Final Project of Cost Accounting

1. BREAKEVEN POINT:
The break-even point in any business is that point at which the volume of sales or revenues exactly equals total expenses -- the point at which there is neither a profit nor loss -- under varying levels of activity. The break-even point tells the manager what level of output or activity is required before the firm can make a profit; reflects the relationship between costs, volume and profits. A business can work out how what volume of sales it needs to achieve to cover its costs. This is known as the break even point. The key to break even is to work out the contribution made from the sale of each unit. The amount of money each unit sold contributes to pay for the fixed and indirect costs of the business.

Contribution = selling price less variable cost per unit

Examples:
A product sells for 15 and has variable costs per unit of 11. Each unit sale therefore makes a contribution of 4 towards the fixed costs of the business. If the business had fixed costs of 20,000, then it would need to sell 5,000 units (4 x 5,000 = 20,000 contribution) in order to break even. The margin of safety is the difference between the number of units of planned or actual sales and the number of units of sales at break even point. If, using the example above, planned sales were thought to be 6,000 units, then the margin of safety would be 6,000 units break even 5,000 units = 1,000 units.

The business would be able to sell 1,000 less than planned before they were in danger of making a loss. A break-even chart plots the sales revenue, different costs and helps identify the break even point and margin of safety.

Drawing break-even charts

To draw a chart the following steps need to be followed: 1. Label the vertical axis sales and costs in pounds. 2. Label the horizontal axis sales/production (units). 3. On another piece of paper sketch the scales that you want to use given the data, then use this plan on the chart. 4. Plot any two points from the sales revenue data for the sales revenue line and then draw a straight line for sales revenue (assumes that the price per unit does not change) if the information is not given for sales revenue, then work out two points, e.g. for 1000 units sold and 1500 units sold. The start of the line should be through the origin (where the axes meet). 5. Draw a horizontal line for total fixed costs starting at the point on the vertical axis at the level of costs. 6. At the same starting point it is possible to draw the total costs line. Total costs are fixed costs plus variable costs. Work out what the total costs are for say 1000

units and 1500 units. Then draw the straight line starting at the same point as the fixed costs started and then through the two plotted points. 7. Where the sales revenue crosses the total costs line is the break even point. Read off the units of sales to give the break even level of sales. 8. The gap between the total costs line and sales revenue line after the break even point represents the level of profit.

It is important for a business to understand its break-even point because the contribution from every unit sold above the break-even point adds to profit. The break-even point provides a focus for the business, but also helps it work out whether the forecast sales will be enough to produce a profit and whether further investment in the product is worthwhile. The main limitations of break-even charts are:

Do not take into account possible changes in costs over the time period. Do not allow for changes in the selling price. Analysis only as good as the quality of information. Do not allow for changes in market conditions in the time period e.g. entry of new competitor.

Contribution Margin
Contribution margin is the amount remaining from sales revenue after variable expenses have been deducted. Thus it is the amount available to cover fixed expenses and then to provide profits for the period. Contribution margin is first used to cover the fixed expenses and then whatever remains go towards profits. If the contribution margin is not sufficient to cover the fixed expenses, then a loss occurs for the period. This concept is explained in the following equations:

[Sales revenue Variable cost* = Contribution Margin]

*Both Manufacturing and Non Manufacturing

[Contribution margin Fixed cost* = Net operating Income or Loss]

*Both Manufacturing and Non Manufacturing

The phrase "contribution margin" can also refer to a per unit measure of a product's gross operating margin, calculated simply as the product's price minus its total variable costs.

Consider a situation in which a business manager determines that a particular product has a 35% contribution margin, which is below that of other products in the company's product line. This figure can then be used to determine whether variable costs for that product can be reduced, or if the price of the end product could be increased. If these options are unattractive, the manager may decide to drop the unprofitable product in order to produce an alternate product with a higher contribution margin.

Variable cost:
Definitions
1. The costs of production that vary directly in proportion to the number of units produced. Variable costs often include labor expenses and raw material costs, because labor and raw material usually must be increased to increase output. Firms for which variable costs represent a high proportion of total costs are usually less likely to experience large fluctuations in earnings, because changes in sales and revenues are accompanied by nearly equal changes in costs 2. A cost of labor, material or overhead that changes according to the change in the volume of production units. Combined with fixed costs, variable costs make up the total cost of production. While the total variable cost changes with increased production, the total fixed cost stays the same.

Example of variable cost:

A good example of a variable cost is fuel for an airline. This cost changes with the number of flights and how long the trips are.

Fixed cost:
1. A cost that remains unchanged even with variations in output. An airline with 20 airplanes has the fixed costs of depreciation and interest (if the planes are partially financed with debt), regardless of the number of times the planes fly or the number of seats filled on each flight. Firms with high fixed costs tend to engage in price wars and cutthroat competition because extra revenues incur little extra expense. These firms tend to experience wide swings in profits. 2. An expense that does not change from one time period to other. 3. Fixed costs are those that do not change with the level of sales. If sales
increase or decrease but nothing else changes then fixed costs remain the same.

Examples of fixed cost:

Common examples of fixed costs include rents, salaries of permanent employees and depreciation.

Margin of Safety:
Margin of safety (MOS) is the excess of budgeted or actual sales over the break even volume of sales. It stats the amount by which sales can drop before losses begin to be incurred. The higher the margin of safety, the lower the risk of not breaking even.

Formula of Margin of Safety:

The formula or equation for the calculation of margin of safety is as follows:

[Margin of Safety = Total budgeted or actual sales Break even sales]

The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the margin of safety in dollar terms by total sales. Following equation is used for this purpose.

[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales]

Example of margin of safety:

Sales(400 units @ $250) Break even sales Calculate margin of safety $100,000 $87,500

Calculation: Sales(400units @$250) Break even sales $100,000 $ 87,500 --------Margin of safety in dollars $ 12,500 ======= Margin of safety as a percentage of sales: 12,500 / 100,000 = 12.5% It means that at the current level of sales and with the company's current prices and cost structure, a reduction in sales of $12,500, or 12.5%, would result in just breaking even. In a single product firm, the margin of safety can also be expressed in terms of the number of units sold by dividing the margin of safety in dollars by the selling price per unit. In this case, the margin of safety is 50 units ($12,500 $ 250 units = 50 units).

Graphical presentation of break even point:

The Break-Even point in sales volume is defined as:

That point in sales volume, or revenue, where direct costs have been recovered, fixed overhead expenses has been absorbed and where profit begins".

We can relate Break-Even Point to the information in our financial statements, particularly the Income Statement. The Income Statement should be organized into the following sections:

1. Revenue
the sum of all sales and other income net of returns and sales commissions.

2. Cost of Sales (Cost of Goods Sold)

The cost of purchases that are resold (merchandise) and/or raw materials plus the costs of labor to manufacture the product or convert it or install it or deliver it or construct it on site. These costs are also called direct or variable costs.

3. General & Administrative Costs (Overhead)

These are all the costs not directly, or easily, related to sales volume such as Advertising, Bank Charges, Computer Expenses, Insurance, Office Wages & Salaries, Officers Compensation, Telephone, Utilities, Depreciation, Interest, Taxes etc. These costs are also called indirect or fixed costs.

4. 1 minus 2 minus 3 = PROFIT.

Note: If your Income Statement is not organized in this fashion (called managerial accounting format), you need to have a session with your accountant and demand it be put into this format so you can manage the business better. Once you have your financial statements and data in the right format, you can easily calculate Break-Even using the following formula as: Break-Even Point = FC/ (1-VC/S)

Where:
FC = Fixed Costs VC = Variable Costs S = Sales

Calculation of Breakeven and Marginal Safety

DATA
Actual sales 1,462,411,953 Rs

FIXED COST:
Cost of sales Salaries wages and benefits Support services Management charges Insurance Professional charges Depreciation Equipment rental Administrative expenses Salaries, wages and benefits Rent, rates and taxes Legal and professional charges Fees and subscription Management charges Provision for slow moving and obsolete Stores, spare parts, and loose tools Insurance

Rupees

50,671,082 35,427,380 18,480,000 5,666,010 1,160,333 310,374,531 2,715,745

1,877284 422,400 2,247,934 3,472,200 5,760,000

41,000,000 26,244

Auditors remuneration Depreciation

820,000 1,317,586

Auditors remuneration
Audit fee Half yearly review Taxation services Out of pocket expenses 400,000 100,000 300,000 20,000

Distribution cost
Salaries, wages and benefits Support services Fees and subscription Depreciation Management charges 2,572,586 126,432 267,389 1317586 5760,000

Finance cost
Markup on long term financing Markup on short term borrowings Mark up on advances from related Parties Exchange loss net Bank charges and commissions TOTAL 47,587,263 1,207,028 2,618,976 842,992,734 246,727,700 52,549,045

VARIABLE COST:
Cost of sales
Raw and packing material consumed Fuel power Stores, spare parts and loose tolls consumed Repairs and maintenance Utilities Traveling, conveyance and subsistence Communication Printing and stationery Other manufacturing expenses 271,340,574 1,423,331,145 44,260,560 3,505,043 967,570 8,265,148 338,432 746,331 778,485

Administrative expenses
Traveling, conveyance and subsistence Communication Printing and stationery Entertainment Advertising and promotion Miscellaneous 366,924 5993 149,534 20,499 214,300 153,865

Distribution cost
Repairs and maintenance Communication Freight and handling Printing and stationary Entertainment Miscellaneous Freight on export 63,250 77415 1,416,445 170,156 410, 24 16543 115,974 17556,345210

TOTAL

SOLUTION:
BREAK EVEN (IN UNITS) = FIXED COST/CONTRIBUTION MARGIN (per unit) Contribution margin = sale variable cost

= 1,462,411,953 1756,345210 = (293,933,257) Break even (in units) = 842,992,734 - 293,933,257 = (2.868)

BREAK EVEN (IN Rs) =FIXED COST/CONTRIBUTION MARGIN RATIO

Contribution margin ratio = contribution margin/sale = 293,933,257 1,462,411,953 = (0.201) Break even in (Rs) =842,992,734 -0.201 = (4193, 993,701)

MARGIN OF SAFETY = ACTUAL SALE BREAK EVEN SALE

= 14,

62,411,953-