Question

Suppose you are going to start a new business, do the projected following financial statements, and analyse them in your own words:

 

1. Manufacturing Account
2. Trading Account
3. Profit & Loss Account
4. A break-even analysis

 

From your accounts, you find out the

 

1. Manufacturing cost
2. Gross margin
3. Net margin
4. Variable cost
5. Fixed cost
6. margin of safety
7. Contribution Margin
8. Break-even unit
9. Break-even revenue
10. Targeted operating profit before and after tax

 

Then,

 

(1) Give a background description of your business.

(2) Analyse the importance of each of the above accounts.

(3) Identify the essential elements of cost-volume –profit analysis.

(4) Apply the CPV model to calculate a target operating profit.

(5) Apply the CPV model in decision making, and explain how sensitivity analysis can help managers both identify and manage risks.

Answer 1

Background information

ShoeCraft Corporation is a manufacturing company started by two partners A and B. The start-up was started on Jan 1. 2019 and has completed one year of operations. Now, the business partners want to expand their business and collected cost information before taking important decisions regarding selling price to earn target operating income, contribution margin, breakeven units and margin of safety. The following information shows the costs incurred in manufacturing. The depreciation on plant, plant supervisor salaries, insurance, rent, utilities, marketing costs, administration costs are fixed costs. The variable costs involved are direct material and direct labour. The company has sold 100,000 units in first year of operations at selling price of $12.

 

 

 

 

 

 

 

Manufacturing Account for the Year Ended December 31, 2019 (in 000')

 

Trading Account for the Year Ended December 31, 2019 (in 000')

 

Profit and loss Account for the Year Ended December 31, 2019 (in 000')

 

• Importance of manufacturing account:

It is an account prepared by the manufacturing concern for the purpose of finding out the cost of production of the goods manufactured and the profit that has been made by manufacturing department. When the data related to the cost of goods manufactured of a commodity are presented in T-shape form, then it is known as manufacturing account.

• Importance of trading account:

It is very important to find out gross profit or loss for the business to know whether purchasing, manufacturing and sales are sufficient for earning or not. The main objectives of trading account are as follows.
1. Compute gross profit or loss.
2. information about the direct expenses.
3. safety against possibilities of loss.
4. comparison of closing stock with last year's stock

• Importance of Profit and Loss Account

The profit & loss account provides information about an enterprise's income and expenses, which result in net profit or net loss. It helps a businessman evaluate the performance of an enterprise and provides a basis for forecasting future performance.

Apart from direct revenue and direct expenses, indirect expenses are also accounted for in profit and loss account to compute net profit or loss of business.

Components of CVP analysis

1.Selling Price: This is the average price per unit sold, including any sales discounts and allowances that may reduce the gross price

2.Variable Costs:This is the totally variable cost per unit sold, which is usually just the amount of direct materials ,direct labour and direct expenses associated with a unit sale. They vary with sales volume.

3.Fixed Costs:This is the total fixed cost of the business within the measurement period. This figure tends to be relatively steady from period to period, unless there is a step cost transition where management has elected to incur an entirely new cost in response to a change in activity level.

4.Contribution margin :Contribution margin is sales minus variable expenses

5.Break Even units:The total fixed cost of the company are divided by its contribution margin per unit. The break-even point (BEP), in units, is the number of products the company must sell to cover all production costs that is fixed costs + variable costs. The net profit/loss is 0 at this point.

6.Margin of safety(%):Margin of safety = Actual sales – break-even sales

7. Changes in Net Income (what-if analysis): Number of units = (fixed costs + target profit) / CM ratio

 

• Variable Cost per unit= Direct manufacturing labour+ Direct material costs / Number of units sold = $5000000/100000=$5
• Fixed cost= Depreciation +Plant supervisor salaries +Rent +Insurance + Administration cost+ Marketing cost +Taxes =$400,000
• Contribution margin = Selling price- Variable cost per unit

=$12- $5

=$7

• Break even units = Fixed costs/Contribution margin per unit

=$400,000/$7

= 57143units

• Break even sales = Selling price*Break even units

= $12* 57143

=$685,710

• Margin of safety (%)=( Actual sales- Break even sales)/Actual sales

=(120,000-685,710)/120,000

=42.86%

Using CPV model to calculate a target operating profit.

 

Sensitivity Analysis of target operating income to change in fixed cost per unit and variable cost per unit

• Sensitivity analysis is the study of how the uncertainty in the output of a mathematical model or system (numerical or otherwise) can be divided and allocated to different sources of uncertainty in its inputs.
• In the below table, we identified that as the fixed costs and variable costs increase, the number of breakeven units and number of units to achieve target operating income increases Thus, manager can identify such risks of increase in costs in advance and manage them by ensuring that firm achieves number of units requires to cross breakeven level of sales and desirable/ target operating income.