The Importance of understanding break even analysis

The Importance of understanding wear down even synopsisFirst of all, production managers and management accountants acquire to kick in a clear understanding of break-even abridgment. This analysis is used as a general guideline for origin decision making and is important for a tally of reasons, including the ability to forecast the future cost and revenues and determine whether the business is making pull ahead or dismission, and also be able to develop a price strategy. The break-even analysis is based on marginal costing.2008. Business Basics. 3rd edn. Essex BPP publishing.The total cost of manufacturing or producing products or services is divided into two main move = fixed cost and variable costs. contumacious costs argon not directly related to the volume of production and should remain broadly constant piece of music variable costs vary directly with the production volume and change directly when the production volume changes. WWW. http//journal .au.edu/au-techno/2 007/JUL07/auJourna/Tech_article.09.pdf (20 November 2008)The Break-even tear (BEP) is the point at which income and spending are equal, and so neither a profit nor a loss is made. When calculating the break even point the total fixed costs are divided by the contribution per social unit. The contribution is the difference between the gross revenue revenues and the marginal cost of sales (variable costs).2008. Business Basics. 3rd edn. Essex BPP publishing.Fixed Costs (FC) = Fixed production overheads + Fixed administration overheads + fixed distribution overheadsFC = 200000 + 180000 + 120000 = 500000Variable costs (VC) = Direct materials + Direct reinforcement + Variable production overheadsVC = 350000 +50000 + 200000 = 600000VC per 1 unit = 600000 = 1250000SR = light speed0000 = 2050000Contribution = Sales revenue (SR) Variable costs (VC)Contribution = 20 12 = 8Break even point (BEP) = Fixed costs (FC)ContributionBEP = 500000 = 62500 units8Margin of safety (%) = 50000 62500 100 = -25%50000The business is left with 25% of their sales.Taking the role of the management accountant estimate each of the four alternatives.Pay Salespeople a 10 % commission, in anticipation of them sell more and the business reaching the break-even point.FC = 500000VC = 12 + 2 (10% commission of SR) = 14SR = 20Cont = 20 14 = 6BEP = 500000 = 83334 units6The original sales = 50000 units83334 50000= 33334 units33334 100 = 66.7%50000By choosing this option sales production and sales would need to extend by 33334 units. This means that the business needs to sell 66.7% of products more than were the original sales to meet the break-even point. The business should consider that if they increase the production the surplus storage warehouse may be needed so the stepped fixed costs will occur.This idea may be considered as an unrealistic. Especially now, the economic dally is affecting every kind of business and the companies need to be aware of what strategy are they personne l casualty to use in order to increase their sales. The get hold of for products is decreasing because people are aware of this economic situation. They are loosing their confidence to buy products. They prefer to buy only necessities. And also the business needs to be aware of what the competitors will do and how they will undergo the present situation.The management accountant should investigate some unpredictable situations.How does the business know that by stipendiary sales people a 10% commission, the business will reach break-even point? Is there a guarantee that the business will sell more?How can we predict that the invite for the products will increase?Reduce the sell price by 10% in anticipation of increasing sales by 30%. pass judgment sales = 50000 + 30% (15000) = 65000 unitsFC = 500000VC = 12SR = 20 20/10 = 18Contribution = 18 12 = 6BEP = 500000 = 83334 units6Profit/Loss = (65000 x 6) 500000 = 110000 lossMargin of safety (in units) = 65000 83334 = (18334) units Margin of safety (%) = (Expected sales breakeven sales) 100Expected salesMargin of safety (%) = (65000 83334) 100 = 18334 10065000 65000Margin of safety (%) = -0.2821 100 = (28.21 %)By reducing the selling price by 10% the sale should increase by 30%.The break-even analysis presents that even if we sell 15000 units more the business would be left with 18334 units which represents 28.21 % of the production. Reducing the selling price by 10% may be a solid pricing strategy that may increase customers imply for the product but even if we sell the expecting amount of units there will be a loss of 110000, and not just that a new warehouse may be needed because of the increased sales. The stepped fixed costs occur.The management accountant needs to come along for external factors which are affecting the demand for the product.Will this pricing strategy lead customers to buy more products?What the competitors will do? Will they decrease the selling price or will they invest money in improvements?Increase direct wage rates from 4 to 5 per hour as percentage of a productivity/pay deal. It is hoped that this will increase production and sales by 20%, but advertising costs would increase by 50000.Expected sales = 50000 + (20%) = 60000Direct wages = 200000 4 = 50000 hoursNew direct wages = 5 - 50000 = 250000FC = 250000 + 180000 +120000 = 550000VC = (350000 + 250000 + 50000) = 1350000SR = 20Contribution = 20 13 = 7BEP = 550000 = 78572 units7Profit/Loss = (60000 x 7) 550000 = 130000 lossMargin of safety (in units) = 60000 78572 = (18572) unitsMargin of safety (%) = (78572 60000) = 18572 x 100 = 31%60000 60000Increase of direct wages is a good motivation strategy which may increase the production by 20%. However this is not enough to cover the additional increase of wages and advertising costs. This scenario is clearly not a practicable option because the business will be left with 18572 units in the inventory and they will make a loss 130000 loss. In the presen t economic situation is very risky to invest in the advertising because there is no guarantee that the demand for the product will increase as people are buying the cheapest products and services.In anticipation to produce and sell more a new warehouse may be needed. This means that the stepped fixed cost will occur.Can the company deal with 130000 loss?What will the competitors do? Will they invest in the advertising or they will reduce the selling price?Increase sales by additional advertising of 300000, with an increased selling price of 20%, setting a profit margin of 10%.FC = 500000 + 300000 = 800000VC = 12SR = 20 + (20/10) - 2 = 24Contribution = 24 12 = 12BEP = 800000 = 66667 units12Margin of safety (%) = (73334 66667) 100 = 9.1%73334Sales Volume to achieve a target profit = Fixed cost + target profitContribution per unitSales Volume to achieve a target profit = 800000 + 80008 = 73334 units1273334 units need to be produced and sold in order to produce a profit of 10%.This op tion can be considered as the most prosperous of all 4 options. However the business needs to deliberate that the increase of selling price by 20% is very unsecure. Particularly now the market is very unstable and the companies should try to sell everything they have. Producing more products is very risky. There is no guarantee that the sales would be made. Everything depends on customers. Many examples could be used from news. For instance, sales of cars fell by 23% and people are not going to the restaurant for their meal, they are saving their money and buying only necessaries. The business needs to be aware that the demand for the products is decreasing and not increasing.Why they regard to produce more products?Also the business needs to be careful with the investment in adverting. The cost of advertising may be hard to cover.A positive thing is that if the company orders more material to produce more products, the suppliers may offer a discount.The business needs to take in status the competitors in the market and what they would do. Will they reduce the selling price or will they invest in advertising?The management accountant should investigate all the factors that may affect the demand for the product and watch the economic situation.What are the limitations of break-even analysis? Do these limitations invalidate it as a reliable business uninflected tool?The limitations of break-even analysisThe break-even analysis is based on forecasting and has a certain limitations which should be considered. It is not always possible to predict what will devolve on the market.The linear relationship is based on the presumption that costs remain constant. However this is not the case in practical market situations. The business may get some discount from its suppliers. Also the business can often reduce its selling price in order to increase its sales volume and this is an efficient strategy known as a non-linear relationship. Scarlett, R. 2007. Management Acc ounting Performance evaluation. Butterworth-HeinemannThe business need to bear in mind that if a production increases or decreases it may result in expansion or reduction of capacity. If the Henllys scenario is used, in each case there is an anticipation of increased sales and production and this means that a new warehouse may be needed. The stepped fixed costs occur and this situation result in multiple break even points. Wood, F. Sangster, A. Business Accounting 2, 2008, 11 edn. Essex Pearson Education Limited. Pg. 656.Apart from the situation described above the product mix need to be applied as well. Many organisations have more then one product or service and this can have an impact on the apportionment of fixed costs which can become arbitrary. Scarlett, R. 2007. Management Accounting Performance evaluation. Butterworth-HeinemannThe break-even analysis is internal and it is not used to consider the things like competition or market demand which means that the business shoul d use other analysis to watch what is happening on the market and what strategies are used by competitors.These limitations explained above invalidate our break-even analysis as a reliable business analytical tool.