Chapter 10 Breakeven analysis and limiting factor analysis

Question 1

1.1 Breakeven and contribution

Answer 1

The breakeven point (BEP) is when profit = 0. Profit = total revenue (TR) – total variable costs (TVC) – total fixed costs (TFC). Hence, you break even when:
- TR – TVC – TFC = 0
- As contribution = TR – TVC, then
- Contribution = TFC

Question 2

1.2 Breakeven point (BEP)

Answer 2

Contribution = contribution per unit x quantity (Q)
Contribution per unit x Q = fixed costs, so Q is BEP here
BEP in units = total fixed costs / contribution per unit

Question 3

1.3 The contribution ratio

Answer 3

This measures how much contribution is earned from each £1 of sales.
CS ratio = total contribution / total revenue or
CS ratio = contribution per unit / selling price per unit
Breakeven point in terms of sales revenue = fixed costs / contribution ratio

Question 4

1.4 Margin of safety

Answer 4

This is the amount that anticipated sales can fall below budget before a business no longer makes a profit. This can be calculated as either: margin of safety = budgeted output – breakeven output, or
Margin of safety as a % of budgeted sales = (budgeted output – breakeven output / budgeted output) x 100

Question 5

1.5 Profit targets

Answer 5

Companies need to how many units they need to sell to achieve a level of profit. This can be calculated in one of two ways:
- Sales volume for a target profit = fixed costs + target profit / contribution per unit
- Sales revenue for a target profit = fixed costs + target profit / CS ratio

Question 6

1.6 Alteration of costs or revenues

Answer 6

The breakeven point or profit target calculations may alter if there is a change in selling price, variable costs or fixed costs.

Question 7

1.7 Breakeven (or CVP) assumptions and limitations

Answer 7

• Constant sales price
• Constant variable costs per unit
• Constant fixed costs
• Production = sales
• Costs classified easily as fixed or variable
• Applies to single product or a constant mix
• Charts time consuming
• Ignore uncertainty of estimates

Question 8

2.1 Traditional breakeven charts

Answer 8

• The traditional breakeven chart plots total costs and total revenues on the same vertical (y) axis and the level of output on the horizontal (x) axis
• Lines are drawn to represent the fixed costs (straight line parallel to the horizontal axis), total cost (fixed plus variable) and sales revenue
• The breakeven point can be read off where the total sales revenue line cuts the total cost line
• The margin of safety is the difference between the budgeted and breakeven output

Question 9

2.2 Contribution breakeven charts

Answer 9

A variation on the traditional breakeven chart is the contribution breakeven chart. The main differences between the two charts are as follows:
- The traditional breakeven chart shows the fixed cost line whereas the contribution chart shows the variable cost line
- Contribution can be read more easily from the contribution breakeven chart than the traditional breakeven chart

Question 10

3.1 Limiting factor analysis

Answer 10

A limiting factor (or key factor) is a factor (scarce resource) which prevents a company from achieving the level of activity that it would like to achieve. Scarce resources might include labour hours, materials, machine hours and factory space. The idea is to calculate the optimal production plan if there is a limit on production.

Question 11

3.2 Limiting factor analysis/ key factor analysis (KFA) method

Answer 11

If there is just one limiting factor, then the rule is to maximise the contribution per unit of the limiting factor.
- Calculate the contribution per unit for each product
- Calculate the contribution per unit of the limiting factor for each product
- Rank the products in order of the contribution per unit of the limiting factor
- Allocate resources using this ranking and answer the question

Question 12

3.3 Restriction to the optimal level of production

Answer 12

There may be circumstances where you may be restricted by a factor other than a scarce resource. For example,
- A contract with a customer which can’t be cancelled
- A minimum quantity of each product must be produced to maintain customer goodwill
The method remains the same except you must fulfil the restriction first

Question 13

4.1 Make or buy decisions

Answer 13

If demand exceeds production capacity, a firm needs to decide whether to buy in resources from external suppliers. The firm also needs to decide which products to manufacture itself and which to subcontract out. In the presence of a limiting factor, the following step-by-step approach could be adopted with a make vs. buy question:
- The saving per unit of each product is calculated: saving = external purchase price – internal variable cost to make
- Calculate the saving per unit of the limiting factor. Divide the saving by the amount of limiting factor each product uses.
- Rank products. The higher the saving per unit of the limiting factor, the greater the priority to make that should be given to the product
- Once the priorities have been decided, the scarce resource is allocated to the products in the order of the priorities, until it is fully used up
Any products with unsatisfied demand can be satisfied by buying from the external source.