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In general, the break-even point is the point at which the total cost of production of a company equals the total revenue gained from sales. Essentially, the technique of break-even analysis is used widely by production managers and accountants in making decisions bent on what prices to set for company products, and the appropriate margins that have to be met. Additionally, break-even analysis is used as a tool by managers to study the relationship between fixed cost (cost that remain constant regardless of the levels of output), variable costs (costs that change with the change in production output) and a company's revenues. Added, the fixed and variable costs form the total cost which is compared against the total revenue in order to determine the point at which no gain or loss is incurred. This is the point where the cost of production is equal to the income and there is no profit or loss, it is the point at which the company breaks even its income and expenses.
Break-even point can be measured graphically by identifying the point of intersection between the curves of total revenue and fixed costs. Also, it can be measured mathematically through use of formula and ratios by "dividing the total fixed cost by the contribution margin percentage" (Bragg, 2007). Note that the contribution margin is computed as sales less the variable expense.
A contribution marginal income statement organizes cost by behavior through relating the variable costs' components with those of fixed costs. It further aids internal managers in decision making by focusing on the concept of contribution margin which is not necessarily presented in the financial statements meant for use by external stakeholders.
(10) A number of assumptions surround the concept of cost volume profit. First, the costs are assumed to be linear, thus making it possible to categorize them into fixed and variable elements. The variable components are assumed to be constant for every unit and the total fixed cost constant over a long period of time. Secondly, it's maintained that the selling price is constant over time and is not due to change any time soon, and third is that the company's inventory is constant and every unit produced is sold, which is often not the case. Finally, it's assumed that the company only produces one product or service, or that it has a constant sales mix. With these therefore, it's inherent that the cost volume profit technique is somewhat not what is expected in practical situations because of the nonlinear characteristics of fixed and variable costs in the long run. However, it is still the concept widely used by managers to make short term production decisions. Although the cost volume profit analysis' assumptions may be misguiding, it's actually still used by managers because of its intuitive advantage to help in revenue planning through forecasts of the required revenue to meet certain profit levels. Managers also use CVP especially to determine how much variable cost will be incurred if equipment or any other investment is purchased by the company and how it will affect the organization's profitability. It most importantly gives managers a general understanding of fixed and variable costs and aids choice of decisions based on forecasted impacts on profitability. It is therefore a guiding tool in setting prices and determining appropriate sales volumes. In a wrap up, CVP indicates the break-even point, finds the margin of safety, and establishes an appropriate operating gear.
(14) The relevant range is the high and low limits within which the "assumptions of a cost behavior remain valid" (Drury, 2004). This concept helps company managers to determine the limits within which their decisions are most likely to be successful. It's within this range that the concept of CVP remains true and accurate hence the break-even analysis remains useful.
(1) "A cost object is anything that requires a separate recording of cost" (Drury, 2004). This is very important in order to establish a price and to gauge if the costs are justified. A dominant example of cost objects is the output which is either the product or service of the company. Another is the direct materials like cotton in the case of a fabric manufacturing company. It's a tangible input and directly contributes to the cost of the finished product. Operational cost of a company like machining and departments are also an example of cost object whose cost can be measured separately. Also, the labor measured in terms of working hours per day or weekly if not monthly is of great concern to an accountant as a cost object.
(5) Direct cost and indirect cost are independent of fixed and variable costs because a direct cost can be either a fixed or a variable cost and likewise to an indirect cost. It is therefore apparent that direct and indirect costs classify costs by traceability while variable and fixed costs classify them based on variability over a certain period of time and volume of production. An apt illustration of this can be found in the depreciation of production machinery which is indirect to the cost object but is a fixed cost. All the same, wages to a supervisor are fixed cost because they incur every month proportionately but the cost of raw materials that go to a department are variant and depends on the production level.
(12)The practice is not reasonable because the company may face a risk of over or underpriced products thus not being effective for control purposes and the company may be unable to identify cost saving areas.
(15)The methods used for allocating service cost centers are the direct method, sequential method and the reciprocal method. The direct method is simplest because no service costs are allocated to other service departments while the sequential method recognizes the interrelationship between services cost centers. The sequential method allocates costs in a step-down approach which is a little more accurate than the direct method because it acknowledges the interaction between support departments. Additionally, another method used for support center cost allocation is the reciprocal method. It recognizes all the relations between service cost departments and the reciprocity on the cost allocation. With this it sums up the direct costs incurred with the allocated costs to arrive at the total cost of a department.
(3-17A) Given the selling price per unit as $60, manufacturing and selling variable costs as $24 and $12 per unit respectively, and the fixed manufacturing and administrative costs as $189,000 and $141,000 respectively per year,
Sales = Variable expenses + Fixed expenses + profit
Since at the break even point profit is equal to zero, it follows that;
Q = quantity of units sold
$60Q = ($24 + $12)Q + ($189,000 +$141,000) + $0
$60Q = $36Q + $330,000
$24Q = $330,000
Q = 13,750 Units
The break-even point is therefore where the profit is zero and 13,750 units have been sold.
Contribution margin per unit
Break even point in units = Fixed expenses divided by Unit contribution margin.
Contribution Margin = Sales - Variable costs
= $60 - $36
= $24 per unit
Break-even point = $330,000 / $24 per unit
= 13,750 Units
Contribution margin ratio
Break-even point = Fixed expenses / Contribution margin ratio
Contribution margin ration = contribution margin / sales
= $24 / $60
Therefore break-even point= $330,000 / 0.40
Contribution margin income statement
Inman Manufacturing Company
Percent of sales
Sales ( 13,750 units)
Less variable expenses
Less fixed expenses
Net operating income