1. Accounting & Finance 3.3 ~ BREAK-EVEN ANALYSIS SUNDAY, JUNE 05, 2016 PAGES 238-251

2. Contribution Refers to the amount of money that remains after all direct and variable costs have been taken away from the sales revenue of a business. Contribution per unit =P – AVC Total contribution = (P-AVC) x Q Does not equal the actual profit because you haven’t taken out other costs yet. Profit = total contribution – TFC

3. Contribution Profits can be improved in 3 ways: 1.Increase sales revenue 2.Reduce variable costs 3.Reduce fixed costs

4. Exam Tip! Page 238

5. Contribution Table 3.3a, page 239

6. Contribution Analysis Uses: Helps set prices Helps decide which products should be invested in Ensures cost allocation is done in a fair manner Helps decide if a business should produce or buy products Helps decide whether a business should take on a special order. Break-even analysis

7. Common Mistake Page 239

8. Break-even Analysis Serves the purpose of determining the level of sales that must be made for a business to earn a profit. Break-even = exists when a business neither makes a profit nor a loss. Occurs at the level of output where total costs = total revenue (TC=TR). Cash flow must be monitored.

9. Break-even Analysis A business can be in any one of the following financial situations: ◦Loss = costs of production > revenues ◦Break-even = costs of production = revenues ◦Profit = revenues > costs of production

10. Break-even Analysis Informs managers of: 1.Whether it is financially worthwhile to produce goods/services 2.Level of profits that the business is likely to earn if things go according to plan.

11. Break-even Calculations 1.Use TC = TR rule. 2.Using contribution per unit rule (fastest way) ◦Break even = fixed costs/contribution per unit 3.Interpretation of break-even chart. ◦Figure 3.3a, page 240

12. Common Mistakes Page 241 Note how the break even chart should be labeled. BEA doe not ensure a profit will be made!

13. Exam Tip! Page 241 BEA is a heavily tested topic!

14. Break-even Analysis Sales beyond break-even point = profit. Break-even quantity = level of output where total costs = total revenues.

15. Question 3.3.1 Calculate the answers for a – c. Check your work with a partner. Answers: must show work for full marks ◦A. BEQ = Fixed Costs/Contribution per unit: ◦$200,000/($35-$10) = 8,000 units ◦B. Total revenue = P X Q: ◦$35 x 8,000 = $280,000 ◦C. Total costs = TFC + TVC: ◦$200,000 + ($10 x 8,000) = $280,000

16. Margin of Safety Measures the difference between a firm’s current sales quantity and the quantity needed to break-even. Shows how much demand exceeds the break-even quantity.

17. Margin of Safety The larger the positive difference between a firm’s sales output and its BEQ, the safer the firm will be in terms of earning profit.

18. Margin of Safety MOS = Level of Demand – Break-even Quantity ◦Positive margin of safety = profit ◦Negative margin of safety = loss See figure 3.3c, page 242.

19. Common Mistake MOS is not $$$, it’s a quantity (volume of output)

20. Exam Tip! Page 242 Before drawing a BE chart, calculate costs and revenues so you know the scale to use.

21. Constructing a BE Chart See steps on page 243 as you view the chart drawn on page 244.

22. Question 3.3.2 Complete a & b then compare your work to a partner. Answers: A. a.500-250 = 250 units b.500-300 = 200 units c.(300/500) x 100 = 60% B. Tread-it has a better MOS than Play it when measured as a percentage of BEQ (100% vs. 60%). However, play it has the better MOS in absolute terms (300 vs. 250). Nevertheless it tends to be better to use the first method (%) for comparisons across different industries (hiking vs. toys).

23. Homework: Question 3.3.3 Complete all parts a – f Answers: A. $1840 (Rent $600+Salaries $1000+Admin $100+Utilities $140) B. BEQ = $1840/($20-$4) = 115 child places C. Daily demand =.8x25 = 20 child places per day Monthly demand = 20 x 22 days = 440 MOS = 440-115 = 325 child places

24. Question 3.3.3 D. E. F. Strengths: ◦Quick to construct; easy to understand ◦Decision making tool used to study the impact of changes in price ◦Useful when business needs to seek external finance Weaknesses: ◦Fixed costs don’t necessarily remain constant ◦Average costs are unlikely to be constant ◦Cost and revenue figures are based on estimates ◦BEA is sattic so results are of limited use

25. Exam Tip! Page 245 Decimals must be rounded up!

26. Exam Tip! Page 245

27. Changes in Break-even Actual BE, profits & losses are likely to be different than those predicted from BEA because: 1.Price changes over time 2.Level of demand is subject to change. 3.Profit depends on level or risk involved 4.Innovation and the introduction of new technologies 5.Luck!

28. BEA Beneficial to business that 1.Produce or sell a single product. 2.Operate in a single market. 3.Make products to order.

29. BEA assumptions 1.All costs functions are linear 2.Sales revenue function is linear. 3.Businesses will sell all of output.

30. BEA Limitations 1.Static model 2.Original data might not be valid (GIGO) 3.Many other factors will alter costs/revenues

31. Common Mistake Page 248

32. CUEGIS Contribution analysis suggests three broad strategies to improve profit: 1. Increase sales revenues 2. Reduce variable costs 3. Reduce fixed costs

33. CUEGIS BEA aids decisions such as: 1.Product portfolio management – assess expected BEQ when launching a new product. 2.Risk assessment – calculate margin of safety to gauge level of risk. 3.Make-or-Buy decisions – the firm’s choice of whether to produce the product or purchase it from a supplier. 4.Special order decisions – BE analysis helps determine if the profit change will be worth making the special order. (See box 3.3b, page 250)

34. CUEGIS Consider how the CUEGIS concepts apply across the content discussed in this unit on BEA.

35. Homework 3.3 Review Packet Question 3.3.4 Question 3.3.5