Breakeven Analysis and Planning
Introduction
Breakeven analysis represents the evaluation of the level of sales that company costs would equal the total company revenues. The total profits add up to Zero at this level and its practically only if the company prices are relatively higher than the variable costs for each unit that the company sells. Each unit sold makes some contribution towards meeting the fixed costs of the company together with its variable costs. Breakeven analysis provides an opportunity of analyzing the variable costs, prices of products and the fixed costs. Breakeven analysis provides an indicator of the impact of costs on the company revenues Drucker, 1999). Breakeven point is arrived at by subtracting the unit variable cost from the price of the product to get the contribution margin. The fixed costs are divided by the contribution margin to estimate the breakeven point (Helfert, 2004).
Margin of safety indicates the strengths of the company and it assists the company to evaluate its gains or losses as per its projected sales. It’s arrived at by subtracting the current output from breakeven (Dayananda, Irons, Harrison, Herbohn and Rowland, 2002).
| Breakeven Analysis | ||
| Prices | 170.00 | 220.00 |
| variable Costs | 35.00 | 35.00 |
| Fixed Costs | 20,000,000.00 | 25,000,000.00 |
| Contribution margin | 135.00 | 185.00 |
| Breakeven units | 148,148.15 | 135,135.14 |
| Breakeven sales | 25,185,185.19 | 29,729,729.73 |
The breakeven units are 148,148.15 when the prices are fixed at $170 while the fixed costs and variable costs per unit are $20 m and $35 dollars respectively. The breakeven sales are $ 25, 185,185.19 for similar conditions. When the prices and fixed costs are increased to $220 and $25m respectively, the breakeven units and sales adjust to 135,135.14 and 29,729,729.73 respectively (Garrison, Noreen & Brewer, 2009).
If the company produces 150,000 units then it would not be able o achieve its desired profit of $4,000,000 profits as the profits would amount to $250,000 given a price of $170 while the other price of $220, the profits would amount to $2,750,000 (Vance, 2003).
| Breakeven Analysis Option A | (price 170) | ||
| Budgeted production | 150,000.00 | 180,000.00 | 200,000.00 |
| Breakeven units | 148,148.15 | 148,148.15 | 148,148.15 |
| margin of safety | 1,851.85 | 31,851.85 | 51,851.85 |
| Margin of safety % | 1.23 | 17.70 | 25.93 |
| Total sales Expected | 25,500,000.00 | 30,600,000.00 | 34,000,000.00 |
| Variable costs | 5,250,000.00 | 6,300,000.00 | 7,000,000.00 |
| Fixed costs | 20,000,000.00 | 20,000,000.00 | 20,000,000.00 |
| Profits | 250,000.00 | 4,300,000.00 | 7,000,000.00 |
| Return on Investments % | 0.99 | 16.35 | 25.93 |
| Residual Income | 250,000.00 | 4,300,000.00 | 7,000,000.00 |
However, the company would be able to achieve its target of earning more than $4,000,000 in profits if the company manufactured 180,000 and 200,000 units and the profits would amount to 4,300,000 and 7,000,000 for production of 180,000 and 200,000 respectively for a unit price of $170 while for a price of 220 the profits would amount for 8,300,000 and 12,000,000 for the similar productions respectively.
| Breakeven Analysis Option B | Price 220 | ||
| Budgeted production | 150,000.00 | 180,000.00 | 200,000.00 |
| Breakeven units | 135,135.14 | 135,135.14 | 135,135.14 |
| margin of safety | 14,864.86 | 44,864.86 | 64,864.86 |
| Margin of safety % | 9.91 | 24.92 | 32.43 |
| Total sales Expected | 33,000,000.00 | 39,600,000.00 | 44,000,000.00 |
| Variable costs | 5,250,000.00 | 6,300,000.00 | 7,000,000.00 |
| Fixed costs | 25,000,000.00 | 25,000,000.00 | 25,000,000.00 |
| Profits | 2,750,000.00 | 8,300,000.00 | 12,000,000.00 |
| Return on Investments % | 9.09 | 26.52 | 37.50 |
| Residual Income | 2,750,000.00 | 8,300,000.00 | 12,000,000.00 |
The margin of safety for the production of 150,000 units for a price per unit of $170 is 1.23% i.e. the company would be producing only 1,851.85 units above the breakeven units of 148148.15. In case of any pilferages or damages the company would incur losses or make no profits. For the same price if the production is increased to 180,000 and 200,000, the margin of safety would increase to 17.7% and 25.93% respectively. The company would produce an extra of 31,851.85 and 51,851.85 units above the breakeven levels for the production of 180,000 and 200,000 units respectively.
The margin of safety for the production of 150,000 units for a price per unit of $220 is 9.91% i.e. the company would be producing 14,864.86 units above the breakeven units of 135135.14 In case of any pilferages or damages the company would be still better placed to recover and continue with normal operations. For the same price if the production is increased to 180,000 and 200,000, the margin of safety would increase to 24.92% and 32.43% respectively. The company would produce an extra of 44,864.86 and 64864.86 units above the breakeven levels for the production of 180,000 and 200,000 units respectively.
The company should continue with the new product and listen to its marketing team and produce more products (200,000 units) at a price of 220 and with increased fixed cost of $25,000,000. At this level even with a 25% probability of earning the sales, the return on investments would still be higher than those of the first 150,000 units produced.
For a company dealing with a wide range of products it would require more complex calculations of cost volume analysis to complete the total analysis of the production process. Some products would utilize more time in the production process while others would consume more materials besides others would have a higher wastage or pilferage rates than others. Breakeven analysis is largely suitable for companies dealing with a limited range of products for its effective performance and analysis. The return on investments is also applicable to a company with a limited range of products as it’s not very practical to ostensibly calculate all the particular expenses details of each product to ascertain the exact amount of expenses incurred on the product to calculate the ROI. The residual income is easily applicable to all companies as its straight and clear.
Finally to conclude it would be wise to listen to the marketing team as there suggestion to increase advertising costs and increase the fixed expenses by 25% together with the selling price to $220 from $170, it would result in an increased sales of up to 11% while the profits would increase by 62.8%. The restriction of sales to low volumes would result in a very low margin of safety percentage and it would be very risky for the company in case of unforeseen circumstances. When the margin of safety is very low it makes the company to be sensitive to very slight changes in the sales performance. The 1% margin of safety for the production of 150,000 units is not recommendable. The company should encourage the production of more units to cushion itself from any business risks that may affect the company. The residual income trend also follows the profitability trend that’s increases with more production. However, the probability of the sales levels also declines with the increase in the level of sales. The company should balance the level of sales and the margin of safety.
References
Dayananda, D., Irons, R., Harrison, S., Herbohn, J. and P. Rowland (2002) Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press. pp. 150.
Drucker P. F. (1999) Management Challenges of the 21st Century. New York: Harper Business.
Garrison, R., Noreen, W. & Brewer, P. (2009) Managerial Accounting, McGraw-Hill Irwin.
Helfert, E. (2004) Techniques of Financial Analysis: A Modern Approach, New York: McGraw-Hill Education.
Vance, D. (2003) financial analysis and decision making: tools and techniques to solve
financial problems and make effective business decisions. New York: McGraw-Hill.
