaking the above mentioned terms, breakeven point for a new venture has been calculated. The concept of breakeven point has been discussed earlier. In brief, it resembles a point where the total cost is equal to the revenue incurred by the company and profit remains zero. Figure 1: Breakeven point analysis (Source: Chauvel & Fournier, 2003, p.77) In the above given diagram, ‘breakeven’ is a point where the total cost line cuts the income after related expenses. This is a crucial point because if the company’s revenue is below the breakeven point, then the business is said to be unfeasible and should not be run. On the other hand, if the revenue of the company is above the breakeven point, it means the company is earning profit. This point of breakeven can be calculates as: Breakeven point = Fixed cost/Contribution to sales ration Contribution to sales ratio is calculated by dividing contribution margin with the total revenue of the company. If one has to calculate breakeven in units, then the formula is as follows: Breakeven in units = Fixed costs / (Selling price per unit – Unit variable cost) (Source: Needles, Powers & Crosson, 2007, p.1049-1052) Numeric example of breakeven point analysis The concept of breakeven analysis will be clear if a real life situation is taken into consideration. Let us assume that company XYZ has an income statement as follows: $ $ Sales (units 2,000,000) @ 0.25 per unit 500,000 Variable costs 300,000 Fixed costs 100,000 Total cost 400,000 Pre-tax profit 100,000 Less: Taxes 35,000 Profit after tax 65,000 Using this data, the following information has been calculated: $ Total costs TC 400,000 Selling price P 0.25 Fixed costs F 100,000 Variable costs VC 300,000 Variable cost per units VCU 0.15 Sales S 500,000 Contribution C=S-VC 200,000 Contribution-Sales ratio CSR=C/S 0.40 1. Breakeven point (Amount) = FC/CSR = $100,000/0.40 = $250,000 2. Breakeven point (Units) = Breakeven point/P = 250,000/0.25 = 1,000,000 units The company has a plan to expand the production capacity by increasing the fixed cost by $50,000 and thus the capacity will increase by 60 percent. Therefore, the numbers of units to be sold are calculated as: New fixed cost = $(100,000+50,000) = $150,000 3. New breakeven point (Units) = FC/(P-VCU) = 150,000/(0.24-0.15) = 1,500,000 units The company wants to know the manner in which it can retain its pre-tax profit even after expenses. 4. Desired sales = (FC+Profit)/CSR = (150,000+100,000)/0.40 = $625,000 The company’s margin of safety can be calculated as: 5. MS = Desired sales – BEP (amount) = $625,000- $(1,500,000*0.25) =$625,000 - $ 375000 = $ 250,000 Conclusion The above given example puts forward the importance of breakeven point analysis while taking crucial decisions. The management relies on this tool to analyse the feasibility of a project. However, this technique does suffer from certain drawbacks. For example, the breakeven point analysis assumes that per unit variable cost remains constant indifferent of the number of units produced. In reality when production capacity increases, the efficiency to produce also increases and thus the variable cost per unit reduces. Another major disadvantage of breakeven analysis is that it does not take into account the demand factor. This model pays no attention to the willing of the customers to purchase a product at a specific price (Kurtz, MacKenzie & Snow, 2009, p.596). Therefore, to make this vital analytical tool more efficient, the demand component should be incorporated. This will make the process more realistic and effective. Reference Carbaugh, R. J. 2010. Contemporary Economics: An Applications Approach. M.E. Sharpe. Chauvel, A. & Fournier, G. 2003. Manual of process economic evaluation. Editions TECHNIP. Finkler, S. A. & Ward, D. M. 1999. Cost accounting for health care organizations: concepts and applications. Jones & Bartlett Learning. Hansen, D. R. Mowen, M. M. & Guan, L. 2007. Cost Management: Accounting & Control. Cengage Learning. Kurtz, D. L.,MacKenzie, H. F. & Snow, K. 2009. Contemporary Marketing. Cengage Learning. Mankiw, N. J. 2008. Essentials of Economics. Cengage Learning. Needles, B. E. Powers, M. & Crosson, S. V. 2007. Principles of Accounting. Cengage Learning. Vickers, F. 2005. The Dynamic Small Business Manager. Lulu. Read More