Break-even point analysis, Margin of safety PDF

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BMAN10632 Management accounting, lecture 5-6 Break-even point analysis. Definition  The level of sales (measures in units or in £) where total sales revenue is equal to total costs, so there is neither profit or loss. Finding BEP graphically  Where total revenue equals total costs  Remember that can be measured in value (£) or units Finding BEP through an equation

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Total Break even point ( Units )=¿ costs

¿ contrbution margin per unit Total ¿ Break even point ( Sales )=¿ costs contrbutionmargin ratio(%)

when asked to give BEP in sales revenue, you can multiply the BEP(U) number by the sales revenue for a single unit. Target Profit Analysis  Contribution margin allows us to cover fixed costs and tells us after covering fixed costs, any amount contributes to profit.  Target profit, how many units we need to sell to achieve our desired profit. Target profit formula

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Total target profit (Units ) =¿ costs+target profit

¿ contrbutionmargin per unit

Selling one additional unit  If the question is after 400 units (break-even point) what is the profit when the 401st unit is sold? o This will be the contribution per unit, therefore if asked after the 402nd unit is sold it will be £400. Margin of safety  It’s the difference of excess from our actual sales to our break-even point  What does it tell us?

BMAN10632 o It’s an indication of risk, the higher the MOS the less likely the firm will incur a loss o It also tells us how far actual sales can fall before the break-even point is reached. Calculating margin of safety  margin of safety(units )=number of units sold− BEP∈units  margin of safety ( Sales ) =actual sales revenue−sales revenue at BEP actual salesunits∗100 ¿  marginof safety ∈units margin of safety ratio(% )= ¿ break-even point limitations.  we assume that relationships between revenue, Variable costs and volume are linear. this isn’t a problem because o although break even analysis is often conducted in advance and therefore predictions have to be made for future costs and revenue, minor variations from linearity are unlikely to be significant.  a problem is most fixed costs are stepped fixed costs, and are not fixed over all volumes of activity, BE charts do not take this into account.  another problem is we assumed that the business is only making one product, majority of businesses have a range of products with different variable costs, prices. This means the break-even point can be totally different. also attached to this problem is the problem of identifying fixed costs for one particular activity, as fixed costs often relate to more than one activity. although there are ways of splitting fixed costs to activities, they’re arbitrary. this questions to value of BE analysis.  Another limitation of BE point analysis is that is doesn’t look at what’s else can cause the change in revenue and cost. (these cause a non-linear relationship) o (economies of scale, discounts, operation efficiency, learning curves) a more representative chart will be from economist’s approach (below)  One limitation is we assumed that everything is dependent on volume, however in reality this is not as simple, inflation, competition can affect things  Another assumption is sales units are the same as sales produced (that is it assumes all units produces are sold). BE Chart – economists’ approach  Economists don’t look at revenue as always linear, they take into account the product lifestyle, therefore the total revenue line curves. o This means that there will be a decrease in unit price e.g. as a way to boost sales.  Costs are not always linear, what about economies of scale which increase efficiency and can decrease cost, or what about stepped fixed costs which will increase the total cost.  As the lines for total cost and total revenue are not linear it means there is likely to be 2 or more break-even points, the question is which we should focus on.

BMAN10632

Optimal use of scarce (constrained) resources  Most businesses make more than one product, they operate with certain constraints (demand, shortage of labour, equipment capacity, material) in the short term the question is, how do we make the choice of which product to make o since fixed costs are not affected within the short period of time, management can focus on maximising total contribution margin.  Optimisation addresses efficiency not effectiveness o Efficiency is the relative amount of inputs used to achieve a given output level o Effectiveness is the degree to which a predetermined objective or target is met  Which of these should we focus on producing t-shirts, jeans or sweaters? o To priorities our products we want to find the contribution margin per machine hour (more generally this would be per resource e.g. labour, material)  Formula  number of hours required contribution margin per unit make one unit ¿ contribution margin per machine hour = ¿ o t shirts 9/0.75 = 12, (for every machine hour used on t shirts we will earn £12), sweaters 21/1.5 = £14, jeans 24/2.5 = 9.6. we therefore prioritise on sweaters, as this is the most efficient way of doing so. Production plan 1. there are often limiting factors e.g. the machine can only work 2000 hours per month. 2. The order we will make it in our sweaters, t shirts then jeans (based on efficiency) 3. The demand for sweaters per month is 450, how many hours to make this number of sweaters (1.5*450 = 675) is 675 hours, we still have 1325 hours left on the machine 4. We calculate the t-shirts next in the same way, here we use up 600 hours on the machine leaving 725 hours left on the machine. 5. Jeans we can only produce 290 jeans (725/2.5) (if you have to round, round down) To calculate profit from here  Take number of units (for each product) * contribution per unit then sum them all up. E.g 290*24  Contribution margin – fixed cost = profit...