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# Break even example fred

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### Break even example fred

1. 1. Fred M’mbololo Page 1 AMF Cession 5- Suggested Answer A1. Fixed costs are the ones which are not affected by changes in the level of the business activities, over a defined period of time, whereas variables cost do change with the level of the business activities over time. A2: CVP formula Cost function = [(P-VC) Q-TFC] = IBT (Income before tax) Net Income = (Total Revenue-Total Cost)[1-t] Cost Function Net Income = (Total Revenue-Total Variable Costs-Total Fixed Costs)[1-t] Given that miscellaneous office costs are mixed costs then using the two-point method we can derive the cost function: We assume the cost function is y =a +bx Where a is the cost of 20X,1 which is 40,000, X2 represents Year 20X2 and X1 represents Year 20X1, b= Y2-Y1 =45,000-40,000 =5,000 =5000 X2-X1 =2-1 = 1 Therefore Y=40,000+5000X For Year 20X3, the miscellaneous cost will be 50,000. A3.Using the Profit function Net Profit = Total Revenue –Total Costs)[1-t], where t is the tax rate here given as 20% which is 0.2. Therefore for Year 20X2, we have calculated in the below workings and found out that Total cost is 2,003,000 now that the company must achieve a Net income after tax of 500,000, we simply substitute our figures to the above profit function for Year 20X2 500,000 = (Total Revenue-2,003,000) [1-0.2]
2. 2. Fred M’mbololo Page 2 =625,000 = (Total Revenue -2,003,000) Therefore Total Revenue = (2,003,000 +625,000) = 2,628,000 A3: Workings PAUKOVICH CONSULTING INCOME STATEMENTS 20x2 20x1 Revenues 2,500,000.00 2,000,000.00 less: Variable Costs; Consultants salaries (290,000.00) (270,000.00) Other General & Admin Salaries (135,000.00) (130,000.00) Payroll taxes (252,000.00) (231,000.00) Survey labour, Printing (900,000.00) (700,000.00) Miscellaneeus office costs (45,000.00) (1,622,000.00) (41,000.00) (1,372,000.00) Contribution Margin 878,000.00 628,000.00 Contribution Margin Ratio 0.35 0.31 Less: Fixed Costs; President's Salary (150,000.00) (150,000.00) Rent, heat & lights (51,000.00) (50,000.00) Sales Commission (180,000.00) (381,000.00) (200,000.00) (400,000.00) Income before tax (EBIT) 497,000.00 228,000.00 less Income tax expenses @20% (99,400.00) (45,800.00) Net Income after tax 397,600.00 182,200.00 Total Variable Costs 1,622,000.00 1,372,000.00 Total Fixed Costs 381,000.00 400,000.00 Total Costs 2,003,000.00 1,772,000.00 YEARS
3. 3. Fred M’mbololo Page 3 A4: Degree of Operating Leverage Managers decide how to structure the cost function for their organizations. Often, potential trade-offs are made between fixed and variable costs. For example, a company could purchase a vehicle (a fixed cost) or it could lease a vehicle under a contract that charges a rate per mile driven (a variable cost). One of the major disadvantages of fixed costs is that they may be difficult to reduce quickly if activity levels fail to meet expectations, thereby increasing the organization’s risk of incurring losses. The degree of operating leverage is the extent to which the cost function is made up of fixed costs. Organizations with high operating leverage incur more risk of loss when sales decline. Conversely, when operating leverage is high an increase in sales (once fixed costs are covered) contributes quickly to profit. The formula for operating leverage can be written in terms of either contribution margin or fixed costs, as shown here.7 _ _ _ Degree of operating leverage in terms of fixed costs_ _1 Managers use the degree of operating leverage to gauge the risk associated with their cost function and to explicitly calculate the sensitivity of profits to changes in sales (units or revenues):
4. 4. Fred M’mbololo Page 4 Substituting to the above equation for Year 20X2 is 878,000/497,000 =1.76. The greater the Degree of Operating Leverage ratio, the greater TFC and the greater operating risk (potential profit fluctuation). A5. Margin of Safety =Expected Sales – Break Even Sales. Break Even Sales is where (Total Sales-Variable costs –Fixed Costs) = Income before taxes. For Year 20X2 is Contribution Margin is 0.35, as Selling price is unknown, we assume S= Break Even Sales( by setting EBT =0) Therefore (S-0.65S-381,000) = 0 = 0.35S – 381,000 = 0, hence S =381,000/0.35 = 1,088,571 Therefore Margin of Safety = Actual Sales revenue for 20X2= {(2,500,000) -1,088,571} =1,411,429 . = 1,411,429/2,500,000 = 0.565. Margin of Safety: The Margin of Safety is the excess of projected (or actual ) sales over the break-even sales level. This tells managers the margin between current sales and the breakeven point. In a sense,
5. 5. Fred M’mbololo Page 5 margin of safety indicates the risk of losing money that a company faces, that is the amount by which sales can fall before the company is in the loss area. For example for Paukovich Consulting Company: Holding all other variables constant, if current sales for Year 20X2 is 2,500,000, dropped by 56.5%, the company’s profit would be reduced to zero (Break-even) It is often viewed as “cushion of loss”. The larger the ratio, the safer the situation is since there is less risk of reaching the break-even point.