MANAGEMENT INFORMATION

CLASS (L-01 & 02)

Prepared By: A.K.M Mesbahul
Karim FCA
 Chapter – 10 : Breakeven analysis and limiting
factor analysis
Contribution:
Contribution = selling price less variable costs; Profit = contribution less fixed costs.

Breakeven:
The management of an organisation usually wishes to know the profit likely to be made if the
aimed-for production or activity and sales for the year are achieved. Management may also be
interested to know the activity level at which there is neither profit nor loss. This is known as
the breakeven point.

The breakeven point (BEP) can be calculated as

Breakeven point
= Total fixed costs/Number of units of sale required to breakeven
= Contribution required to breakeven/Contribution per unit

Worked example: Breakeven point

Expected sales 10,000 units at Tk. 8 = Tk.80,000

Variable cost Tk.5 per unit
Fixed costs Tk.21,000

Requirement
Compute the breakeven point.
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Solution

The contribution per unit is Tk. (8 - 5) = Tk.3

Contribution required to break even = fixed costs = Tk.21,000
Breakeven point (BEP) = Tk.21,000 ÷ Tk.3
= 7,000 units
In revenue, BEP = (7,000 X Tk.8) = Tk.56,000

Sales above Tk.56,000 will result in profit of Tk.3 per unit of additional sales and sales below
Tk.56,000 will mean a loss of Tk.3 per unit for each unit by which sales fall short of 7,000 units.
In other words, profit will improve or worsen per unit of sales by the level of contribution per
unit.

7,000 units 7,001 units

Tk. Tk.
Revenue 56,000 8 56,008
Less variable costs 35,000 5 35,005
Contribution 21,000 3 21,003
Less fixed costs 21,000 21,000
Profit 0 Breakeven 3
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The contribution ratio:
The contribution ratio is a measure of how much contribution is earned from each Tk. 1 of
sales revenue. An alternative way of calculating the breakeven point to give an answer in terms
of sales revenue and using the contribution ratio is as follows.

Breakeven point = Sales revenue required to break even

= Contribution required to break even/Contribution ratio

Worked example: Contribution ratio

Using the data in the last worked example the contribution ratio is Tk. 3/ Tk. 8 = 37.5%.
Breakeven is where sales revenue equals Tk. 21,000/ .375 = Tk. 56,000. At a price of Tk. 8 per
unit, this represents 7,000 units of sales, as calculated earlier.

The margin of safety:

 The margin of safety is the difference in units between the budgeted or expected sales
volume and the breakeven sales volume. It is sometimes expressed as a percentage of the
budgeted sales volume.
 Alternatively the margin of safety can be expressed as the difference between the budgeted
sales revenue and breakeven sales revenue, expressed as a percentage of the budgeted
sales revenue.
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Worked example: Margin of safety

Mal de Mer Co makes and sells a product which has a variable cost of Tk. 30 and which sells for
Tk. 40. Budgeted fixed costs are Tk. 70,000 and budgeted sales are 8,000 units.

Requirement
Calculate the breakeven point and the margin of safety.

Solution:
(a) Breakeven point = Total fixed costs/ Contribution per unit
= Tk. 70,000/ Tk. (40 - 30)
= Tk. 7,000 Units

(b) Margin of safety = 8,000 - 7,000 units

= 1,000 units

which may be expressed as = 1,000 units/ 8,000 units X 100%

= 12½% of budget

(c) The margin of safety indicates to management that actual sales can fall short of budget by
1,000 units or 12½% before the breakeven point is reached and no profit is made.
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Cost-volume-profit analysis and profit targets

Once the selling price and cost structure have been established for a product or service it is
possible to manipulate the data to provide a variety of information for management decisions.

Worked example: CVP analysis

Butterfingers Company makes a product which has a variable cost of Tk.7 per unit.

Requirement
If fixed costs are Tk. 63,000 per annum, calculate the selling price per unit if the company wishes
to break even with a sales volume of 12,000 units.

Solution:

Contribution required to breakeven (= fixed costs) = Tk. 63,000

Volume of sales = 12,000 units
Required contribution per unit = Tk.63,000 ÷ 12,000 = 5.25
Variable cost per unit = 7.00
Required sales price per unit = 12.25
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Worked example: Target profits
RB Co makes and sells a single product, for which variable costs are as follows.

Materials 10
Labour 08
Production overhead 06
24

The sales price is Tk. 30 per unit, and fixed costs per annum are Tk. 68,000. The company wishes to make a profit of
Tk.16,000 per annum.
Requirement
Determine the sales required to achieve this profit.

Solution:
Since the contribution earned in a period is literally the contribution towards fixed costs and profit, in order to
achieve a certain target profit the contribution required is equal to the fixed costs plus the target profit.
Required contribution = fixed costs + profit = Tk. 68,000 + Tk. 16,000 = Tk. 84,000
Required sales can be calculated in one of two ways.

a) Required contribution/ Contribution per unit = Tk. 84,000/ Tk. (30 - 24) = 14,000 units, or Tk. 420,000 in
revenue
b) Required contribution/ Contribution ratio = Tk. 84,000/ 20% = Tk. 420,000 of revenue, or 14,000 units.

Contribution ratio = Tk.30 – Tk. 24/ Tk. 30 = Tk.6/ Tk. 30 = 0.2 = 20%.
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Worked example: Change in selling price

MN Ltd bakes and sells a single type of pen. The variable cost of production is Tk. 0.15 per cake and the current
sales price is Tk. 0.25 per pen. Fixed costs are Tk. 2,600 per month, and the annual profit for the company at the
current sales volume is Tk. 36,000. The volume of sales demand is constant throughout the year.

The sales manager wishes to raise the sales price to Tk.0.29 per pen, but considers that a price rise will result in
some loss of sales.

Requirement
Ascertain the volume of sales required each month to maintain current profitability, if the selling price is raised to
Tk. 0.29.
Solution:
The volume of sales required is one which would leave total profit the same as before, ie Tk. 3,000 per month.
Required profit should be converted into required contribution, as follows.

Monthly fixed costs 2,600

Monthly profit required 3,000
Current monthly contribution 5,600

The volume of sales required after the price rise will be an amount which earns a contribution of Tk. 5,600 per
month, the same as before. The contribution per cake at a sales price of Tk. 0.29 would be (Tk.0.29 – Tk.0.15) = Tk.
0.14.

Required sales = Required contribution/ Contribution per unit = Tk.5,600/ Tk. 0.14 = 40,000 cakes per month
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Worked example: Change in production costs
PQ Ltd makes a product which has a variable production cost of Tk. 8 and a variable selling cost of Tk. 2 per unit. Fixed
costs are Tk. 40,000 per annum, the sales price per unit is Tk. 18, and the current volume of output and sales is 6,000
units.

The company is considering whether to hire an improved machine for production. Annual hire costs would be Tk. 10,000
and it is expected that the variable cost of production would fall to Tk. 6 per unit.

Requirement
(a) Determine the number of units that must be produced and sold to achieve the same profit as is currently earned, if
the machine is hired.
(b) Calculate the annual profit with the machine if output and sales remain at 6,000 units per annum.

Solution:
(a) The current unit contribution is Tk. (18 - (8+2)) = Tk. 8

Current contribution (6,000 × Tk. 8) 48,000

Less current fixed costs 40,000
Current profit 8000
With the new machine fixed costs will increase by Tk. 10,000 to Tk. 50,000 per annum. The variable cost per unit will
reduce to Tk. (6 + 2) = Tk. 8, and the contribution per unit will increase to Tk. 10.

Required profit (as currently earned) 8,000

Fixed costs 50,000
Required contribution 58,000

Contribution per unit

Sales required to earn Tk. 8,000 profit = Tk. 58,000/Tk. 10 = 5,800 units
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(b) If sales are 6,000 units
Profit at 5,800 units of sale (see (a)) 8,000
Contribution from sale of extra 200 units (× Tk.10) 2,000
Profit at 6,000 units of sale 10,000

Breakeven charts:
The breakeven point can be determined graphically using a breakeven chart. A breakeven chart is a chart that indicates the profit
or loss at different levels of sales volume within a limited range.
A breakeven chart has the following axes.
 A horizontal axis showing the sales/output (in value or units)
 A vertical axis showing Tk. for sales revenues and costs

Lines on a breakeven chart:

The following lines are drawn on the breakeven chart.
(a) The sales line
 Starts at the origin
 Ends at the point signifying expected sales volume and sales value
(b) The fixed costs line
 Runs parallel to the horizontal axis
 Meets the vertical axis at a point which represents the value of total fixed costs

(c) The total costs line

 Starts where the fixed costs line meets the vertical axis
 Ends at the point which represents anticipated sales volume on the horizontal axis and the total
costs of anticipated sales on the vertical axis

The breakeven point is the intersection of the sales line and the total costs line.
The distance between the breakeven point and the expected (or budgeted) sales, in units, indicates the margin of safety at that
level of sales.
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Worked example: A breakeven chart

The budgeted annual output of a factory is 120,000 units. The fixed overheads amount to Tk. 40,000 and
the variable costs are 50p per unit. The sales price is Tk. 1 per unit.

Requirement
Construct a breakeven chart showing the current breakeven point and profit earned up to the present
maximum capacity of 120,000 units.

Solution:
We begin the construction of the breakeven chart by calculating the profit at the budgeted annual output.

Sales (120,000 units) 120,000

Variable costs 60,000
Contribution 60,000
Fixed costs 40,000
Profit 20,000
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Limitations of breakeven or CVP analysis and breakeven charts :
CVP analysis is a useful technique for managers. It can provide simple and quick estimates, and breakeven charts provide a
graphical representation of breakeven arithmetic. It does, however, have a number of limitations.

 It can only apply to a single product or a constant mix of a group of products

 A breakeven chart may be time-consuming to prepare
 It assumes fixed costs are constant at all levels of output
 It assumes that variable costs are the same per unit at all levels of output
 It assumes that sales prices are constant at all levels of output
 It assumes production and sales are the same (inventory levels are ignored – effectively marginal costing is used)
 It ignores the uncertainty in the estimates of sales prices, fixed costs and variable cost per unit.

Limiting factor analysis

Limiting factors:
One of the more common problems faced by management is a situation where there are insufficient resources to meet the
potential sales demand. In this situation a decision has to be made about what mix of products to manufacture or services to
provide, using the available resources as effectively as possible. The resource that limits the organisation's ability to meet sales
demand is called a limiting factor or key factor.

A limiting factor or key factor is 'anything which limits the activity of an entity'. An entity seeks to optimise the benefit it obtains
from the limiting factor. Examples are a shortage of supply of a resource or a restriction on sales demand at a particular price.

A limiting factor could be sales if there is a limit to sales demand but any one of the organisation's resources (labour, materials and
so on) may be insufficient to meet the level of production demanded.

It is assumed in limiting factor analysis that management wishes to maximise profit and that since there is no change in the fixed
cost incurred profit will be maximised when contribution is maximised.
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Limiting factor situations:

For example if grade A labour is the limiting factor, contribution will be maximised by earning the highest contribution from each
hour of grade A labour worked. The limiting factor decision therefore involves the determination of the contribution earned by
each different product or service from each unit of the limiting factor.
Worked example: Limiting factor

AB Ltd makes two products, the Ay and the Be. Unit variable costs are as follows.

Ay Be
Tk. Tk.
Materials 1 3
Labour (Tk. 9 per hour) 18 9
Overhead 1 1
20 13

The sales price per unit is Tk. 26 per Ay and Tk. 17 per Be. During July 20X2 the available labour is limited
to 8,000 hours. Sales demand in July is expected to be 3,000 units for Ays and 5,000 units for Bes.

Requirement
Determine the profit-maximising production mix, assuming that monthly fixed costs are Tk. 20,000, and that
no inventories are held.
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Solution

Step 1
Confirm that the limiting factor is something other than sales demand.

Ays Bes Total

Labour hours per unit 2 hrs 1 hrs
Sales demand 3,000 units 5,000 units
Labour hours needed 6,000 hrs 5,000 hrs 11,000 hrs
Labour hours available 8,000 hrs
Shortfall 3,000 hrs

Labour is the limiting factor on production

Step 2
Identify the contribution earned by each product per unit of limiting factor, that is per labour hour worked.

Ays Bes
Tk. Tk.
Sales price 26 17
Variable cost 20 13
Unit contribution 6 4

Labour hours per unit 2 hrs 1 hrs

Contribution per labour hour (= unit of limiting factor) Tk. 3 Tk. 4

Although Ays have a higher unit contribution than Bes, two Bes can be made in the time it takes to make
one Ay. Because labour is in short supply it is more profitable to make Bes than Ays.
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Step 3

Determine the optimum production plan. Sufficient Bes will be made to meet the full sales demand, and the remaining labour hours available

will then be used to make Ays.

Hours
Product Demand required Hours available Priority of manufacture

Bes 5,000 5,000 5,000 1st

Ays 3,000 6,000 3,000 (bal) 2nd

11,000 8,000

Hours Contribution per

Product Units needed hour (Tk.) Total

Bes 5,000 5,000 4 20,000

Ays 1,500 3,000 3 9,000

8000 29,000

Less fixed costs 20,000

Profit 9,000
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Limiting factor analysis and restricted freedom of action

In certain circumstances an organisation faced with a limiting factor on production and sales might not be able to produce
the profit-maximising product mix because the mix and/or volume of products that can be produced and sold is also
restricted by a factor other than a scarce resource.

(a) A contract to supply a certain number of products to a customer which cannot be cancelled
(b) Production/sales of a minimum quantity of one or more products to provide a complete product range and/or to
maintain customer goodwill
(c) Maintenance of a certain market share of one or more products

In each of these cases, the organisation might have to produce more of a particular product or products than the level
established by ranking according to contribution per unit of limiting factor.

If an organisation has to produce more of a particular product or products than the level established by ranking according
to contribution per unit of limiting factor, the products should be ranked in the normal way but the optimum production
plan must first take into account the minimum production requirements. The remaining resource must then be allocated
according to the ranking.
 Make or buy decisions and scarce resources
An organisation might want to do more things than it has the resources for, and so its
alternatives would be as follows.

(a) Make the best use of the available resources and ignore the opportunities to buy help from outside
(b) Combine internal resources with subcontracting externally so as to do more and increase profitability

Worked example: Make or buy decisions with scarce resources

MM manufactures three components, S, A and T using the same machines for each and assembles
them into a single product. The budget for the next year calls for the production and assembly of
4,000 of each component. The variable production cost per unit of the final product is as follows.
Machine hours Variable cost (Tk.)
1 unit of S 3 20
1 unit of A 2 36
1 unit of T 4 24
Assembly 100

Only 24,000 hours of machine time will be available during the year, and a subcontractor has quoted the
following unit prices for supplying components: S Tk.29; A Tk.40; T Tk.34.

Requirement
Advise MM on its most profitable plan.
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Solution
 The organisation's budget calls for 36,000 hours of machine time, if all the components are to be
produced in-house.
 Only 24,000 hours are available, and so there is a shortfall of 12,000 hours of machine time,
which is therefore a limiting factor.
 The shortage can be overcome by subcontracting the equivalent of 12,000 machine hours'
output to the subcontractor.
 The assembly costs are not relevant costs because they are not affected by the decision.
 The decision rule is to minimise the extra variable costs of subcontracting per unit of scarce
resource saved (that is, per machine hour saved).
S A T
Tk. Tk. Tk.
Variable cost of making 20 36 24
Variable cost of buying 29 40 34
Extra variable cost of buying 9 4 10
Machine hours saved by buying 3 hrs 2 hrs 4 hrs
Extra variable cost of buying per hour saved Tk. 3 Tk. 2 Tk. 2.5
 This analysis shows that it is cheaper to buy A than to buy T and it is most expensive to buy
S.
 The priority for making the components in-house will be in the reverse order: S, then T, then
A.
 There are enough machine hours to make all 4,000 units of S (12,000 hours) and to produce
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The cost-minimising and so profit-maximising make and buy schedule is as
follows.

Machine hours Unit variable Total variable

Component used/saved Number of units cost cost

Make: S 12,000 4,000 20 80,000

T 12,000 3,000 24 72,000
24,000 152,000

Buy: T 1,000 34 34,000

A 4,000 40 160,000
194,000

Total variable cost of components, excluding assembly costs 346,000