Final Project of Cost Accounting

Submitted By:

Maryam Fayyaz 10132

Haneen Agha 10128

Submitted To:

Sir. Mubasshar

1. BREAKEVEN POINT:

The break-even point in any business is that point at which the volume of sales or

revenues exactly equals total expenses -- the point at which there is neither a

profit nor loss -- under varying levels of activity. The break-even point tells the

manager what level of output or activity is required before the firm can make a

profit; reflects the relationship between costs, volume and profits.

A business can work out how what volume of sales it needs to achieve to cover its

costs. This is known as the break even point. The key to break even is to work out

the contribution made from the sale of each unit. The amount of money each unit

sold contributes to pay for the fixed and indirect costs of the business.

Contribution = selling price less variable cost per unit

Examples:

A product sells for £15 and has variable costs per unit of £11. Each unit sale

therefore makes a contribution of £4 towards the fixed costs of the business. If

the business had fixed costs of £20,000, then it would need to sell 5,000 units (£4

x 5,000 = £20,000 contribution) in order to break even.

The margin of safety is the difference between the number of units of planned or

actual sales and the number of units of sales at break even point.

If, using the example above, planned sales were thought to be 6,000 units, then

the margin of safety would be 6,000 units – break even 5,000 units = 1,000 units.

The business would be able to sell 1,000 less than planned before they were in

danger of making a loss.

A break-even chart plots the sales revenue, different costs and helps identify the

break even point and margin of safety.

Drawing break-even charts

To draw a chart the following steps need to be followed:

1. Label the vertical axis “sales and costs in pounds”.

2. Label the horizontal axis “sales/production (units)”.

3. On another piece of paper sketch the scales that you want to use given the

data, then use this plan on the chart.

4. Plot any two points from the sales revenue data for the sales revenue line and

then draw a straight line for sales revenue (assumes that the price per unit does

not change) – if the information is not given for sales revenue, then work out two

points, e.g. for 1000 units sold and 1500 units sold. The start of the line should be

through the origin (where the axes meet).

5. Draw a horizontal line for total fixed costs starting at the point on the vertical

axis at the level of costs.

6. At the same starting point it is possible to draw the total costs line. Total costs

are fixed costs plus variable costs. Work out what the total costs are for say 1000

units and 1500 units. Then draw the straight line starting at the same point as the

fixed costs started and then through the two plotted points.

7. Where the sales revenue crosses the total costs line is the break even point.

Read off the units of sales to give the break even level of sales.

8. The gap between the total costs line and sales revenue line after the break

even point represents the level of profit.

It is important for a business to understand its break-even point because the

contribution from every unit sold above the break-even point adds to profit. The

break-even point provides a focus for the business, but also helps it work out

whether the forecast sales will be enough to produce a profit and whether further

investment in the product is worthwhile.

The main limitations of break-even charts are:

Do not take into account possible changes in costs over the time period.

Do not allow for changes in the selling price.

Analysis only as good as the quality of information.

Do not allow for changes in market conditions in the time period – e.g.

entry of new competitor.

Contribution Margin

Contribution margin is the amount remaining from sales revenue after variable

expenses have been deducted. Thus it is the amount available to cover fixed

expenses and then to provide profits for the period. Contribution margin is first

used to cover the fixed expenses and then whatever remains go towards profits. If

the contribution margin is not sufficient to cover the fixed expenses, then a loss

occurs for the period. This concept is explained in the following equations:

[Sales revenue − Variable cost* = Contribution Margin]

*Both Manufacturing and Non Manufacturing

[Contribution margin − Fixed cost* = Net operating Income or Loss]

*Both Manufacturing and Non Manufacturing

The phrase "contribution margin" can also refer to a per unit measure of a

product's gross operating margin, calculated simply as the product's price minus

its total variable costs.

Consider a situation in which a business manager determines that a particular product has a 35% contribution margin, which is below that of other products in the company's product line. This figure can then be used to determine whether variable costs for that product can be reduced, or if the price of the end product could be increased.

If these options are unattractive, the manager may decide to drop the unprofitable product in order to produce an alternate product with a higher contribution margin.

Variable cost:

Definitions

1. The costs of production that vary directly in proportion to the number of

units produced. Variable costs often include labor expenses and raw

material costs, because labor and raw material usually must be increased to

increase output. Firms for which variable costs represent a high proportion

of total costs are usually less likely to experience large fluctuations in

earnings, because changes in sales and revenues are accompanied by

nearly equal changes in costs

2. A cost of labor, material or overhead that changes according

to the change in the volume of production units. Combined with fixed

costs, variable costs make up the total cost of production. While the total

variable cost changes with increased production, the

total fixed cost stays the same.

Example of variable cost:

A good example of a variable cost is fuel for an airline. This cost changes with the

number of flights and how long the trips are.

Fixed cost:

1. A cost that remains unchanged even with variations in output. An airline

with 20 airplanes has the fixed costs of depreciation and interest (if the

planes are partially financed with debt), regardless of the number of times

the planes fly or the number of seats filled on each flight. Firms with high

fixed costs tend to engage in price wars and cutthroat competition because

extra revenues incur little extra expense. These firms tend to experience

wide swings in profits.

2. An expense that does not change from one time period to other.

3. Fixed costs are those that do not change with the level of

sales. If sales increase or decrease but nothing else changes

then fixed costs remain the same.

Examples of fixed cost:

 Common examples of fixed costs include rents, salaries of permanent

employees and depreciation.

Margin of Safety:

Margin of safety (MOS) is the excess of budgeted or actual sales over the break

even volume of sales. It stats the amount by which sales can drop before losses

begin to be incurred. The higher the margin of safety, the lower the risk of not

breaking even.

Formula of Margin of Safety :

The formula or equation for the calculation of margin of safety is as follows:

[Margin of Safety = Total budgeted or actual sales − Break even sales]

The margin of safety can also be expressed in percentage form. This percentage is

obtained by dividing the margin of safety in dollar terms by total sales. Following

equation is used for this purpose.

[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales]

Example of margin of safety:

Sales(400 units @ $250) $100,000

Break even sales $87,500

Calculate margin of safety

Calculation:

Sales(400units @$250) $100,000

Break even sales $ 87,500

---------

Margin of safety in dollars $ 12,500

=======

Margin of safety as a percentage of sales:

12,500 / 100,000

= 12.5%

It means that at the current level of sales and with the company's current prices

and cost structure, a reduction in sales of $12,500, or 12.5%, would result in just

breaking even. In a single product firm, the margin of safety can also be expressed

in terms of the number of units sold by dividing the margin of safety in dollars by

the selling price per unit. In this case, the margin of safety is 50 units ($12,500 ÷ $

250 units = 50 units).

Graphical presentation of break even point:

The Break-Even point in sales volume is defined as:

“That point in sales volume, or revenue, where direct costs have been recovered,

fixed overhead expenses has been absorbed and where profit begins".

We can relate Break-Even Point to the information in our financial statements,

particularly the Income Statement. The Income Statement should be organized

into the following sections:

1. Revenue

the sum of all sales and other income net of returns and sales commissions.

2. Cost of Sales (Cost of Goods Sold)

The cost of purchases that are resold (merchandise) and/or raw materials plus the

costs of labor to manufacture the product or convert it or install it or deliver it or

construct it on site. These costs are also called direct or variable costs.

3. General & Administrative Costs (Overhead)

These are all the costs not directly, or easily, related to sales volume such as

Advertising, Bank Charges, Computer Expenses, Insurance, Office Wages &

Salaries, Officer’s Compensation, Telephone, Utilities, Depreciation, Interest,

Taxes etc. These costs are also called indirect or fixed costs.

4. 1 minus 2 minus 3 = PROFIT.

Note: If your Income Statement is not organized in this fashion (called managerial

accounting format), you need to have a session with your accountant and

demand it be put into this format so you can manage the business better.

Once you have your financial statements and data in the right format, you can

easily calculate Break-Even using the following formula as:

Break-Even Point = FC/ (1-VC/S)

Where:

FC = Fixed Costs

VC = Variable Costs

S = Sales

Calculation of Breakeven and Marginal Safety

DATA

Actual sales 1,462,411,953 Rs

FIXED COST: Rupees

Cost of sales

Salaries wages and benefits 50,671,082

Support services 35,427,380

Management charges 18,480,000

Insurance 5,666,010

Professional charges 1,160,333

Depreciation 310,374,531

Equipment rental 2,715,745

Administrative expenses

Salaries, wages and benefits 1,877284

Rent, rates and taxes 422,400

Legal and professional charges 2,247,934

Fees and subscription 3,472,200

Management charges 5,760,000

Provision for slow moving and obsolete

Stores, spare parts, and loose tools 41,000,000

Insurance 26,244

Auditors remuneration 820,000

Depreciation 1,317,586

Auditors’ remuneration

Audit fee 400,000

Half yearly review 100,000

Taxation services 300,000

Out of pocket expenses 20,000

Distribution cost

Salaries, wages and benefits 2,572,586

Support services 126,432

Fees and subscription 267,389

Depreciation 1317586

Management charges 5760,000

Finance cost

Markup on long term financing 246,727,700

Markup on short term borrowings 52,549,045

Mark up on advances from related

Parties 47,587,263

Exchange loss – net 1,207,028

Bank charges and commissions 2,618,976

TOTAL 842,992,734

VARIABLE COST:

Cost of sales

Raw and packing material consumed 271,340,574

Fuel power 1,423,331,145

Stores, spare parts and loose tolls consumed 44,260,560

Repairs and maintenance 3,505,043

Utilities 967,570

Traveling, conveyance and subsistence 8,265,148

Communication 338,432

Printing and stationery 746,331

Other manufacturing expenses 778,485

Administrative expenses

Traveling, conveyance and subsistence 366,924

Communication 5993

Printing and stationery 149,534

Entertainment 20,499

Advertising and promotion 214,300

Miscellaneous 153,865

Distribution cost

Repairs and maintenance 63,250

Communication 77415

Freight and handling 1,416,445

Printing and stationary 170,156

Entertainment 410, 24

Miscellaneous 16543

Freight on export 115,974

TOTAL 17556,345210

SOLUTION:

BREAK EVEN (IN UNITS)

= FIXED COST/CONTRIBUTION MARGIN (per unit)

Contribution margin

= sale – variable cost

= 1,462,411,953 – 1756,345210

= (293,933,257)

Break even (in units)

= 842,992,734

- 293,933,257

= (2.868)

BREAK EVEN (IN Rs)

=FIXED COST/CONTRIBUTION MARGIN RATIO

Contribution margin ratio

= contribution margin/sale

= − 293,933,257

1,462,411,953

= (0.201)

Break even in (Rs)

=842,992,734

-0.201

= (4193, 993,701)

MARGIN OF SAFETY

= ACTUAL SALE – BREAK EVEN SALE

= 14, 62,411,953-