Student lecture notes

CHAPTER 21 BREAKEVEN ANALYSIS AND SHORT-TERM DECISION MAKING Fixed and variable costs A variable cost is one which .. with changes in the level of activity, over a defined period of time A fixed cost is one which is .. by changes in the level of activity, over a defined period of time Cost related to activity level The economists view Total cost varying with activity: the economists view

Revenue and costs: the economists view

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.1

The accountant's view Variable cost

Fixed cost

Table of data showing variable and fixed costs Activity level Variable cost Fixed cost Total cost Total cost 0 units 0 20 20 100 units 10 20 30 200 units 20 20 40 300 units 30 20 50

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.2

Total cost and total sales

The breakeven point is that point of activity (measured as sales volume) where and .. are equal, so that there is .. The margin of safety is the difference between the and the .. (measured in units or in s of sales). Breakeven chart

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.3

Breakeven analysis Case study: Market trader A market trader rents a stall at a fixed price of 200 for a day and sells souvenirs. These cost the trader 50 pence each to buy and have a selling price of 90 pence each. How many souvenirs must be sold to break even? Algebraic method The equation for the breakeven point is: .. = .costs + .. costs

If the number of souvenirs sold at the breakeven point is n, then the total sales revenue is 0.9n and the total variable cost is 0.5n. . = = .. + ..

Solving the equation, n = .. souvenirs to be sold to break even. Formula method Contribution per unit is the minus the .. It measures the contribution made by each item of output to .. and . of the organisation. Breakeven point = .. .. Contribution is per souvenir (selling price 90 pence minus variable cost 50 pence) and the fixed costs are 200. Breakeven point = . . = 500 units

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.4

Graphical method Sales of 900 souvenirs at 90 pence each =

The sales line will therefore join the points (.) and (..) Variable cost of 900 souvenirs at 50 pence each Fixed cost Total cost = .. =

The total cost line joins () and (..). Breakeven chart

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.5

Profitvolume graph Profit/volume ratio = 100 .. Profitvolume chart

Illustration When sales are zero, there will be a loss equal to the fixed cost, which gives the first point to plot at (..). When 900 units are sold the sales are 810 and the profit is 160, giving the second point to plot at (.). Profit-volume chart using data from the case study 'Market trader'

The breakeven point of profit or loss is at a sales level of ... The graph rises by of profit for every increase in sales activity, giving a slope of ..%.

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.6

The profit/volume ratio is calculated by formula as: .. . Using breakeven analysis Breakeven analysis may be used to answer questions such as: What level of . is necessary to cover and make a specified ..? What is the effect of contribution per unit ? What happens to the breakeven point when the . changes? What happens to the breakeven point when the changes? What happens to the breakeven point when the .. change? = .. = 44.4%

Covering fixed costs and making a profit Data Selling price per unit Variable cost per unit Fixed cost Desired level of profit 80 pence 30 pence 300 400

The contribution per unit is pence (80 pence 30 pence). To find the breakeven point, the .. are divided by the to obtain a breakeven point of .. To meet fixed costs of and desired profit of .. requires the contribution to cover . in all. Volume of sales required = .. .. = .. units

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.7

Beyond the breakeven point A dry-cleaning shop takes two types of clothing. Jackets cost 6 to clean and the customer is charged 9 per garment. Coats cost 10 to clean and the customer is charged 12 per garment. The monthly fixed costs are 600 for each garment (representing the rental costs of two different types of machine). The shop expects to take in 500 jackets and 500 coats in the month. Calculation of breakeven point and of sales beyond the breakeven point Jackets 9 6 3 600 units .. Coats 12 10 2 600 . units

Selling price Variable cost Contribution per item Fixed costs Breakeven point Profit for sales of 500 units

The calculations show that, although both products have the same ., the jackets have a lower .. because they make a . contribution per unit. Beyond the breakeven point they continue to contribute . The profits at any given level of activity are therefore for jackets. Change in selling price If the selling price per unit .. and costs remain ., then the contribution per unit will .and the breakeven volume will be ... Take as an example the dry-cleaning business of the previous illustration. If the selling price of cleaning a coat rises to 15 then the contribution per unit will rise to . That will require cleaning only . coats to break even. The .. of raising the price is that customers may move elsewhere so that while it may not be difficult to exceed the breakeven point at a selling price of 12 it may be extremely difficult at a selling price of 15.

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.8

Change in variable cost If the variable cost increases then the contribution per unit will ., with the result that items will have to be sold in order to reach the breakeven point. If it is possible to . variable costs then the contribution per unit will . The enterprise will reach the breakeven point at a .. level of activity and will then be earning profits at a faster rate. Change in fixed costs If fixed costs increase then . units have to be sold in order to reach the breakeven point. Where the fixed costs of an operation are relatively high, there is a perception of greater . because a cut-back in activity for any reason is more likely to risk leading to a loss. Where an organisation has relatively low fixed costs, there may be . concern about margins of safety because the breakeven point is correspondingly . Limitations of breakeven analysis The breakeven graphs assume that cost and revenue behaviour patterns are . and change on a .. basis as activity levels change. It may not always be feasible to split costs neatly into variable and fixed categories. Some costs show . behaviour. The breakeven graphs assume that fixed costs remain . over the volume range under consideration. If that is not the case then the graph of total costs will have a in it where the fixed costs are expected to increase. Breakeven analysis, as described so far in this text, assumes input and output volumes are , so that there is no build-up of stocks and work-inprogress. Breakeven charts and simple analyses can only deal with at a time. It is assumed that cost behaviour depends entirely on ..

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.9

Applications of contribution analysis Accepting a special order to use up spare capacity. Abandoning a line of business. The existence of a limiting factor. Carrying out an activity in-house rather than buy in a service under contract.

Special order to use up spare capacity The special order is acceptable provided the sales price per item covers the . costs per item, and there is . for the spare capacity which could give a higher contribution per item. Abandonment of a line of business In the short term it is worth continuing if the business makes a to fixed costs. If the line of business is abandoned and nothing better takes its place, then that . but the fixed costs run on regardless. Existence of a limiting factor This means shortage of ., or .. Contribution analysis shows that maximisation of profit will occur if the activity is chosen which gives the highest contribution .. In-house activity versus bought-in contract The decision should be based on . of variable costs per unit, relating this to the .. in fixed costs between the options.

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.10

Pricing decisions Economic factors affecting pricing Monopoly position will be able to dictate its own price but may attract new entrants. Market leader may be able to set its price by reference to covering its full costs and making a satisfactory profit. A few large sellers may compete with each other on price. In the perfectly competitive market optimal price will be achieved where ... equals .. Pricing policy depends primarily on the circumstances of the business. Pressure from customers may force business to reduce selling price. There are some situations in which a cost-based pricing formula may be appropriate.

Cost-based pricing The most readily available cost-based approach to pricing is to calculate the total cost per unit of output and add a percentage to that cost called the A normal mark-up may be characteristic. Cost-plus pricing may not take into account the demand for the product.

Financial and Management Accounting, Third Edition P Weetman and P Gordon. Copyright Pearson Education Limited 2003

Student notes 21.11