Break Even Point Falls Under Cost Volume Profit Accounting Essay
Break-even point falls under cost-volume-profit (CVP) analysis which indicates the relationship between volume of activity, costs and profit. For organisations it is always useful to know the desired output level to reach for a planned profit. As the name suggests, a position where all the components are equal and there is no profit or loss is known as break even. (Atril &Mclaney, 2001)
Break-even is a position where organisations recover their fixed cost and accordingly the net income is equal to zero. (Jackson et al. 2008)
Figure source: http://www.bized.co.uk/
In this diagram:
TC =Total Cost
TR= Toatal Revenue
FC= Fixed Cost
Break-even method can be applied to any future investment, revenue or administration. Break-even point should not be confused with payback method because in both the models organisations approach is different.
Margin of Safety:
As per Atril &Mclaney, 2001 “The margin of safety is the extent to which the planned level of output or sales lies above the break-even point.” In other words, it is the last area where company can afford to lose output or sales after that there will be break-even and then loss.
Break-even sales= Fixed cost + Variable cost
Break-even point in units= Fixed Cost/Unit contribution margin
Break Even example:
JK Hosiery makes male undergarments. The fixed costs of operating the factory for a month total £500. Each undergarment requires material that cost £2. Each undergarment takes two hours to make, and the business pays the labour £3 an hour. The labourers are on contracts such that if they do not work for any reason, they are not paid. The undergarments are sold to wholesaler for £10 each.
So, the break even point (in number of undergarments):
= Fixed Costs/ (sales revenue per unit-variable costs per unit) or unit contribution margin
= £500/ [£10-(2+6)] =250 undergarments per month
Financial and management accounting are the two major areas of accounting which cater information to wider audience or stakeholders. Management accounting is a tool used by managers for the day-to-day operation whereas financial accounting information can be used by people in or out of the organisation. Briefly, the major differences are as follows:
Type of Reports
Reports produced under financial accounting are general in nature which can be used by anybody not necessarily stakeholders only.
These reports serve the specific needs. They are designed with a specific decision in mind or for a particular business manager.
Eye for detail
Financial reports looks after the broader picture like whole organisations accounting record. So, if anybody is looking for detailed information then they have to use eye for detail.
As explained before these reports are designed to solve a specific problem.
Legally, every organisation is bound to produce financial documents as per local accounting standards.
As the name suggests, these reports are for the internal management so it doesn’t carry legal obligations.
Period of documentation
Financial accounting in most of the organisations is done on annual basis. Few large organisations do produce half yearly & quarterly reports as well.
Management accounting are produced and documented as when managers need it. Organisations these days provide management accounting reports on daily, weekly, fortnightly or on monthly basis but just to check the progress of the organisation.
Field of vision
Financial accounting records company’s position & functioning in the market from day one to present day. Hence, it looks into the past.
Management accounting provides information on how company is going to perform in future.
Range of Data
Focus of financial management report is on the data which can be explained in monetary terms
Management accounting also can produce data in monetary terms but it generates non-monetary reports as well.
In this question, two aspects are involved which are as follows:
Profit & Loss account (P&L): A P&L account is a statement which shows the net profit or net loss. In P&L account, we record all the indirect income & expenses which affects the business. We don’t consider direct income & expenses in P&L because they are part of trading account. If income is more than expense than it is a net profit or if expenses are more than income then it is a net loss.
Cash Flow: As the name suggests, it is the circulation of cash in or out of business. Any revenue generated by business or an outside investment through bank or any other person & sale of asset can affect any organisation’s cash flow.
Now, the level of profit/loss shown in the P&L account does not equate with the increase/decrease in cash during the year because they both are two different statements which takes care different set of records & data.
Profitability of a business does not mean that business is equally liquid. Let’s assume a scenario, if someone has started his business with a loan from a bank & if it will take some time to repay then every time he makes profit the maximum part of it will go to bank. Hence, profitability and liquidity is not same. In another case, to prove that cash flow & P&L account are 2 separate poles, if a business sells off its one of the asset then the income from that asset will not affect the P&L but it will definitely affect the cash flow and balance sheet.
P&L account is a mandatory statement which is prepared according to regulations for all the stakeholders whereas cash flow is prepared to ascertain how much liquidity organisation has for future operations.
Lasher (2007), “ratio analysis involves taking sets of numbers out of the financial statements & forming ratios with them.” It calculates risk and profitability both from the same set of data. Ratios can be expressed in proportion or times or rate or in percentage.
Advantages of Ratio analysis:
Comprehension: Ratio analysis helps in comprehending the liquidity, operational efficiency and profitability of an organisation through financial statements.
Relationship: It explains the relationship of one item on a financial statement with another. Ratios provide basis for strategic co-ordination among various departments.
Comparison: It provides a basis for comparison.
Explains the change: Ratio analysis explains the change in financial statement like why figures of this year have changed from last year’s financial statement.
Decision making: Ratios help in decision making related to investment & optimising the operational efficiency.
Trends: Ratios can ascertain the trends out of financial figures.
Limitations of Ratio analysis:
Basis of existence: Imagine a scenario, where by mistake accountant did a wrong entry into the books and analyst pulled the data from the same book. Hence, ratios existence sometimes can offer challenges
Comparison: If you are analysing the competition through ratios alone then they are not fit enough to get the accurate comparison because it’s not necessary that your competitor is identical to you. Thus, comparison is not always accurate.
Dependence on ratios: Decision making should not be only based on ratios because if top-management does not get the conclusion on time then the whole exercise will result in a slow process.
Relationship among ratios: One single ratio is not enough to get the result. To get the accurate result one must get all the ratio results.
Quantitative vs. Qualitative: Ratios only provides the quantitative side of business it does not explains the qualitative aspect of business e.g. brand.
Decision making process is a situation specific exercise which needs customized details. In the words of Drury (2008), "the relevant financial inputs for decision making purposes are therefore future cash flows, which will differ between the various alternatives being considered".
Now, it is not always easy to ascertain relevant cost because of non-availability of data on any organisation’s accounting data. For instance, opportunity cost which explains how much opportunity is lost or sacrificed to make one decision are not readily available but those costs which are already acquired is easily available in form of data like sunk cost. As per Drury (2008), “they are costs that have been created by a decision made in the past and that cannot be changed by any decision that will be made in the future.”
Concept of relevant cost given by Shim & Siegel (1998) makes it a step by step process to understand which is as follows:
“Gather all data costs associated with each alternative.
Drop the sunk cost.
Drop those costs which do not differ between alternatives.
Select the best alternative based on the remaining cost data. “
Example of Relevant Data:
Original cost £80,000 £100,000
Useful life 4 years 4 years
Accumulated depreciation £50,000
Book value £30,000
Disposal price £14,000
Annual costs £46,000 £ 10,000
Ignoring the time value of money and income taxes, should the company replace the existing machine?
The cost savings over a 4-year period will be £30,000 × 4 = £120,000
Investment =£100,000 – £14,000 = £86,000
£120,000 – £86,000 = £34,000 advantage of the replacement machine
Application of Relevant Data:
Scarce resource decision (Human resource, machine hours or raw material)
Sales Mix decision
Special order decision (bidding or job for dull period)
Product Line & Segment Decision
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