Relationship Between Fixed Cost And Variable Cost Accounting Essay

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A calculation of the sales volume (in units) required to just cover costs.  A lower sales volume would be unprofitable and a higher volume would be profitable.  Break-even analysis focuses on the relationship between fixed cost, variable cost (and cost per unit), and selling price (or selling price per unit).

Fixed Costs

Cost that do not change when production or sales levels change, such as rent, property tax, insurance, or interest expense. The fixed costs are summarized for a specific time period (generally one month).

Variable Cost (Per Unit Cost)

Variable costs are costs directly related to production units.  Typical variable costs include direct labor and direct materials. The variable cost times the number of units sold will equal the Total Variable Cost. Total Variable costs plus fixed costs make up the total cost of production.

Selling Price (per unit price)

The price that unit is sold for. Sales Tax is not included the selling price and sales taxe paid is not included as a cost.  The Selling Price times the number of units sold equals the Total Sales.

Break Even Point

he sales volume (express as units sold) at which the company breaks even.  Profits are $0 at the breakeven point.  The breakeven point is calculated by the following formula: Break Even Point = Fixed Costs / (selling price-variable costs).

Time Period

The fixed costs are summarized for a specific time period.

The per unit variable cost is not dependant on a specific period of time.

The per unit selling price is not dependant on a specific period of time.

The Break Even Point is expressed a number of units, over a specific time period that must be sold to obtain a Net Profit of $0.  The time period the units must be sold is always the same as the time period of the fixed costs.

The break-even analysis provides you with a crucial piece of data: your company's break-even point. The break-even point occurs when your company's revenues exactly equal its costs and expenses, resulting in neither a profit nor loss. When sales fall below the break-even point, your business incurs a loss; when sales climb higher, you see profits.

To come up with your break-even point, you need three pieces of information: the total expected fixed costs, projected variable costs, and projected sales. Fixed costs include both administrative expenses (a.k.a. overhead) and interest, all of which must be paid whether or not you make a single sale. Variable costs include cost of goods sold and selling expenses; total variable costs naturally go up as sales volume increases. Your projected sales volume should be based on how much you realistically expect to sell at a particular price. Keep in mind, those projected sales are what you expect to sell, not your break-even point.

To calculate a break-even point for your service business, use service salaries as your cost of goods sold. When employees perform services on behalf of the company, divide up their salaries into units that match your revenue units (whatever basis you use to determine customer prices, such as hours). Don't forget to include a rate for yourself when you perform services.

If your break-even analysis doesn't pan out, which indicates loss potential; you may be inclined to keep working the numbers until you get a favorable outcome. Your energy may be better spent on rethinking this plan or considering a different direction for your company. When you start pulling numbers out of the air to make an analysis come out the way you want, you could be setting yourself up for losses.

When to Prepare a Break-Even Analysis

Use this analysis every time you plan to make a major change in the business. Major changes include:

Adding a new product

Expanding the business

Taking on significant debt

Entering a long-term contract (with either a supplier or customer)

Setting or changing prices

Prepare a break-even before you definitively decide to make such a major change. This will let you know whether that change can be profitable; if it can't, reconsider your plans.

There are a number of ways to reduce the breakeven point, which increases the margin of safety of a business. Consider the following possibilities:

Reduce coupons and one-time price reductions. If a large number of customers take advantage of cut-rate prices, the breakeven point will suffer.

Outsource fixed cost activities. There may be cases where the company can shift some activities to an outside supplier, along with the attendant fixed asset costs. Then the company only pays on a per-unit basis for whatever the goods or services may be, thereby converting the fixed cost to a variable cost.

Bundle products and services into packages, or up sell customers to more expensive products. Either approach increases the margin per sale.

Formula: To calculate the breakeven point, divide the average contribution margin (sales minus variable expenses, divided by sales) into total fixed expenses.  Extraordinary items that are in no way related to ongoing operations should be excluded from this formula, which is:

Total Fixed Expenses

Contribution Margin Percentage

A variation on the formula is to remove all non-cash expenses, such as depreciation, from the calculation.  This approach is useful for companies that are more interested in determining the point at which they break even on a cash flow basis, rather than on an accrual reporting basis.  This formula is:

Total Fixed Expenses - (Depreciation + Amortization + Other Non-Cash Expenses)

Contribution Margin Percentage

Yet another variation is to measure the breakeven point in terms of the number of units that must be sold in order to achieve the breakeven point. This formula is:

Total Fixed Expenses

Contribution Margin per Unit

Benefits / Advantages of Break Even Analysis:

The main advantages of breakeven point analysis are that it explains the relationship between cost, production, volume and returns. It can be extended to show how changes in fixed cost, variable cost, commodity prices, and revenues will affect profit levels and break even points. Break even analysis is most useful when used with partial budgeting, capital budgeting techniques. The major benefits to use break even analysis are that it indicates the lowest amount of business activity necessary to prevent losses.

Limitations of Break Even Analysis:

It is best suited to the analysis of one product at a time. It may be difficult to classify a cost as all variable or all fixed; and there may be a tendency to continue to use a break even analysis after the cost and income functions have changed.

PRACTICAL UTILITY

Q1. Sue's Day Care : Seeing a need for childcare in her community, Sue decided to launch her own daycare service. Her service needed to be affordable, so she decided to watch each child for $12 a day. After doing her homework, Sue came up with the following financial information:

Selling Price (per child per day) $12

Operating Expenses (per month)

Insurance 400

Rent 200

Total Operating Expenses $600

Costs of goods sold $4.00 per unit

Meals 2 @ $1.50 (breakfast & lunch)

Snacks 2 @ $0.50

Gross Margin (per unit)= Selling Price - Cost of Goods Sold

$12.00 - $4.00 = $8.00 per unit

The month of June has 20 workdays, Monday through Friday for four weeks. How many children will Sue need to take care of just to break-even in her new business?

SOLUTION:

Break-evens are calculated using the following formula:

Break-even = operating expenses ÷ gross margin per unit

Break-even = operating expenses ÷ ($ 12.00 - $ 4.00)

Break-even = $ 600 ÷ $ 8.00

Break-even = 75 units (children) in June

CONCLUSION

Since there are 20 days in June. Sue must watch 75 ÷ 20 = 3.75 kids or four children every day. Right from the start, sue knows that she must take care of at least four kids every day to start to make a profit.

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