# Gadget Products Division’s Break-Even Analysis

## Introduction

Break-even analysis is a managerial economic tool that is used to ascertain the number of units that generate revenue and covers the cost of production. This tool also helps to ascertain the level of sales that will generate a desired level of profit. This economical tool is often used to make pricing decisions. For instance, when variable costs of production increase, the product prices should also be increased to maintain the same break-even level. The management also uses the tool to determine price levels. To attain a ascertain level of profit, the management needs to come up with several strategies that would generate the break-even sales level and profit. Thus, breaking even analysis is an important tool for carrying out sensitivity analysis (Collier 98). It helps the management to determine desired levels of sales, costs, and profitability.

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### Aim of the paper

The paper carries out a break-even analysis under different proposals suggested by different senior staff members of the Gadget Products Divisions. The paper will also provide recommendations on the best proposal that can facilitate turn around of the company. The head of the division requires a strategy that would change the losses to a profit level of 5% of the sales.

## Break-even analysis for the year 2010

### Break-even number of units and revenue

Break-even analysis shows the number of units that should be produced and sold by the division so as to earn zero profit (Holmes and Sugden 76).

Total revenue (P * Q) = total cost [Variable (C *Q) + fixed cost]

Price per unit (P) = \$112.5

Units produced (Q) = to be estimated

Variable cost per unit = \$76.875 (as summarized in the table below)

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 Item Annual costs (000 \$) Unit cost (\$) Variable costs Raw materials 4,050,000 45.0 Direct labour 1,350,000 15.0 Production overhead 810,000 9.0 Variable expenses Sales commission (5%) 506,250 5.6250 Distribution (1.5%) 151,875 1.6875 Administration (0.5%) 50,625 0.5625 Total variable costs & expenses 6,918’750 Unit variable cost \$76.875

Total fixed cost = \$3,681,000 (as shown in the table below)

 Item Annual costs (000 \$) Fixed costs Production 1,770,000 Salaries and wages 891,000 Advertising 120,000 Administration 900,000 Total fixed costs 3,681,000

From the information above, the calculations of the break-even number of units are shown below.

Total revenue (P * Q) = total cost [Variable (C *Q) + fixed cost]

\$112.5 * Q = \$76.875 * Q + \$3,681,000

112.5Q – 76.875Q = 3,681,000

35.625Q = 3, 681, 000

Q = 103,326.3158

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Annual revenue for the break-even number units = \$112.5 * 103,326.3158 = \$11,624,210.53

From the calculation above, the total amount of annual dollar revenue is \$11,624,210.53, while the annual sales amount to 103,326.3158 units.

### Marginal analysis

The table below shows the marginal cost statement at the break-even units of output.

Marginal Costing Cost Statement

For the year ended 31/12/2010

 Number of units 103,326.32 Sales (112.5 *103,326.32) 11,624,210.53 11,624,210.53 Variable costs Raw material 45.00 4,649,684.21 Direct labour 15.00 1,549,894.74 Production overhead 9.00 929,936.84 7,129,515.79 Variable expenses Sales commission (5%) 5.63 581,210.53 Distribution (1.5%) 1.69 174,363.16 Administration (0.5%) 0.56 58,121.05 813,694.74 Total variable cost 7,943,210.53 Total fixed cost 3,681,000.00 Profit 0.00

Based on the marginal cost statement, the profit at the break-even point is zero. Thus, the minimum number of units that the division needs to produce to avoid losses is 103,326.32.

## Conclusion

Based on the calculations above, it is clear that the losses incurred by the company were as a result of the production of a low amount of units. The company produced 90,000 units which are less than the total of 103,326.32 units; which is the break-even number of units. The management of the company failed to estimate the number of units that would enable the company to cover all costs and earn a profit.

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### Impact of human resource manager’s proposal on sales, costs, and profitability for the year 2011

The suggestions of the human resource manager are summarized below.

1. Sales should be increased up to the level of production. This implies that sales will be 136,000 units (the maximum possible level of production).
2. An additional 10% discount on the net selling price. This implies that the new selling price per unit based on the proposal will be \$112.5 (100% – 10%) = \$101.25.
3. Variable costs will increase by the increase in the volume of units produced.
4. Percentages of the variable expense will remain unchanged.

Based on the proposals above, the new income statement will change, as shown below.

Income Statement

For the year ended 31/12/2011

 Sales (136,000 * 101.25) 13,770,000 Cost of sales Direct materials 6,120,000 Direct labour 2,040,000 Total direct cost 8,160,000 Production overhead Fixed 1,770,000 Variable 8% 1,101,600 Total overhead 2,871,600 Total costs 1,031,600 Gross profit 2,738,400 SD & GA costs Fixed Salaries and wages 891,000 Advertising 120,000 Variable Commission 5% 688,500 Distribution 1.5% 206,550 Total sales and distribution 1,906,050 General administration Fixed 900,000 Variable 0.5% 68,850 Total Administration 968,850 Total sales and administration expenses 2,874,900 Net loss (136,500) Net loss margin 0.99%

The proposal by the human resource manager increases the total amount of sales from \$10,125,000 to \$13,770,000. The total direct costs and overheads amount to \$11,031,600. It is an increase from \$7,980,000, which is incurred in the production and sale of 90,000 units. The total sales and administration expenses amount to 2,874,900. It is an increase from \$2,619,750, which is incurred for the production and sale of 90,000 units. This yields a net loss amounting to \$136,500. Thus, the opinion of the human resource manager reduces the net loss from \$474,750 to \$136,500. It does not ensure a complete turnaround. Further, the opinion of the human resource manager results in a net loss margin of 0.99%. The opinion does not achieve the group’s long term profitability goal of 7%. Also, it does not attain the division’s profitability goal of 5%.

### Impact of marketing and sales manager’s proposal on sales, costs, and profitability for the year 2011

The suggestions for the marketing and sales manager are summarized below.

1. Increase the number of units produced and sold from 90,000 units to 125,000 units.
2. Increase the price level by 10%. The new price level will be \$112.5 (100% +10%) = \$123.75.
3. Increase advertisement expense from \$120,000 to \$275,000.
4. Increase commissions from 5% to 10% of sales.
5. Variable costs will increase by the increase in the volume of units produced.
6. Percentages of the variable expense will remain unchanged.

Based on the proposals above, the new income statement will change, as shown below.

Income Statement

For the year ended 31/12/2011

 Sales (125,000 * 123.75) 15,468,750 Cost of sales Direct materials 5,625,000 Direct labor 1,875,000 Total direct cost 7,500,000. Production overhead Fixed 1,770,000 Variable 8% 1,237,500 Total overhead 3,007,500 Total costs 10,507,500 Gross profit 4,961,250 SD & GA Costs Fixed Salaries and wages 891,000 Advertising 275,000 Variable Commission 10% 1,546,875 Distribution 1.5% 232,031 Total sales and distribution 2,944,906 General administration Fixed 900,000 Variable 0.5% 77,344 Total Administration 977,344 Total sales and administration expenses 3,922,250 Net Profit 1,039,000 Net profit margin 6.72%

The opinion of the sales and marketing manager results in an increase in the total amount of sales from \$10,125,000 to \$15,468,750. The total direct costs and overheads amount to \$10,507,500. It is an increase from \$7,980,000, which is incurred for the production and sale of 90,000 units. The total amount of sales and administration expenses amounts to 3,922,250. It is an increase from \$2,619,750, which is incurred for the production and sale of 90,000 units. This yields a net profit amounting to \$1,039,000. Thus, the opinion of the sales and marketing manager changes the financial results of the division from a net loss of \$474,750 to a net profit amounting to \$1,039,000. It is better than the opinion of the human resource manager. Further, the opinion of the sales and marketing manager yields a net profit margin of 6.72%. The opinion does not achieve the group’s long term profitability goal of 7%. However, it attains the division’s profitability goal of 5%.

### Impact of production manager’s proposal on sales, costs, and profitability for the year 2011

The suggestions for the production manager are summarized below.

1. Increase the number of units from 90,000 units to 130,000 units.
2. Price per unit should remain the same at \$112.5.
3. Increase advertisement expense from \$120,000 to \$275,000 (since he supports the opinion of the marketing and sales manager).
4. Increase commissions from 5% to 10% of the total sales (since he supports the opinion of the marketing and sales manager).
5. Variable costs will increase by the increase in the volume of units produced.
6. Percentages of variable expenses will remain unchanged.

Based on the proposals above, the new income statement will change, as shown below.

Income Statement

For the year ended 31/12/2011

 Sales (130,000 * 112.5) 14,625,000 Cost of sales Direct materials 5,850,000 Direct labor 1,950,000 Total direct cost 7,800,000 Production overhead Fixed 1,770,000 Variable 8% 1,170,000 Total overhead 2,940,000 Total costs 10,740,000 Gross profit 3,885,000 SD & GA Costs Fixed Salaries and wages 891,000 Advertising 275,000 Variable Commission 10% 1,462,500 Distribution 1.5% 219,375 Total sales and distribution 2,847,875 General administration Fixed 900,000 Variable 0.5% 73,125 Total Administration 973,125 Total sales and administration expenses 3,821,000 Net Profit 64,000 Net profit margin 0.44%

The opinion of the production manager increases the total amount of sales from \$10,125,000 to \$14,625,000. The total direct costs and overheads amount to \$10,740,000, considering the production manager’s opinion. It is an increase from \$7,980,000, which is incurred for the production and sale of 90,000 units. The gross profit margin generated amounts to \$3,885,000. The total sales and administration expenses amount to 3,821,000. It is an increase from \$2,619,750, which is incurred for the production and sale of 90,000 units. This creates a net profit amounting to \$64,000.

Thus, the opinion of the production manager turns around the financial results of the division from a net loss of \$474,750 to a net profit amounting to \$64,000. It is better than the opinion of the human resource manager, though it generates a lower net profit than the opinion of the sales and marketing manager. Further, the opinion of the production manager yields a net profit margin of 0.44%. The opinion does not achieve the group’s long term profitability goal of 7% and the division’s profitability goal of 5%.

### Impact of finance manager’s proposal on sales, costs, and profitability for the year 2011

The finance manager focuses on expanding the foreign market. The suggestions of the finance manager are summarized below.

1. Increase in sales will have a direct impact on profitability.
2. He suggests that the division should maintain the current level of sales, volume, cost structure, and price in the home market.
3. Grow sales by expanding into a new market that is, the MEA region.
4. Conclude agreements initiated with the retail chains in the MEA region.
5. The content of the agreement is to sell additional 50,000 units of the mpg product.
6. The selling price per unit to be \$114.
7. For the additional units, the company will spend \$37,500 thousand on the advertisement and \$15,000 thousand on the packaging.
8. There will be no commissions on sales of the additional units sold.
9. Fixed costs will remain unchanged.
10. Variable costs will be based on the number of additional units.

Based on the proposals of the finance manager above, two-income statements will be prepared. The first income statement will show the profitability of the additional 50,000 units to be sold in the MEA region. The second income statement will consolidate the results of the foreign market and home market operations. This will help ascertain if the opinion of the finance manager generates profit or not. The two-income statements are shown below.

Income Statement (for MEA region)

For the year ended 31/12/2011

 Sales (50,000 * 114) 5,700,000 Cost of sales Direct materials 2,250,000 Direct labour 750,000 Total direct cost 3,000,000 Production overhead Variable 8% 456,000 Total overhead 456,000 Total costs 3,456,000 Gross profit 2,244,000 SD & GA Costs Fixed Packaging 15,000 Advertising 37,500 Variable Distribution 1.5% 85,500 Total sales and distribution 138,000 General administration Variable 0.5% 28,500 Total administration 28,500 Total sales and administration expenses 166,500 Net Profit 2,077,500 Net profit margin 36.45%

The total sales generated from the foreign market amount to \$5,700,000. The total cost of sales amounts to \$3456, 000. This generates a gross profit that amounts to \$2,244,500. The division will incur fixed costs on packaging and advertising only. The total sales and administration expenses amount to \$166,500. The net profit margin generated a total amounting to \$2,077,500. The net profit margin amounts to \$36.45%. The profit arising from the foreign market is higher than if the goods were sold in the home market. The table below shows the consolidated income statement that combines sales and expenses from both foreign and home markets.

Consolidated Income Statement

For the year ended 31/12/2011

 Sales (50,000 * 114) 15,825,000.00 Cost of sales Direct materials 6,300,000.00 Direct labor 2,100,000.00 Total direct cost 8,400,000.00 Production overhead Fixed 1,770,000.00 Variable 8% 1,266,000.00 Total overhead 3,036,000.00 Total costs 11,436,000.00 Gross profit 4,389,000.00 SD & GA Costs Fixed Salaries and wages 891,000.00 Packaging 15,000.00 Advertising 157,500.00 Variable Commission 10% 506,250.00 Distribution 1.5% 237,375.00 Total sales and distribution 1,807,125.00 General administration Fixed 900,000.00 Variable 0.5% 79,125.00 Total Administration 979,125.00 Total sales and administration expenses 2,786,250.00 Net profit 1,602,750.00 Net profit margin 10.13%

The proposal of the finance manager increases the total amount of sales from \$10,125,000 to \$15,825,000. The total direct costs and overheads amount to \$11,436,000. It is an increase from \$7,980,000, which is incurred for the production and sale of 90,000 units. The gross profit margin generated amounts to \$4,389,000. It is an increase from \$2,145,000 earned from the production and sale of 90,000 units. The total sales and administration expenses amount to 3,821,000. It is an increase from the total of \$2,619,750 that was spent on production and sale of 90,000 units. This yields a net profit amounting to \$1,602,750.

Thus, the opinion of the finance manager changes the current state of the financial results of the division from a net loss of \$474,750 to a net profit amounting to \$1,602,750. It also generates higher returns than the opinion of the other three managers. Further, the opinion of the production manager yields a net profit margin of 10.13%. The profitability ratio surpasses the group’s long term profitability goal of 7% and the division’s profitability goal of 5%.

## Conclusion and recommendations

The table below summarizes the results of the opinions of the four managers.

 Item Human resource manager Sales and marketing manager Production manager Finance manager 1 Sales revenue 13,770,000 15,468,750 14,625,000 15,825,000 2 Gross profit 2,738,400 4,961,250 3,885,000 4,389,000 3 The total cost of sales 11,031,600 10,507,500 10,740,000 11,436,000 4 Total sales and administration expenses 2,874,900 3,922,250 3,821,000 2,786,250 5 Net profit (loss) (136,500) 1,039,000 64,000 1,602,750 6 Net profit (loss) margin (0.99%) 6.72% 0.44% 10.13%

The opinion of the finance manager generates the highest amount of sales followed by the opinion of the sales and marketing department. Highest gross profit will be earned if the proposal for the sales and marketing manager is implemented. However, his proposal will entail increasing cost by a substantial amount. The proposal of the finance manager generates the highest amount of net profit of \$1,602,750, followed by the opinion of the sales and marketing manager (\$1,039,000). The proposal of the human resource manager generated the least amount of sales and profit followed by that of the production manager. The profitability of the proposal can be ranked, as shown below.

 Manager Net profit 1 Finance 1,602,750 2 Sales and marketing 1,039,000 3 Production 64,000 4 Human resource (136,500)

Based on the rankings shown above, Tom Roberts should implement the opinion of the finance manager because it generates the highest amount of net profit. Besides, the net profit margin generated surpassed the target of 7% for the group and 5% for the division. The only constraint with the proposal is that the total number of units which is 140,000 units exceed the current production capacity of the plant which is136,000 units. The difference of 4,000 units is dismal and can be attained by improving efficiency and minimizing idle time (McLaney and Atrill 110).

## Works Cited

Collier, Paul. Accounting for Managers, London: John Wiley & Sons Ltd, 2012. Print.

Holmes, Geoffrey, and Sugden, Alan. Interpreting Company Reports, New York: Harlow, 2005. Print.

McLaney, Eddie, and Atrill, Peter. Financial Accounting for Decision Makers, London: Harlow, 2008. Print.

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