JENNIFER JENNIFER I. MALABRI MALABRIGO GO Case 16-3: Bill French Introduction
Case Facts
Firm sells 3 products A, B and C with demand of A expected to fall, that of B to remain stable and that of C to double Fixed costs in the plant change with capacity of utilization Half of the profit after taxes are shared with the government The selling price of C to be increased to reflect quality and maintain reputation Existing Existing condition condition
Plant Capacity Total fixed costs Total revenue Sales volume Capacity utilization Average unit price Average unit variable cost Aver Averag agee unit unit cont contri ribu buti tion on Marg Margin in to sale saless Break-even sales point Break-even sales units
2,000,000 per year $2,970,000 $10,800,000 1,500,000 units 75% $7.20 $4.50 0.37 0.375 5 $7,920,000 1100000
New Information Information
Capacity of the plan to be increased by investment of $60,000 per month (720,000 per year) Sale price to C is to be increased by 100% Sales volume of C is to be increase by 450000 units Sales volume of A is reduced to 2/3 to 400000 units
Statement Statement of the Problems Problems
To compute an organization breakeven sales level for a multi-products firm using cost behavior information
To use CVP in decision-making decision-making
To determine the level at which the company must operate in order to break-even.
To set assumptions implicit in Bill-French determination in his company’s break-even point.
To analyze the individual product lines to see it differences in calculations
To see the limit sales increase factored.
To know what does next year look like on the basis of French revised information.
Case Analysis Proper (Answers to Guide Questions) Question 1 The assumptions implicit in Bill French’s determination of his company’s break-even point
There is undoubtedly a long list of assumptions that can be related to this, or any, break-even analysis. Part of the problem of dealing with analyses of this sort is that they take on the characteristic of being static even though the form of presentation might lead one to believe that here is a moving, dynamic analysis that allows for a variety of changed conditions. To an extent this is true; but there are many conditions that are assumed to be constant. It is to the assumed constants that the students must ultimately direct their attention. For instance:
French has had to assume that the variability of the variable costs is constant. French has thus assumed a relatively constant level of efficiency for machines and direct labor over all portions of the range of operations. Whether or not this is a valid assumption in a practical sense is highly questionable.
Similarly, there is an assumption that the fixed costs are truly fixed over the full range of operations that has been pictured. In fact, some fixed costs are likely to be step functions over this range.
The calculation of a break-even point based on sales assumes that there will be a reasonably constant relationship between the production and the sales pattern. Were this not the case, the spread between the patterns would lead to an incurrence of costs to be carried in inventory, and the full contribution suggested by the chart may not be realized.
Along somewhat the same vein, the assumption (and a basic one in either aggregate or productline analyses) that the sales mix will remain constant is a crucial one.
And, obviously, there is considerable reliance in French's analysis that sales prices will remain constant.
Considering the objections of the participants at the meeting, it is easy to see where French's failure to make explicit his assumptions got him into the position of appearing to be a naive, inexperienced "whiz kid."
Question 2 On the basis of French’s revised information, next year look like:
Additional Investment in C=60000*12 = 720000, New C price is doubled. A’s new volume is 2/3 and C’s volume is increased by 450000
ChangeinProductStructure NewSales Volume Sale Price Sales Revenue VariableCost VariableCostto sales UnitContribution to sales UtilizaitonofCapacity Total VariableCost FixedCost Profit Break-EvenPoint(Units) Break-EvenPoint(Dollars)
"A" 400,000 10.00 4,000,000.00 7.50 0.75 0.25 20% 3,000,000.00 960,000.00 40,000.00 384,000
"B" 400,000.00 9.00 3,600,000.00 3.75 0.42 0.58 20% 1,500,000.00 1,560,000.00 540,000.00 297,143
"C" 950,000.00 4.80 4,560,000.00 1.50 0.31 0.69 47.50% 1,425,000.00 1,170,000.00 1,965,000.00 354,545
TOTAL 1,750,000.00 6.948571 12,160,000.00 3.3857140 0.4872530 0.5127470 87.50% 5,925,000.00 3,690,000.00 2,545,000.00 1,035,688.00 $7,196,536.00
a. The break-even points
There is an extra $720,000 a year in fixed costs estimated by Fred Williams for this year. Since capacity is being expanded to increase production of Product C, it could be assumed that this increase should be allocated to this product. Production of Product A is to be scaled down, but as there isn't any information as to whether its relevant range of fixed costs will change, I have left its level of fixed costs unchanged. As a result both A's and B's breakeven points remain the same. For C the breakeven point is 354,545 units. The overall breakeven point is 1,035,688 units. b. The level of operations to achieved to pay the extra dividend, ignoring union demands. Duo-Products must make a $1.2 million profit before tax to meet this requirement. To do this it must sell 1,372,494 units. c.
The level of operations to achieved to meet the union demands, ignoring bonus dividends. An increase in variable costs across the board by 10% would increase the average variable cost to $3.72 per unit. For Duo-Products to break even under these conditions it would need to sell 1,144,440 units. d. The level of operations to achieved to meet both dividends and expected union requirements. Duo-Products would have to sell 1,516,615 units to meet both the extra dividends and expected union requirements.
Question 3 Can the break-even analysis help the company decide whether to alter the existing product emphasis. The company can afford to invest for additional “C” capacity.
Two points should be recognized in considering a shift of capacity f rom product "A" to "C": 1. While the ratio of variable income to sales price is much higher for "C" than for "A" (66% against 18%); this is in part compensated for by the lower sales price of "C." 2. While the per unit dollar contribution for "C" is higher than for "A" ($3.15 against $1.75), the number of units that can be sold is a critical factor. Since the "A" contribution is 56 percent of the "C" contribution, this would mean that the company can afford to gain in "C" units only 56 percent of the number of "A" units that it gives up. Similarly, in viewing the amount of capacity that can be added for "C," we must consider (in addition to the compelling factors that do not come directly under the costrevenue measurement) the amount of variable income available to pay for the added capacity and to return a reasonable profit at the same time. Here the analysis wanders into the area of return on investment. On the basis of a per unit contribution of $3.15 from "C," an addition that would yield 100,000 additional units of "C" annually must not cost more than about $300,000 by the time amortization and profit (at a proper rate of return) are considered.
Question 4 The calculation of each three products’ break-even points using the data in Exhibit 3.
EXHIBIT 3 Product Class Cost Analysis Normal Year Aggregate "A" "B" "C" Salesat full capacity (units) 2,000,000.00 Actual salesvolume (units) 1,500,000.00 600,000.00 400,000.00 500,000.00 Unit sales price 7.20 10.00 9.00 2.40 Total salesrevenue 10,800,000.00 6,000,000.00 3,600,000.00 1,200,000.00 Variable cost per unit 4.50 7.50 3.75 1.50 Total variable cost 6,750,000.00 4,500,000.00 1,500,000.00 750,000.00 Fixed costs 2,970,000.00 960,000.00 1,560,000.00 450,000.00 Profit 1,080,000.00 540,000.00 540,000.00 Ratios Variable cost to sales 0.625 0.75 0.42 0.625 Unit contribution to sales 0.375 0.25 0.58 0.375 Utilization of capacity 75% 30% 20% 25% Based on the data given in Exhibit 3, the individual product break-even analysis is follows: Fixed costs Unit sales price-Variable Cost per unit Break-even points in units Break-even points in dollars total
Product"A" Product"B" Product "C" $ 960,000.00 $ 1,560,000.00 $ 450,000.00 $10.00- $7.50 $9.00- $3.75 $2.40- $1.50 =384,000units =297,143units =500,000units or $3,840,000 or $2,674,000 or $1,200,000 A total of 1,181,143units or $7,714,000
Versus 1,100,000 units or &7,920,000 on aggregate basis
The sum total is not equal to the 1,100,000 units aggregate break-even volume because each product has a different contribution margin ratio and different level of fixed costs and sales volume.
Question 5 The Value of Break-even Analysis
Break-even analysis is a basic tool that can be used to determine the level of sales that is required for the company to start earning a profit.
Helps understand and formulate the relationship between costs (fixed and variable), output and profit
Helps quickly observe profit levels at different outputs.
In a wide product range, the analysis helps to find out which products are performing well and which are leading to losses.
The technique can be used to set sales targets and/or prices to generate target profits
It is also versatile enough to include items like donations, wage increases, etc. that directly or indirectly affect costs.
Conclusions and Recommendations
We can conclude that the use of break-even point analysis is to give a measure of risk, not of profitability. Break-even point enables to assess the degree of risk of a company’s cost structure. A planning tool that useful to forecast financial needs. CVP analysis is not for discontinuing decisions. A negative/positive UCM is not the only relevant criteria to decide whether or not to drop a product. CVP analysis is insufficient for discontinuing decisions (outsourcing, change in the product portfolio, etc..) and need to know the nature of fixed costs (direct and indirect) and what are the direct avoidable versus indirect largely unavoidable cost. CVP analysis is not for comparing products. Basic UCMs usually do not tell us which products should be pushed. Contrary to UCMs, unit contribution margins per unit of scarce resource are not misleading. UCMs may be used when all products have the same scarce resources consumptions. Line-by-line analysis tells us about virtual profitability for each product. From manufacturing and sales point of view, it is very useful to make planning for each product. Aggregate analysis answers whether we can meet our profit targets. From the financial point of view, it is very useful to target the aggregate profit level. Focus on net profit rather than operating profit.
