TOC o “1-3” h z u 1.Introduction PAGEREF _Toc518905923 h 31.1Purpose PAGEREF _Toc518905924 h 31.2Company Profile PAGEREF _Toc518905925 h 32.Literature Review PAGEREF _Toc518905926 h 42.1Cost Accounting PAGEREF _Toc518905927 h 42.2Break-Even point PAGEREF _Toc518905928 h 42.2.1Theory PAGEREF _Toc518905929 h 42.2.2Calculations PAGEREF _Toc518905930 h 52.2.3Weaknesses of the break-even point PAGEREF _Toc518905931 h 62.2.4Theoretical solution PAGEREF _Toc518905932 h 62.3Margin of Safety PAGEREF _Toc518905933 h 72.3.1Theory PAGEREF _Toc518905934 h 72.3.2Calculations PAGEREF _Toc518905935 h 82.3.3Issues and Theoretical Solution PAGEREF _Toc518905936 h 82.4Operating leverage/ Gearing. PAGEREF _Toc518905937 h 92.4.1Theory PAGEREF _Toc518905938 h 92.4.2Calculation PAGEREF _Toc518905939 h 92.4.3Issues and Theoretical Solution PAGEREF _Toc518905940 h 103.Financial summary of the three years PAGEREF _Toc518905941 h 114.Cost-Volume Analysis PAGEREF _Toc518905942 h 134.1Break-even point PAGEREF _Toc518905943 h 134.2Margin of Safety PAGEREF _Toc518905944 h 144.3Operating leverage PAGEREF _Toc518905945 h 155.Recommendations and Conclusion PAGEREF _Toc518905946 h 166.References PAGEREF _Toc518905947 h 17
TOC h z c “Figure” Figure 1. Relationship between Financial, Managerial and Cost Accounting (Kinney and Raiborn, 2011) PAGEREF _Toc518905948 h 4Figure 2 Break-Even Graph (Atrill and McLaney, 2016) PAGEREF _Toc518905949 h 5Figure 3 Break-Even Calculation (My Accounting Course1, n.d, a) PAGEREF _Toc518905950 h 5Figure 4 BEP units (Atrill and McLaney,2016) PAGEREF _Toc518905951 h 6Figure 5 Calculation of Margin of Safety in units, dollars and % (Kinney and Raiborn, 2011) PAGEREF _Toc518905952 h 8Figure 6. Margin of Safety (Drury, 2018) PAGEREF _Toc518905953 h 8Figure 7 MOS in units (accountingverse.com, n.d.d) PAGEREF _Toc518905954 h 8Figure 8 DOL (1) (My Accounting Course, n.d, e) PAGEREF _Toc518905955 h 9Figure 9 DOL (2) (Gitman and Zutter, 2014) PAGEREF _Toc518905956 h 10Figure 10 DOL (3) (My Accounting Course, n.d, e) PAGEREF _Toc518905957 h 10Figure 11 DOL (4) (Horngren et. al, 2016) PAGEREF _Toc518905958 h 10 TOC h z c “Graph”
Graph 1 Total Cost Break Down PAGEREF _Toc518905972 h 12 TOC h z c “Table”
Table 1 Income Statement (Anonymous, 2018) PAGEREF _Toc518909873 h 11Table 2 Relevant variable for CV-analysis PAGEREF _Toc518909874 h 13Table 3 Break-Even Point (units and LKR) and variables used for calculation PAGEREF _Toc518909875 h 14Table 4 Margin of Safety (units, LKR and %) PAGEREF _Toc518909876 h 14Table 5 Degree of Operating Level (DOL) PAGEREF _Toc518909877 h 15
IntroductionPurposeAccounting is a topic that based on uncomplicated principles and concepts, and as one starts to understand the basics of accounting it becomes easy to understand any business and accounting concepts (My Accounting Course, n.d, c). Accounting is a subject that includes various topics but mainly focuses on three main concept, financial-, managerial-, and cost-accounting.
For any company, the need for cost accounting is required in order to avoid loss and if there are multiple products cost accounting can assist to identify the products that are giving a profit and the products going on loss and aid in the decision to keep the product or not.
Cost accounting takes into consideration the accruing costs for inventory estimation to meet with the external financial accounting and the internal monthly or quarterly profit measurement necessity. (Drury, 2018). This is done with the intention for profit analysis and for the preparation of the budget. Profit analysis is mainly done with cost-volume-profit analysis.
The purpose of this assignment is to analyse the changes and effects on the break-even, safety of margin and degree of operating leverage in an organization of choice.
Company ProfileThe company used for this assignment, due to anonymity has been renamed as Full Energy group. Full Energy group is company that operates as a distribution partner (DP) to Anon Exports Pvt. Ltd. This partnership has thus far lasted for 11 years in Sri Lanka. Although they are a distribution company, they have established their own marketing and sales department together with an Administration. In order to work smoothly with Anon Exports in their day-to-day running of the company CITATION Ano18 l 1044 (Anonymous, 2018).
Full Energy is company that distributes to over 171 countries, and has the largest consumption of energy drinks globally.
Literature ReviewCost AccountingFigure 1 indicates the relationship it has to the two main principles, which are financial and managerial accounting.
Figure SEQ Figure * ARABIC 1. Relationship between Financial, Managerial and Cost Accounting (Kinney and Raiborn, 2011)Cost accounting focuses on the demands of both financial and management accounting information by delivering the products cost details to external parties and internal managers. The former for investment and credit decisions, and the latter for planning, controlling, decision making and performance evaluation. (Kinney and Raiborn, 2011)
Break-Even pointTheoryThe break-even analysis is also called CVP-analysis, and is used to specify the level operations needed to cover all costs and determine the profitability level in considering differing levels of sale (Gitman and Zutter, 2014). Break-even point, also known as operating break-even point, is when there is neither loss nor profit. Taking into consideration volume, if it is below BEP, the company will suffer losses as the total costs are higher than the total sales revenue. On the other hand, if the volume is above the BEP, company will incur a profit since the total sales revenue surpasses the total costs.
CalculationsThere are various methods in identifying BEP, it can be through calculations, graph and income statement. BEP is when total costs are the same as total sales revenue (Atrill and McLaney, 2016)
By graph, BEP can be identified when the total cost and total sales revenue crosses each other.
Figure SEQ Figure * ARABIC 2 Break-Even Graph (Atrill and McLaney, 2016)Figure 2, as mentioned above, the BEP is when the total cost = total sales revenue
Another method is by using formulas to calculate the break-even point
(My Accounting Course, n.d, b)
One formula is by using the contribution margin and fixed cost:
Contribution margin= total sales revenue – variable costs. But for the calculation of BEP units are mostly calculated, therefore it is important to calculate
Contribution margin per unit = selling price per unit – variable cost per unit.
From this we can calculate the break-even point:
Figure SEQ Figure * ARABIC 3 Break-Even Calculation (My Accounting Course1, n.d, a)Another formula is by using the sales revenue per unit, variable cost per unit and fixed cost:
Figure SEQ Figure * ARABIC 4 BEP units (Atrill and McLaney,2016)Though, it can be considered the same as using the contribution margin per unit.
Weaknesses of the break-even pointBreak-even point has its uses, it also has weaknesses, such as non-linear relationships, stepped fixed costs and multi-products business. For non-linear relationships, the theoretical viewpoint is that the variable cost and total revenue sales are straight lines when plotted against volume output. However it does not occur in the businesses these days, the lines are not perfectly linear and there can be fluctuations due to various reasons.
The assumptions of a non-changeable fixed cost, such as stepped fixed cost, needs to be taken into consideration since such occurrences are due to many activities may have various types of fixed costs and those can change annually (Atrill and McLaney, 2016).
The third weakness BEP has is when a company is a multi-product business. Which will cause an issue with the break-even analysis as the additional sales of another product can affect the sales of the other product. Therefore, making it difficult to identify the fixed cost associated to the products, since it can be related to more than one product.
Break-even point is sensitive to three variables; sales price per unit, fixed cost and variable operating cost per unit. Therefore, any movements in these three variables can influence the break-even point (Gitman and Zutter, 2014)
Even with these three weaknesses, businesses prefer to use break-even point to analyse the relationship between cost and volume.
Theoretical solutionAn analysis, depending on the circumstances, may change the variable costs and fixed costs depending on the type of business. Agriculture and suppliers are dependent on the weather, since it may affect the crop and supplier chains, with the need to increase the marketing. In these cases the fixed costs will increase.
Break-even point increase can be due to several reason, one reason can be due to an increase in fixed cost, such as an increase in rent, depreciation, salaries and etc… Another reason can be due to a decrease in the contribution margin, where the quantity sold is unable to cover the fixed cost and the operating variable cost (Averkamp, n.d, b).
To overcome these difficulties a company can have several solutions: (Averkamp, n.d, a).
Reduce the fixed cost
Reduce the variable cost per unit, which will increase the contribution margin
Increase the selling price per unit as much as possible, so long as quantity of units sold does not reduce.
Margin of SafetyTheoryAccording to Kinney and Raiborn (2011), margin of safety is the surplus of budgeted or actual sales over break-even sales. Even Horngren et. al (2016) and Accountingformanagement.org (n.d.) clarifies that margin of safety is the amount that either expected or actual sales exceeds the break-even revenue. Though, Drury states that margin of safety shows by how much sales can decrease until loss is incurred. On the other hand Atrill and McLaney (2016), states that margin of safety is the range at which planned volume of output or sales exceeds the break-even point and that margin of safety can be used as a part of risk measurement.
Margin of safety is a vital value for any companies because the value indicates to the management how much the revenue can be reduced until it reaches break-even. Therefore, the higher the margin of safety the lower the risk is for business (Accountingformanagement.org, n.d.; Bragg, 2017a).
It also works as a buffer, which can help a company to ensure that the operation doesn’t run in loss (My Accounting Course, n.d, d)
This concept is useful when the sales of a product is at a significant risk, such as in the case of an ending of a contract. A small margin will encourage the company to start reducing the expenses, though the opposite may occur when the margin of safety is large enough so a business is protected from any sales variation (Bragg, 2017a).
There are two alternative version of margin of safety (Bragg, 2017a):
Budget based – the safety of margin may be based on a future budget, therefore can replace current sales in the formula, below, with budgeted sales level.
Unit based – translation of margin of safety to the number of unit sold, by exchanging in the formula, in the division part, with selling price per unit.
CalculationsThe common calculation for Margin of safety:
Figure SEQ Figure * ARABIC 5 Calculation of Margin of Safety in units, dollars and % (Kinney and Raiborn, 2011)Figure 5, shows the calculation for Margin of Safety in units, dollars/LKR and percentage.
Alternate percentage calculation:
Figure SEQ Figure * ARABIC 6. Margin of Safety (Drury, 2018)As mentioned above the formula to calculate the unit based margin of safety:
Figure SEQ Figure * ARABIC 7 MOS in units (accountingverse.com, n.d.)Formula for budget based margin of safety (Bragg, 2017a):
(Budgeted sales level – Break-even point) / budgeted sales level
Issues and Theoretical SolutionMargin of Safety calculations can be classified as a type of sensitivity analysis, as it takes into consideration of the “what ifs”, since managers tend to use this method to check the outcome changes if the expected target is not reached or if circumstances can affect the data. This means that if revenue decreases more than the calculated margin of safety, the company may increase the risk of loss though if the revenue goes higher than it then there will be lesser risk to the company (Horngren et. al, 2016).
The issues with safety of margin, mainly occurs when the percentage of margin of safety is too low which makes the company to have more risks than companies with a higher percentage. To reduce the risk, would be to increase the revenue and have a lower break-even point.
Margin of safety is important for the management, especially when they are planning to expand or launch a new product line. Since this can indicate how risk-prone the company and how loss and increased expenses the company can bear (My Accounting Course, n.d, d). On the other hand, if the sales are seasonal this concept is not viable due to the fluctuations of the sales revenue (Bragg, 2017a).
Operating leverageTheoryThere are two types of leverage; financial leverage takes into consideration interest, taxes, dividends, earnings per share, net profit before taxes. On the other hand operating leverage focuses on the cost of goods sold (variable cost) and gross profits (Gitman and Zutter, 2014).
Operating leverage considers the company’s relationship between the sales revenue and operating profits. Though it results from the fixed costs can enhance the effect changes in sales has on the company’s earnings before tax and profit. One can expect to discover operating leverage in firms that have fixed costs (Gitman and Zutter, 2014). However, operating leverage can also be the relationship between the firm’s variable and fixed costs. Generally labour-intensive firms have high variable cost and low fixed costs which gives a low operating leverage. However, capital intensive organizations cost structure includes low variable cost and high fixed cost giving a high value in operating leverage (Kinney and Raiborn, 2011).
CalculationThe way to calculate operating leverage is classified as degree of operating leverage, a percentage measurement. This indicates the company’s profit sensitivity to change in sales volume (Raiborn).
Figure SEQ Figure * ARABIC 8 DOL (1) (My Accounting Course, n.d, e)Another way of calculating DOL:
Figure SEQ Figure * ARABIC 9 DOL (2) (Gitman and Zutter, 2014)Figure SEQ Figure * ARABIC 10 DOL (3) (My Accounting Course, n.d, e)Figure SEQ Figure * ARABIC 11 DOL (4) (Horngren et. al, 2016)Operating income can also be classified as break-even point in LKR (Horngren et al, 2016, pp 68-69).
Issues and Theoretical SolutionHigh DOL generally is beneficial for companies but they are highly susceptible to business’ fluctuations and the changes in the macroeconomic environment (My Accounting Course, n.d, e).
Booming economy, can give a high DOL which will help in increasing the profitability of the company, though the need to spend money on property, plant, suppliers, distribution channels and machinery cannot control the consumers demand (My Accounting Course, n.d, e).
Low DOL suggests that a large fraction of the company’s total sales are variable costs, and conversely fixed costs have a rather smaller proportion allocated. This implies that the company operates less on fixed assets to support the core business whilst bearing low gross margin (Bragg, 2017b; My Accounting Course, n.d, e).
Due to the above mentioned issues, the need to constantly monitor the operating leverage is beneficial in comparison to having a high DOL, since a reduced percentage can result in a significant increase or decrease in profits. Therefore, operating leverage knowledge can have an effect on the pricing policy, as companies need to be cautious to set the price at a level where the contribution margin can compensate the fixed cost (Bragg, 2017b).
Financial summary of the three yearsFull Energy Group, as mentioned above in the company profile, is a distribution partner with their own marketing and sales department. As such, they do not produce the energy drinks in Sri Lanka, hence their variable cost is cost of goods sold. This includes the raw materials used, direct labour, production related costs, transportation and freight costs of the purchase quantities from Sri Lanka. Full Energy HQ in Europe, incurs these costs and is then transferred to Sri Lanka P ; L Line as cost of goods sold.
Table SEQ Table * ARABIC 1 Income Statement (Anonymous, 2018) Table 1 displays the income statement for the past three years of Full Energy. And shows how for each year the demand for the energy drink has increased by the amount of serving units imported. However, the price of the energy drink per unit increased by 75 LKR, which can be due to the high demand and the taxation on the ingredients and import has increased. The cost of goods sold and total gross profit has gradually increased from 2015 to 2016, though in 2017 there is an increase in cost of goods sold by 11.9% and an increase in total gross profit by 63.8%. This indicates the revenue is higher than the variable cost.
Royalties, for Full Energy Group, determined % of the sales revenue that has to be given to the owner of Full Energy, as can be seen without the royalties the company is in profit for all the three though when royalties are included the profit decreases in 2015-2016 and in 2017 Full Energy has incurred losses due to the increased costs and the royalty percentage has also increased, which can be due to the increased price.
Conversely, fixed costs (total market costs and total indirect costs) has increased significantly in 2017, especially Trade promotions. This due to the floods and drought that created a substantial impact on the company. Because of the overall downfall in the economy there was significant amount spent on trade and consumer promotions in order to push the product out in the market, therefore total marketing cost in 2017 has a considerable increase, as seen in Graph 1 of total cost break down without royalties.
Graph SEQ Graph * ARABIC 1 Total Cost Break DownThe effect of the increased fixed cost and variable cost together with royalties, Table 1, in 2017 on the controllable operational profit is noted by profit decrease – 40,850,000 LKR, which is almost -158%. This is a significant decrease in Full Energy’s profit, and as mentioned above, this is due to the large amount of floods, droughts and bad economy.
Cost-Volume AnalysisFor the CV-Analysis, Table 2, has been used to calculate Break-even point, Margin of Safety and Operating Leverage.
Table SEQ Table * ARABIC 2 Relevant variable for CV-analysis
Table 2 provides the total sales revenue, total fixed cost, total variable cost, total costs, operating income, quantity, and price per unit, variable cost per unit and contribution per unit, contribution margin for 2015, 2016 and 2017 and how it has increased over the years.
Break-even pointThe formula used to calculate break-even point is the formula from Figure 3, and the variables from Table 2, contribution per unit and fixed cost. Table 3 indicates that the break-even points has increased over the past three years but table 2 indicates in 2017 the total costs were higher than the sales revenue. As fixed costs, total marketing cost and total indirect, increased by 68.7% and the contribution margin per unit increased by 37.6% due to reduction in variable cost per unit by 7.76 LKR from 2016 to 2017, and the increased selling price per unit by 75 LKR.
Table SEQ Table * ARABIC 3 Break-Even Point (units and LKR) and variables used for calculation At 3,374,677 units in 2015 Full Energy will operate at zero operating income, as shown in table 3. The same is for 2016 and 2017, in 2016 the zero operating income is at 4,004,757 units and in 2017 the zero operating income is at 4,909,241
In 2015 the trade sale units for Full Energy, Table 2, exceeded the break-even units by 3.7%, therefore they have a profit and not a loss with royalty inclusion, Table 1. The same can be observed in 2016, Table 2, with an increase from break-even units by 4.9% and still generates a profit after royalties. Though, in 2017 even with the serving units increase by 1.8% Full Energy incurs a loss of 158% due to the increased royalties by 148%. The royalties together with the total cost has gone beyond the total sales revenue generated.
Margin of Safety (MOS)
The analysis of margin of safety is excluding the royalties of Full Energy. With the use of Figure 7, the margin of safety units has been calculated from the variable in Table 2.
Table SEQ Table * ARABIC 4 Margin of Safety (units, LKR and %) By looking at the MOS units and sale:
In 2015, Full Energy sales can decrease by 43,862,903.23 LKR or 125,323 units from the total revenue without incurring loss. Though if it decreases more than above stated units and LKR Full Energy will suffer losses.
In 2016, Full Energy sales can decrease by 195,243 units or 68,335,135.14 LKR from the total sales revenue without experiencing any losses, though if there is a further decline in either two the company will suffer a loss.
In 2017, Full Energy can withstand any losses if the sales does not go below by 38,572,607.26 LKR or 90,759 units from the total sales revenue.
From 2015 to 2016, the margin of safety (units) has increased by 55.8% but from 2016 to 2017 it has decreased by 53.5%. The same can be seen in margin of safety sale, from 2015-2016 it increased by 35.8% but from 2016-2017 it decreased by 43.6%.
When observing the MOS percentage, it is observed that it is not constant for the three years. In 2015 it is 4%, in 2016 it is 5%, which means the company can bear a total sales revenue loss of 4% and 5%, respectively, without incurring any losses. On the other hand, MOS % has significantly decreased to 2% in 2017 as a result of total sales revenue and break-even sales are almost identical. However, even with the decrease in 2017, Full Energy can bear 2% loss in total sales revenue
Operating leverageThe focus is on the degree of operating leverage, by using figures from Table 2 (contribution margin, total sales revenue, total fixed costs and total variable cost) to calculate the degree of operating leverage by using figure 11.
Table SEQ Table * ARABIC 5 Degree of Operating Level (DOL)
Full Energy’s degree of operating leverage in 2015 is 27.93 times, this shows if total sales revenue increases or decreases by a percentage alteration, the operating income will change 27.93 times the percentage alteration in sales. Despite the decrease from 27.93 times to 21.51 times from 2015-2016, the DOL conveys the effect on the percentage alterations in sales. However, in 2017 there is a significant increase in DOL from 21.51 times to 55.09 times. This increase can be due to high contribution margin and low operating income in comparison the previous years, as can been seen Table 2.
Conclusion and Recommendations
Cost-volume analysis is a practice that all companies practice to avoid loss in profit, as it gives the quantity needed to sell in order to maintain a zero operating income, and the percentage, quantity and amount of revenue one can reduce before the company goes into loss.
Through the analysis from point 3-4, by not taking into consideration the royalties, Full Energy is profit generating distribution company in Sri Lanka.
Full Energy can improve their DOL, even though it is already high, by increasing reducing their variable cost. The reduction in variable cost will ensure that the BEP will reduce and the risk of losing profit will reduce.
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