Break-Even Point: Calculating Unit & Pound Contributions - Research Paper

Introduction

Total contribution=total sales-total variable costsTotal contribution=PS 1,575,000-PS (225,000+150,000)=PS 1,200,000contribution per unit=selling price per unit-variable cost per unitcontribution per unit=PS 1,575,0007,500-PS 375,0007500contribution per unit=PS 210-PS 50=PS 160This means that one unit of the product contributes PS160 to the company's profit or bottom line.

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Break-Even Point in Units and Pounds

Break-even in units=fixed costscontribution margin per unitBreak-even in units=PS 180,000PS 160=1,125 unitsBreak-even in pounds=sales price per unit*break-even point in unitsBreak-even in pounds=PS 210*1,125= PS 236,250The results indicate that the company needs to produce 1,125 units which equate to 236,250 to generate enough revenues that would be able to meet the fixed costs.

Margin of Safety in Units and Percentage of Sales

Margin of safety in units=current sales level-break-even pointMargin of safety in units=7,500-1,125=6,375 units Margin of safety in percentage of sales=Margin of safety in unitscurrent sales level*100%Margin of safety in percentage of sales=6,3757,500*100%=85%This indicate the total number of sales above the break-even point. The results indicate that the company has to lose 1,125 units or 85% of its sales to lose money.

The Number of Units to Make PS235,000 Profit

Number of units=desired profitscontribution margin per unit+break-even unitsNumber of units=PS 235,000PS 160+1,125=2,593.75 unitsThe company has to produce 1,468 units more than the break-even units (2,594 units) to make a profit of 235,000.

Profit for 8,500 Units

Total contribution=contribution per unit*number of units soldTotal contribution=PS 160*8,500=PS 1,360,000Net operating profit=contribution margin-fixed costsNet operating profit=PS 1,360,000-PS 180,000=PS 1,180,000Producing 8,500 units would result in an increase in the net operating profit from PS1,020,000 to PS1,180,000.

Payback Period

Project A

• Year Outstanding cash flow (PS000)
• 1 360-180=180
• 2 180-120=60
• 3 60/80=3/4*12=9 months
• The payback period is 2 years 9 months

Project B

• Year Outstanding cash flow (PS000)
• 1 380-200=180
• 2 180-140=40
• 3 40/60=2/3*12=8 months
• The payback period is 2 years 8 months

With reference to the payback period, project B would be preferable because of its shorter payback period. This means a shorter period for the company to recoup its initial investment.

Net Present Value

NPV=n=1n-1CFn(1+i)n-CF0Project A

NPV=PS180,0001.081+PS120,0001.082+PS80,0001.083+PS40,0001.084-PS360, 000NPV=166.67+102.88+63.49+29.41-360NPV=PS362,450-PS360,000=PS2,450Project B

NPV=PS200,0001.081+PS140,0001.082+PS60,0001.083+PS40,0001.084-PS380,000NPV=185.19+120.03+47.62+29.41-380NPV=PS382,250-PS380,000=PS2,250With reference to the net present value, project A would be preferable since it has a higher net present value.

Advantages and Disadvantages of Investment Appraisal Methods

Payback Period

Advantages

• The payback period is simple to compute as it doesn't require any technical knowledge or mathematical know-how.
• It provides an easy way to compare several projects and easily select the one with the shortest payback period ("Woodruff, 2019).

Disadvantages

• The method ignores the time value of money, i.e., the value of money remains constant throughout the project's lifetime.
• It neglects the cash flows received after the payback period, i.e., some projects may present the largest cash flows after the payback period.
• It ignores the profitability of the project, i.e., just because a project has a short payback period doesn't mean it is profitable (Woodruff, 2019).
• It does not consider the return on investment of a project.

Net Present Value

Advantages

• The method considers the time value of money. i.e., the cash flows in every period are discounted by a cost of capital.
• It indicates whether and by how much an investment will create value for the company or investors.
• The method also considers the cost of capital and the inherent risks in making future projections, i.e., those projections further into the future have a less impact on the net present value compared to the more predictable cash flows that occur during the earlier periods ("Motley fool", 2019).

Disadvantages

• The method requires some guesswork concerning the company's cost of capital.
• It is also not useful for comparing two projects that are of different sizes, i.e., a project with a higher capital investment is likely to have a higher initial investment ($1 million) is likely to provide higher returns compared to a project with low initial capital ($ 1,000) ("Motley fool", 2019).

The Practice of Working Capital Management

Working capital management is a strategy that is designed to monitor and utilize the two components of working capital, ie., current assets and current liabilities. This is performed to ensure that the company's operations are financially efficient. The primary purpose of this process is to ensure that the company always maintains a sufficient flow of cash to meet its short-term operating costs and debt obligations (Kenton, 2018). Management of working capital entails monitoring of a company's assets, cash flows, and liabilities via ratio analysis of the vital elements of operating expenses. This includes the collection ratios, capital ratio, and the inventory turnover ratio.

Proper working capital management maintains smooth operation of the operating cycle (reflects the minimum time required to convert net current assets and liabilities to cash) and helps to improve the firm's profitability and earnings. Working capital management includes management of inventory, accounts payables and accounts receivables. The main objectives of the process are to maintain the working capital operating cycle and ensuring that its operation is ordered, minimizing the cost of capital spent while maximizing the return on current asset investments (Kenton, 2018).

The major elements of working capital management include the working capital ratio, collection ratio, and inventory management. The working capital ratio (obtained by diving the current assets by the current liabilities) indicates the financial health of the company, i.e., its ability to meet its short-term financial obligations. A ratio of less than 1.0 indicates a troubled company in meeting its short-term obligations while a value of more than 1.0 is desirable (Kenton, 2018). However, a value of more than 2.0 indicates underutilization of its assets to increase revenues.

A collection ratio indicates how effectively a company manages its accounts receivables. It indicates the average number of days that a company takes to receive a payment for delivered goods or services provided. Inventory management entails maintaining a comfortably high level of working capital while establishing a sufficient inventory on hand to meet its customer requirements.

Importance of Working Capital Management

Working capital is a vital component of a business that provides the following merits:

• It provides a higher return on capital. Companies with lower working capital record higher return on capital. As a result, shareholders often benefit by obtaining a higher return on every dollar invested in the business.
• It improves a company's solvency and credit profile. The ability of a company to meet its short-term obligation helps to maintain long-term solvency. Adequate working capital management enables a business to pay its short-term obligations on time which may include the purchase of raw materials, payment of salaries and operational expenses which lower its credit risk (Howley, 2018).
• It increases the organization's liquidity. A company that manages a large amount of cash tied on its working capital could benefit from additional liquidity and reduced dependence on external financing. This may be vital for smaller businesses as they have limited access to external sources of funds.
• It increases business value. Companies with a more effective working capital management generate more free cash flows that result in a higher valuation of the business and enterprise.
• It ensures an uninterrupted production process. A company that pays its suppliers on time gains by a regular flow of raw materials which ensures that the production process remains uninterrupted while producing quality products and the clients receive their products on time.
• It provides firms with a competitive advantage. Companies with an efficient supply chain process are able to sell their products at a discounted rate compared to similar companies with inadequate sourcing. Efficient working capital would, therefore, enable a firm to survive in the event of a crisis or in the event of a ramp-up of its production (Howley, 2018).

Incremental Budgeting

Incremental budgeting is a vital part of managerial accounting that bases on the concept of making a small adjustment to an existing budget to arrive at a new budget. In this case, only incremental amounts are added to achieve the new budgeted amounts. The current fiscal year's budget acts as the base for working on the next year's budgetary allocation (Ouassini, 2018). On a business operational concept, the management has an assumption that all the departments will continue to operate at their current level of expenditure and any additional amount would be added to arrive at the next year's budget estimates.

I believe that incremental budgeting is the most appropriate method of applying budgets due to the following reasons:

• It is simple to present or establish. This type of budgeting is very simple to establish and understand. In comparison to the other methods of budgeting in business, it is one of the easiest to present in a practical aspect. In such a case, one does not require any technical skills, knowledge in accountancy or have any prior experience in business to use this form of budgeting. It is easy to implement and does not involve any complex calculations. This makes it possible to be achieved by various departments without many concerns as one does not require any detailed analysis irrespective of the department under consideration.
• It involves a gradual change in the previous budget. With this type of budgeting, one will have a very stable budget from one period to the next which enables a gradual change within the company (Ouassini, 2018). A lot of managers get intimidated by large increments in the budget while transiting from one period to the next. This form of budgeting would therefore not result in problems since it is just a mere adjustment of the previous budget.
• It is a very flexible type of budgeting that can easily be done from one month to another. This enables changes to be spotted easily and transitions to be observed. The effects of implementing any new policies or budget adjustments can also be easily identified.
• It helps to avoid conflicts among departments within the company. Organizations with many departments often run into conflicts between the departments because of the varied budgets. This method of budgeting, therefore, makes it easier and possible to keep everyone and every department in an organization within the same page to avoid any conflict arguments. It is used by many organizations to eliminate rivalry and build a value of equality among departments since all the departments are provided with a similar amount of adjustment from the previous financial year (Ouassini, 2018). The management would also assume that each department will continue to operate at or near their current level of expenditures with a slight addition or deduction to arrive next year's budget estimates.

While these may come as benefits of incremental budgeting, it also comes along with various limitations that include settling for non-innovative and conservative mindsets and ignorance on changes in efficiency and productivity of workers a...