History Of The Break Even Analysis Accounting Essay

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Most sales will be for cash, but he does not expect a quarter of each month's sales will be made to computer shops. He plans to allow those customers one month's credit.

His stock purchase during the six months during the six months were nil for January, £250 for February, 400 for March, 450 for April, 500 for May and 1,000 for June respectively

Apart from the purchase of initial stock, all purchases will be made from suppliers who will allow him one month's credit

He will spend £250 each month on advertising, this must be paid immediately. The stand at the computer exhibition in May will cost £400, and must be paid in April.

Various sundry expenses are expected to cost £100 each month for January, February and March and £150 per month for the remaining months

He will need to buy office equipment in January at a cost of £500.

For the first six months, John will take £100 per month as drawings, once the business is established; he hopes to draw out more.

Solution:

The estimation for cash inflows and outflows for "Biz Solutions" for the months from January till June has been shown in the table below.

Cash Flow Forecast for "Biz Solutions"

Cash Movement

January

February

March

April

May

June

Initial Capital

£1,250

 

 

 

 

 

Income

 

 

 

 

 

 

Cash Sales

£375

£600

£675

£750

£1,500

£900

Credit Sales

£125

£200

£225

£250

£500

£300

Total Sales

£500

£800

£900

£1,000

£2,000

£1,200

Payment from debtors

£0

£125

£200

£225

£250

£500

Total incoming Cash

£375

£725

£875

£975

£1,750

£1,400

Outgoings

 

 

 

 

 

 

Software Purchase

£1,000

 

 

 

 

 

Stock Purchase

 

£250

£0

£400

£450

£500

Payment to creditors

 

 

£250

£0

£400

£450

Advertising cost

£250

£250

£250

£250

£250

£250

Exhibition cost

 

 

 

£400

 

 

Sundry Expenses

£100

£100

£100

£150

£150

£150

Office equipment purchase

£500

 

 

 

 

 

Owner's drawing

£100

£100

£100

£100

£100

£100

Total Outgoing cash

£1,950

£450

£700

£900

£900

£950

Net Cash

-£1,575

£275

£175

£75

£850

£450

As per the above table, it is clear that the net cash flow is negative for the month of January. This is because lot of capital is invested in buying initial setup requirements e.g. Office equipment purchases for £500. But as we can see, in the succeeding months, the business has positive cash flows. To check break-even for the business, we plot a curve of Cumulative Incoming Cash vs. Cumulative Outgoing Cash. (Givoly)

As per the graph shown above, we conclude that the business is able to achieve break-even in the 6th month (i.e. in the month of June). It means that in the starting few months, the business will run in loss due to initial high investments. But gradually, when the sales pick up, the quantum of incoming cash keeps increasing at a higher pace than the outgoing cash. This is very natural and very common among startups.

The above table also shows some problems in the working methodology of the business which have been listed below.

In the month of January when the business is starting, the total initial capital available is £1,250 and the total incoming cash is £375, totaling £1625. The total outgoing cash is £1,950. So there will be a total deficit of £325. This fund has to be arranged from banks which come at some interest. Even getting a loan from bank in the early phases of the business is very tough. There is also very low chance of getting credit from the capital market. Angel investors may fund the business but that will dilute the profit of the sole owner of the company as per the agreement between both the parties.

£1,000 is invested in the very first month in software stock purchase out which total sales of £500 only is achieved. This clearly shows that a lot of inventory is leftover with the business in the month of January. As software technology lifecycle is very low, new updates keep coming at a very fast rate and it is not advised to keep high inventory of such items.

To improve the cash flow position, it is highly recommended that small amount of software stock is bought in the very first month. This will decrease the inventory as well as eliminate any need of external funding as we have seen in the problems mentioned above.

The initial software stock purchase may be reduced to £500. The resulting cash flow has been shown in the table below.

Cash Flow Forecast for "Biz Solutions"

Cash Movement

January

February

March

April

May

June

Initial Capital

£1,250

 

 

 

 

 

Income

 

 

 

 

 

 

Cash Sales

£375

£600

£675

£750

£1,500

£900

Credit Sales

£125

£200

£225

£250

£500

£300

Total Sales

£500

£800

£900

£1,000

£2,000

£1,200

Payment from debtors

£0

£125

£200

£225

£250

£500

Total incoming Cash

£375

£725

£875

£975

£1,750

£1,400

Outgoings

 

 

 

 

 

 

Software Purchase

£500

 

 

 

 

 

Stock Purchase

 

£750

£0

£400

£450

£500

Payment to creditors

 

 

£750

£0

£400

£450

Advertising cost

£250

£250

£250

£250

£250

£250

Exhibition cost

 

 

 

£400

 

 

Sundry Expenses

£100

£100

£100

£150

£150

£150

Office equipment purchase

£500

 

 

 

 

 

Owner's drawing

£100

£100

£100

£100

£100

£100

Total Outgoing cash

£1,450

£450

£1,200

£900

£900

£950

Net Cash

-£1,075

£275

-£325

£75

£850

£450

The total incoming cash in the month of January is £375 while total outgoing cash is £1,450. Hence net cash requirement is £1,075 which can be funded from £1,250 initially available capital.

As we can see from the above chart, the breakeven is still achieved in the 6th month only, but the slope of Cumulative outgoing cash is lower in the first month. The extra £500 saved in the first month has to be invested in the month of February. But since this purchase will be made on credit, its payment needs to be done on March. Hence this strategy will not only reduce the initial burden of high investment but it also allows earning interest on any surplus money saved in the first month, for the month of January and February.

Task 2:

This is a details concerning two possible choices of purchase of machinery by Norton Ltd. Norton Ltd is considering the purchase of new machinery, for which they have two possible choices:

Machinery A will cost £200,000 and the estimated useful life is 5 years, while Machinery B will cost £245,000 and will operate for 7 years.

Given the longer implementation period, Machinery B will not realize any cash savings until the end of year 2.

The directors of the company are asking you to evaluate the two choices. The cash savings from any new investment in the years of operation are expected to be as follows:

Machinery A

Machinery B

£000

£000

1

50

_

2

70

80

3

80

85

4

70

86

5

60

101

6

_

81

7

_

71

Solution:

Project evaluation is very important since organizational progress in long terms is determined by that only. It is very important for an organization to correctly evaluate a project. There are various methods for evaluating the projects. Different methods use different criteria to evaluate which project should be taken or whether the project is giving any positive return or not. Some of the methods are - NPV, IRR, ARR, payback period, etc. Discussing two of the these methods-

NPV- Net Present Value method. It can be defined as the difference between the present value of cash inflows and present value of cash outflow. NPV is a standard tool for computing the benefit from a project since it takes into consideration the time value of money (Investment Decision).

The formula for computing NPV is -

Formula:

Description: Net Present Value (NPV)

Where Ct- the cash inflow at time period t

r - Discounted rate of return

Co- the initial cash outflow.

If

Meaning

Conclusion

NPV>0

The investment will add value to the firm

The project may be accepted

NPV<0

The investment will subtract value from the firm

The project should be rejected

NPV=0

There is no gain or loss to the value of the firm

It depends on various criteria whether to accept or reject the project since in monetary terms the project doesn't add any value.

ARR- Accounting Rate of return is a technique which provides quick estimate of a project's worth over its useful life. But there are cons of this method too. It uses profit rather than cash flows and it doesn't takes into consideration time value of money.

The formula is :

average profit ÷ average investment

The only advantage of this method is that it is very easy to compute. But, it is rarely used in practice because of the cons mentioned above.

Investment appraisal of the two options by employing Accounting Rate of Return and Net Present Value methods :

By ARR method :

Cash Savings

Year

Machinery A (in 000 euro)

Machinery B (in 000 euro)

1

£50

£0

2

£70

£80

3

£80

£85

4

£70

£86

5

£60

£101

6

£0

£81

7

£0

£71

Average Accounting Profit

£66

£72

Initial Investment

£200,000

£245,000

Estimated life

5

7

ARR

0.33

0.29

Preference for Investment

Machinery A

 

By using ARR method the rate of return from Machinery A is 0.33% while from Machinery B is 0.29%. Since the rate of return in case of Machinery A is greater than that of Machine B so, according to this method Machinery A should be preferred for investment. (Reul)

By NPV Method:

Assuming rate of return 12% per annum

Cash Savings

Year

Machinery A (in 000 euro)

Machinery B (in 000 euro)

1

£50

£0

2

£70

£80

3

£80

£85

4

£70

£86

5

£60

£101

6

£0

£81

7

£0

£71

Assuming rate of return

12%

12%

NPV

235.92

309.40

Preference for Investment

Machinery B

 

Using NPV method it is seen that in both the machineries the value of NPV is positive which means both the investments will add value to the firm. But, NPV value of Machinery A i.e. 235.92 is lesser when compared to the NPV value of Machinery B i.e. 309.42. This means Machinery B should be preferred over Machine A as it offers greater value of money when considering time value of money.

Even when the assumed rate of return is taken 8% - NPV of Machinery A is 262.10 and that of B is 360.49. If the rate of return is taken as large as 15 % then also NPV of Machinery A is 218.86 and that of B is 277.48. This implies for a wider range of rate of return Machinery B is a preferred investment over Machinery A.

Investment to be undertaken:

NPV method is a much better method when compared to ARR. ARR doesn't take any account time value of money and also cash flows. So, Machinery B should be considered for investment.

Task 3:

The Clarke Apparel Company's profit statement for the preceding year with respect to their textile product "Basic" is presented below. The cost and sales relationship for the coming year is expected to follow the same pattern as in the preceding year.

Sales (50000 units at £10) £500,000

Variable costs 300,000

Fixed costs 100,000

Total costs 400,000

Profit 100,000

Solution:

In this analysis we determined the Break-even point which is the indicator of the point at which cost associated with the revenue is equal to the revenue received. For the calculation of Break-even point we need calculation of number of units, amount of sales, total fixed cost and total variable cost.

We have assumed that the initial number of units is zero and it is incremented by 50,000 unites after each iteration and time is in years. Our assumptions are:

 

 

 

Assumptions

 

 

Time

Unit Start

Unit Increment

Unit Income per transaction

Unit Variable Cost

Total Fixed Cost

Year

0

50000

£10

£6

£100,000

Calculation of sales, variable cost, contribution margin, fixed cost and total cost:

Sales = number of units * unit price

Variable cost = number of units * unit variable cost

Contribution margin = sales - variable cost

Fixed cost = £100,000

Total cost = fixed cost + variable cost

The values which we got after doing the above mentioned calculation is:

Units

Sales

Variable Cost

Contribution Margin

Fixed Cost

Total Cost

0

0.00

0.00

0.00

100,000.00

100,000.00

50000

500,000.00

300,000.00

200,000.00

100,000.00

400,000.00

100000

1,000,000.00

600,000.00

400,000.00

100,000.00

700,000.00

150000

1,500,000.00

900,000.00

600,000.00

100,000.00

1,000,000.00

200000

2,000,000.00

1,200,000.00

800,000.00

100,000.00

1,300,000.00

250000

2,500,000.00

1,500,000.00

1,000,000.00

100,000.00

1,600,000.00

300000

3,000,000.00

1,800,000.00

1,200,000.00

100,000.00

1,900,000.00

350000

3,500,000.00

2,100,000.00

1,400,000.00

100,000.00

2,200,000.00

Break even points:

Break-even x i.e. number of units = fixed cost / contribution margin

= £100,000/ £4

= 25, 000 units

Break even y i.e. sales revenue at which break-even obtained = break-even units * unit price

= 25, 000* £10

= £250,000.00

Break-even x

Break-even y

Label

£25,000

£250,000.00

BEU approx.=25000

Above graph represent the relationship between number of unit of sales and total cost of sales We have represented four parameters in the graph namely fixed cost, total cost, sales, break even unit and linear sales Through this graph we found that number of Break Even Units are 25000. .This graph represent the breakeven will be reached at units 25,000 and the cost of sale at breakeven point will be £250,000.00.

Break-even point after extension

 

 

 

Assumptions

 

 

Time

Unit Start

Unit Increment

Unit Income per transaction

Unit Variable Cost

Total Fixed Cost

Year

0

80000

£10

£6

£150,000

Units

Sales

Variable Cost

Contribution Margin

Fixed Cost

Total Cost

0

0.00

0.00

0.00

150,000.00

150,000.00

80000

800,000.00

480,000.00

320,000.00

150,000.00

630,000.00

160000

1,600,000.00

960,000.00

640,000.00

150,000.00

1,110,000.00

240000

2,400,000.00

1,440,000.00

960,000.00

150,000.00

1,590,000.00

320000

3,200,000.00

1,920,000.00

1,280,000.00

150,000.00

2,070,000.00

400000

4,000,000.00

2,400,000.00

1,600,000.00

150,000.00

2,550,000.00

480000

4,800,000.00

2,880,000.00

1,920,000.00

150,000.00

3,030,000.00

560000

5,600,000.00

3,360,000.00

2,240,000.00

150,000.00

3,510,000.00

Break-even x

Break-even y

Label

£37,500

£375,000.00

BEU approx.=37500

Benefit of Break-even Analysis in Decision Making

Breakeven pints tell the quantity of units to be sold before earning any profit because At the stage of breakeven there is no profit no loss to an organization. After the moving up from this stage organization starts to earn profit. Breakeven point also helps n business by identifying the excessive fixed cost because breakeven point is directly dependent upon fixed cost. So a manager can control and reduce fixed cost to reduce the value of breakeven and it will help in gaining quicker profit. It also helps a manager by determining the minimum number of unit to be sold to avoid the losses at a sales price. For example in this case if The Clarke Apparel Company wants to earn profit it must sell more than 2500 units. And this company will try to reduce this breakeven point so that they can start earn profit at the sales of less amount of units.

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