Revision point: Fixed costs are those that do not change with changes in production levels, e.g. rent.

SECTION ONE BREAK-EVEN ANALYSIS Break-even point What is meant by the term break even? A firm breaks even when income is sufficiently high to exactly cover total costs therefore neither a profit nor a loss is made. However, break-even analysis is not usually applied to the whole firm but rather to a single product, studying its profitability by comparing its estimated revenue and costs. Break-even analysis does more than just estimate the break-even point (BEP): it also shows how much profit or loss should be made at various levels of activity. It is therefore seen as a valuable tool for the management accountant. To use break-even analysis several assumptions must be made: there is only one product all costs can be classified as either fixed or variable costs remain constant over the whole range of output selling price remains constant for the whole range of output production is equal to sales so there is no adjustment for stock figures there are no changes in materials, labour, design or manufacturing methods. Revision point: Fixed costs are those that do not change with changes in production levels, e.g. rent. Variable costs vary in proportion to changes in production levels, e.g. raw materials. A simple table can be drawn up to show: increasing levels of activity estimated costs of production at these levels estimated revenue at these levels the resulting profit/loss for each level. ACCOUNTING AND FINANCE 1

BREAK-EVEN ANALYSIS Example 1 The following figures have been supplied by A Gardiner, who is considering making plant pots. He is particularly concerned to know how many he must make before the product becomes profitable. Total fixed costs 1,000 Variable costs per unit 3 Selling price per unit 8 We can draw up a table to show the information. Units of Fixed Variable Total Sales Profit output costs costs costs revenue (loss) 0 1,000 1,000 (1,000) 100 1,000 300 1,300 800 (500) 200 1,000 600 1,600 1,600 300 1,000 900 1,900 2,400 500 400 1,000 1,200 2,200 3,200 1,000 500 1,000 1,500 2,500 4,000 1,500 At an output of 200 units, where both sales revenue and total costs amount to 1,600, he is making neither a profit nor a loss on the plant pots. < Any output below 200 units will result in a loss. Any output above 200 units will result in a profit. Break-even point is therefore at a sales volume of 200 units and a sales revenue of 1,600. 2 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Profit/loss Profit/loss (the difference between sales revenue and total costs) at various output levels is shown in the final column of the table on p. 2. At 100 units of output the loss is ( 500) and at 400 units of output a profit of 1,000 is made. Break-even analysis is thus useful in forecasting profit/loss figures for different production levels. Margin of safety Output above BEP which gives a profit is the margin of safety. This margin can be measured by comparing the level of output with BEP and it can be expressed in units or in sales revenue. Units of BEP Margin of safety Selling price Margin of safety output (units) (units) per unit (sales revenue) 300 200 100 8 800 400 200 200 8 1,600 500 200 300 8 2,400 The margin of safety in sales revenue can also be calculated by comparing the sales revenue for the output level with the sales revenue at BEP. Sales BEP Margin of safety revenue (sales revenue) 2,400 1,600 800 Formulae: 3,200 1,600 1,600 4,000 1,600 2,400 Margin of safety (units) = actual units BEP units Margin of safety (revenue) = actual revenue BEP revenue or actual units BEP units x selling price per unit ACCOUNTING AND FINANCE 3

BREAK-EVEN ANALYSIS Task 1 Use the following information supplied by Julie Carter to complete the table and answer the questions that follow. Total fixed costs 12,000 Variable costs per unit: materials 7 wages 5 12 Selling price per unit 20 Units of Fixed Variable Total Sales Profit output costs costs costs revenue (loss) 0 500 1,000 1,500 2,000 2,500 3,000 (a) (b) (c) What is the break-even point in units and sales revenue? What is the margin of safety (in units and sales revenue) at an output of 2,000 units? How much is the profit when 3,000 units are produced? 4 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Task 2 Julie is considering reducing the selling price to 18 per unit although the costs would remain unchanged. Draw up another table to show the effect of this change on the figures then answer the following questions. (a) (b) (c) What is the break-even point in units and sales revenue? What is the margin of safety (in units and sales revenue) at an output of 2,500 units? How much is the profit at an output of 2,500 units? ACCOUNTING AND FINANCE 5

BREAK-EVEN ANALYSIS Suggested solution to Task 1 Units of Fixed Variable Total Sales Profit output costs costs costs revenue (loss) 0 12,000 12,000 (12,000) 500 12,000 6,000 18,000 10,000 (8,000) 1,000 12,000 12,000 24,000 20,000 (4,000) 1,500 12,000 18,000 30,000 30,000 2,000 12,000 24,000 36,000 40,000 4,000 2,500 12,000 30,000 42,000 50,000 8,000 3,000 12,000 36,000 48,000 60,000 12,000 (a) Break-even point = 1,500 units or 30,000 sales revenue. (b) Margin of safety at 2,000 units = 2,000 1,500 = 500 units 500 units x 20 = 10,000 sales revenue (c) Profit at 3,000 units = 12,000 Suggested solution to Task 2 Units of Fixed Variable Total Sales Profit output costs costs costs revenue (loss) 0 12,000 12,000 (12,000) 500 12,000 6,000 18,000 9,000 (9,000) 1,000 12,000 12,000 24,000 18,000 (6,000) 1,500 12,000 18,000 30,000 27,000 (3,000) 2,000 12,000 24,000 36,000 36,000 2,500 12,000 30,000 42,000 45,000 3,000 3,000 12,000 36,000 48,000 54,000 6,000 (a) Break-even point = 2,000 units or 36,000 sales revenue (b) Margin of safety = 2,500 2,000 units = 500 units 500 units x 20 = 10,000 sales revenue (c) Profit at 2,500 units = 3,000 6 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Break-even charts A chart is a simple method of conveying information, particularly where there are many figures to be read. A line chart is considered the most suitable way of showing the data in the previous tables. A break-even chart displays the following details: fixed costs shown as a horizontal line total costs (fixed + variable costs) shown as a straight line sloping upwards from the start of the fixed costs line revenue (sales) an upward sloping line starting from the origin (indicated by 0) of the graph where no output results in no revenue. It has been constructed from the table on page 2, and shows fixed costs, total costs, revenue lines and the BEP. Break-even chart S a l e s 4,000 3,000 a n d c o s t s 2,000 1,000 BEP 0 0 100 200 300 400 500 Output (units) Fixed costs Total costs Sales revenue Break-even point is where the sales revenue and total costs lines cross. The area of profit/loss at any level of output can be measured between the sales revenue and total costs lines: the area of profit, known as the margin of safety, is to the right of breakeven point the area of loss is to the left of break-even point. ACCOUNTING AND FINANCE 7

BREAK-EVEN ANALYSIS Constructing a break-even chart Before a break-even chart is produced, the following points should be considered: the level of activity is always shown on the horizontal axis and it must allow for all levels of production to be shown sales revenue and costs (in ) are shown on the vertical axis: the scale chosen should allow for the highest possible figure (usually the highest sales figure) the chart must have a title the axes (vertical and horizontal) must be clearly labelled a key must be shown to identify each line (or the lines can be labelled) the sales revenue line will always begin at the origin of the graph (no sales = no revenue) the fixed costs line is horizontal (fixed costs do not change with changes in production levels) the total costs line starts at the same point as the fixed costs line the break-even point must be clearly labelled. Task 3 (a) Using graph paper, draw a break-even chart to illustrate the figures in the table for Task 1 (p. 4). Label clearly the fixed costs, total costs and revenue lines and the break-even point. (b) On the same chart, add the new sales revenue line for the figures in Task 2 (p. 5), showing the new break-even point. 8 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Suggested solution to Task 3(a) 60,000 Break-even chart S a l e s a n d c o s t s 50,000 40,000 30,000 20,000 10,000 BEP 0 0 500 1,000 1,500 2,000 2,500 3,000 Output (units) Fixed costs Total costs Sales revenue Suggested solution to Task 3(b) 60,000 Break-even chart S a l e s a n d c o s t s 50,000 40,000 30,000 20,000 10,000 BEP 1 BEP 2 0 0 500 1,000 1,500 2,000 2,500 Output (units) Fixed costs Total costs Sales revenue 3,000 Sales revenue (b) ACCOUNTING AND FINANCE 9

BREAK-EVEN ANALYSIS Break-even charts: exercises Exercise 1 (a) Using the data given below prepare a break-even chart to show fixed costs, total costs, sales and break-even point. Data Total fixed costs 4,000 Variable costs per unit 15 Selling price per unit 25 Projected output levels 100 700 units (b) From your chart find the break-even point in (i) units of output (ii) sales value. (c) Find the profit at output levels of 500 and 700 units. Exercise 2 (a) Using the data given below prepare a break-even chart to show fixed costs, total costs, sales and break-even point. Data Total fixed costs 48,000 Variable costs per unit 12 Selling price per unit 24 Projected output levels 1,000 7,000 units (b) From your chart find the break-even point in (i) units of output (ii) sales value (c) Find the profit at outputs of 5,000 and 7,000 units. 10 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 3 (a) Prepare a break-even chart to show fixed costs, total costs and sales revenue lines. Indicate the break-even point. Data Variable costs per unit: materials 10 labour 15 Selling price per unit 40 Total fixed costs 60,000 Projected output levels 1,000 8,000 units (b) From your chart find the break-even point in (i) units of output (ii) sales value (c) (d) (e) Find the profit expected at outputs of 6,000 and 8,000 units. Management are considering increasing the selling price to 45 per unit. Add this new sales line to your chart and show the new break-even point. State the new break-even point in (i) units of output (ii) sales value (f) Find the new profit expected at outputs of 4,000 and 6,000 units. ACCOUNTING AND FINANCE 11

BREAK-EVEN ANALYSIS Exercise 4 (a) Using the following information prepare a break-even chart, labelling break-even point. Data Projected output levels 1,000 7,000 units Total fixed costs 40,000 Variable costs per unit: materials 12 wages 10 Selling price per unit 30 (b) From your chart find the break-even point in (i) units of output (ii) sales value (c) (d) (e) Find the profit expected at outputs of 6,000 and 7,000 units. It may be possible to reduce the cost of materials to 10 per unit. Add the new total costs line to your chart and show the new break-even point. State the new break-even point in (i) units of output (ii) sales value (f) Find the new profit expected at outputs 5,000 and 7,000 units. 12 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 5 Study the break-even chart below and answer the questions that follow. S a l e s a n d c o s t s 14,000 12,000 BEP 8,000 6,000 4,000 2,000 0 0 100 200 300 400 500 600 Output (units) Fixed costs Total costs Sales revenue 10,000 Break-even chart 700 (a) (b) How much are the fixed costs? What is the total variable cost of making 100 units? (c) What is the total cost of producing (i) 100 units (ii) 300 units? (d) What revenue is received from (i) 200 units (ii) 500 units? (e) Give the break-even point in units of output and in sales revenue. (f) Find the profit made at the following levels of output: 500 units, 600 units and 700 units. ACCOUNTING AND FINANCE 13

BREAK-EVEN ANALYSIS Exercise 6 Study the break-even chart below and answer the questions that follow. S a l e s a n d c o s t s 25,000 20,000 15,000 10,000 5,000 Break-even chart 0 0 100 200 300 400 500 Output (units) Fixed costs Total costs BEP 600 Sales revenue 700 800 (a) (b) How much are the fixed costs? What is the total variable cost of making 300 units? (c) What is the total cost of producing (i) 300 units (ii) 600 units? (d) What revenue is received from (i) 300 units (ii) 600 units? (e) Give the break-even point in units of output and in sales revenue. (f) Find the profit made at the following levels of output: 700 units and 800 units. 14 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Break-even charts: suggested solutions to exercises Exercise 1 (a) S a l e s a n d c o s t s (b) Break-even point = 400 units; 10,000 (c) Profit at 500 units = 1,000 Profit at 700 units = 3,000 Exercise 2 (a) S a l e s a n d c o s t s 18,000 16,000 14,000 12,000 10,000 Fixed costs Total costs (b) Break-even point = 4,000 units; 96,000 (c) Profit at 5,000 units = 12,000 Profit at 7,000 units = 36,000 Break-even chart BEP 8,000 6,000 4,000 2,000 0 0 100 200 300 400 500 180,000 160,000 140,000 Fixed costs Output (units) Break-even chart 120,000 BEP 100,000 80,000 60,000 40,000 20,000 0 0 1,000 2,000 3,000 4,000 5,000 Sales revenue Sales revenue 600 700 Output (units) Total costs 6,000 7,000 ACCOUNTING AND FINANCE 15

BREAK-EVEN ANALYSIS Exercise 3 (a) S a l e s a n d c o s t s (b) Break-even point = 4,000 units; 160,000 (c) Profit at 6,000 units = 30,000 Profit at 8,000 units = 60,000 (d) S a l e s a n d c o s t s 400,000 300,000 200,000 100,000 400,000 300,000 200,000 100,000 Fixed costs Total costs Fixed costs Total costs (e) Break-even point = 3,000 units; 120,000 (f) Profit at 4,000 units = 20,000 Profit at 6,000 units = 60,000 Break-even chart BEP 0 0 1,000 2,000 3,000 4,000 5,000 Output (units) Break-even chart Output (units) Sales BEP 0 0 1,000 2,000 3,000 4,000 5,000 Sales 6,000 6,000 7,000 7,000 Sales 2 8,000 8,000 16 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 4 (a) S a l e s a n d c o s t s Fixed costs Total costs (b) Break-even point = 5,000 units; 150,000 (c) Profit at 6,000 units = 8,000 Profit at 7,000 units = 16,000 (d) S a l e s a n d c o s t s 250,000 200,000 150,000 100,000 50,000 250,000 200,000 150,000 100,000 0 0 1,000 2,000 3,000 4,000 5,000 50,000 Fixed costs (e) New break-even point = 4,000 units; 120,000 (f) Profit at 5,000 units = 10,000 Profit at 7,000 units = 30,000 Break-even chart BEP Output (units) Break-even chart 0 0 1,000 2,000 3,000 4,000 5,000 Sales 6,000 BEP Output (units) Total costs 6,000 Total costs 2 7,000 7,000 Sales ACCOUNTING AND FINANCE 17

BREAK-EVEN ANALYSIS Exercise 5 (a) Total fixed costs = 4,000 (b) Variable cost of 100 units = 1,000 (c) Total cost of 100 units = 5,000 Total cost of 300 units = 7,000 (d) Revenue from 200 units = 3,600 Revenue from 500 units = 9,000 (e) Break-even point = 500 units; 9,000 (f) Profit at 500 units = 0 Profit at 600 units = 800 Profit at 700 units = 1,600 Exercise 6 (a) Total fixed costs = 6,000 (b) Variable cost of 300 units = 6,000 (c) Total cost of 300 units = 12,000 Total cost of 600 units = 18,000 (d) Revenue from 300 units = 9,000 Revenue from 600 units = 18,000 (e) Break-even point = 600 units; 18,000 (f) Profit at 700 units = 1,000 Profit at 800 units = 2,000 18 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Contribution in break-even analysis calculation of BEP Although break-even charts are easily produced and interpreted, it is not necessary to have a chart to find the profitability of a product at different output levels. This can be done by simple calculation. The word contribute is familiar in its usual meaning of give or donate. In break-even analysis the word contribution is used for the amount which the sale of each unit gives towards meeting the fixed costs. In other words, the amount left over after meeting the variable costs can be put towards the fixed costs. Once the fixed costs have been covered, that contribution becomes profit. Example Lightwell makes lamps and is investigating the profitability of producing a new design. The following figures are available. Estimated variable cost per lamp 40 Selling price per lamp 60 Total fixed costs 4,000 (a) How much is the contribution per lamp? Contribution per lamp = selling price variable costs = 60 40 = 20 (b) If each lamp can contribute 20 towards meeting the fixed costs, how many lamps need to be sold in order to break even? Break-even point (BEP) = fixed costs unit contribution = 4,000 20 = 200 lamps (c) What is the sales revenue of these lamps? BEP in sales revenue = selling price x number of lamps = 60 x 200 lamps = 12,000 ACCOUNTING AND FINANCE 19

BREAK-EVEN ANALYSIS Check: Sales revenue of 200 units = 60 x 200 = 12,000 Less variable cost of 200 units = 40 x 200 = 8,000 Total contribution from 200 units = 12,000 8,000 = 4,000 Fixed costs = 4,000 At break-even point, total contribution equals total fixed costs. Formulae: BEP (units) = fixed costs/unit contribution BEP (revenue) = fixed costs/unit contribution x selling price per unit 20 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Task 4 Complete the figures in the following table. Firm Selling price Variable cost Contribution Fixed BEP BEP per unit per unit per unit costs (units) (revenue) a 30 15 15,000 b 5 3 5,000 c 8 7 4,000 d 140 90 50,000 e 380 260 240,000 ACCOUNTING AND FINANCE 21

BREAK-EVEN ANALYSIS Suggested solution to Task 4 Firm Selling price Variable cost Contribution Fixed BEP BEP per unit per unit per unit costs (units) (revenue) a 30 15 15 15,000 1,000 30,000 b 5 3 2 5,000 2,500 12,500 c 8 7 1 4,000 4,000 32,000 d 140 90 50 50,000 1,000 140,000 e 380 260 80 240,000 3,000 1,140,000 22 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Contribution in break-even analysis calculation of profit Break-even analysis can be used to estimate profit or loss at various levels of output. On a break-even chart, the margin of safety is the area to the right of break-even point where output is greater than break-even point and a profit is shown. The margin of safety is the excess of sales over break-even point and can be expressed in sales volume (units) and sales revenue ( ). At break-even point fixed costs have been covered therefore in the margin of safety contribution becomes profit. The calculation of profit is therefore very simple. In the Lightwell example on p. 19, break-even point is 200 units therefore all output above 200 units results in profit. The table below shows how much profit will be made at output levels of 250, 320, 400, 480 and 500 units. Output BEP Margin Contribution Profit level (units) of safety per unit (units) (units) 250 200 50 20 1,000 320 200 120 20 2,400 400 200 200 20 4,000 480 200 280 20 5,600 550 200 350 20 7,000 Check: Output Unit Total Fixed Profit level contribution contribution costs (units) 250 20 5,000 4,000 1,000 320 20 6,400 4,000 2,400 400 20 8,000 4,000 4,000 480 20 9,600 4,000 5,600 550 20 11,000 4,000 7,000 ACCOUNTING AND FINANCE 23

BREAK-EVEN ANALYSIS Contribution in break-even analysis calculation of required output As well as being used to forecast profit or loss at different levels of output, breakeven analysis is also useful in calculating the output required to give a certain amount of profit. After break-even point, contribution becomes profit therefore: total contribution required = fixed costs + desired profit. Example M Morrison has provided the following information: Selling price per unit 30 Variable costs per unit 20 Contribution per unit 10 Total fixed costs 2,000 (a) What is the total contribution required to give a profit of 1,000? (b) Total contribution required = fixed costs + profit = 2,000 + 1,000 = 3,000 How many units will give this total contribution? Total contribution required = 3,000 Unit contribution = 10 Output required = 3,000 10 = 300 units 24 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Check: Break-even point = 2,000 10 = 200 units Profit required = 1,000 Unit contribution = 10 Number of profitable units = = 1,000 10 100 units Total output required = break-even point + profitable units = 200 + 100 units = 300 units ACCOUNTING AND FINANCE 25

BREAK-EVEN ANALYSIS Task 5 Complete the figures in the following table using the information in the example on p. 24. Profit Fixed Total Unit Required required costs contribution contribution output (units) 1,000 2,000 3,000 10 300 1,800 2,000 10 2,300 10 3,000 3,500 Check: Required Unit Profitable Break-even Required profit contribution output point output (units) (units) (units) 1,000 10 100 200 300 1,800 10 180 200 2,300 10 200 3,000 3,500 26 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Suggested solution to Task 5 Profit Fixed Total Unit Required required costs contribution contribution output (units) 1,000 2,000 3,000 10 300 1,800 2,000 3,800 10 380 2,300 2,000 4,300 10 430 3,000 2,000 5,000 10 500 3,500 2,000 5,500 10 550 Check: Required Unit Profitable Break-even Required profit contribution output point output (units) (units) (units) 1,000 10 100 200 300 1,800 10 180 200 380 2,300 10 230 200 430 3,000 10 300 200 500 3,500 10 350 200 550 ACCOUNTING AND FINANCE 27

BREAK-EVEN ANALYSIS Break-even analysis: theory questions Question 1 Break-even analysis is seen as a valuable tool for the management accountant. List 3 of its uses. Question 2 List 4 assumptions made in the use of break-even analysis. Question 3 Explain what is meant by the following terms used in break-even analysis: (a) unit contribution (b) margin of safety (c) break-even point (d) fixed and variable costs. Question 4 Describe how each of the following lines can be shown on a break-even chart: (a) fixed costs (b) total costs (c) sales. Question 5 After break-even point, contribution becomes profit. Explain what is meant by this statement. 28 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Break-even analysis: suggested solutions to theory questions Question 1 Three uses of break-even analysis are: 1 to calculate the break-even point in units of output and in sales revenue for a product 2 to estimate the profit/loss that will result from any given level of output 3 to find the level of output needed for a given profit figure. Question 2 Four assumptions made in the use of break-even analysis are: 1 all costs are either fixed or variable 2 the selling price remains unchanged for the entire range of output regardless of different markets and conditions 3 costs remain unchanged because there are no changes in materials, wages or methods 4 there is no adjustment for stock figures because production is equal to sales. Question 3 (a) (b) (c) (d) Unit contribution is the difference between the selling price and the variable costs of one unit. It is the amount the unit can give towards meeting the fixed costs and, after fixed costs are covered, towards profit. Margin of safety is the profitable output above break-even point and can be expressed in units or sales revenue. It is shown to the right of breakeven point on a break-even chart. Break-even point is the point at which fixed costs are covered and neither a profit nor a loss is made. Total contribution is equal to fixed costs and total revenue is equal to total costs. Fixed costs remain unchanged regardless of changes in the level of production. Variable costs vary in proportion to changes in production levels. ACCOUNTING AND FINANCE 29

BREAK-EVEN ANALYSIS Question 4 (a) (b) (c) The fixed costs line is horizontal because fixed costs remain constant at different output levels. The total costs line slopes upward to the right from the start of the fixed costs line. The sales line slopes upward to the right from the origin of the graph where no sales shows no revenue. Question 5 Contribution is the difference between selling price and variable costs and, in the first place, goes towards meeting fixed costs. Once fixed costs have been covered, i.e. at break-even point, any further contribution that arises from additional sales is profit as only the variable costs have to be met. 30 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Contribution in break-even analysis: exercises Exercise 1 Three firms have supplied the following information: A Anderson B Benson C Cameron Variable costs per unit 3.00 4.50 6.80 Selling price per unit 6.00 8.50 11.80 Fixed costs 4,500 6,400 17,500 (a) (b) (c) Calculate the contribution per unit for each firm. For each firm find the break-even point in units of output. For each firm find the sales revenue at break-even point. Exercise 2 A manufacturing firm expects to sell 8,000 units in the next year and has provided the following figures: Selling price per unit 40 Variable costs per unit 22 Total fixed costs 63,000 (a) (b) (c) (d) Calculate the contribution per unit. Find the break-even point in units of output. What is the sales revenue of these units? What is the margin of safety in (i) units (ii) sales revenue ( )? ACCOUNTING AND FINANCE 31

BREAK-EVEN ANALYSIS Exercise 3 Alert plc installs burglar alarm systems and expects to install 400 units of System A in the next year. Costs are estimated as follows: Total fixed costs 81,400 Selling price per unit 850 Variable costs per unit 480 (a) (b) (c) (d) Calculate the contribution per unit. Find the break-even point in units. Find the sales revenue of these units. What is the margin of safety in (i) units (ii) sales revenue ( )? Exercise 4 The following data has been supplied by D Denver, who is considering manufacturing a new style of shirt: Selling price per unit 21.00 Variable costs per unit: materials 6.50 wages 4.50 Total fixed costs 33,000 (a) (b) (c) (d) (e) (f) Calculate the contribution per shirt. Find the break-even point in units of output. What is the sales revenue of these units? What is the new contribution per shirt if they could be sold at 22 each? Calculate the new break-even point in units at the increased selling price. What is the sales revenue of these units? 32 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 5 Novelties plc assembles novel clocks and and has estimated the following figures for a new style: Selling price per unit 34 Variable costs per unit: component parts 12 wages 6 Total fixed costs 8,960 (a) (b) (c) (d) (e) Calculate the contribution per clock. Find the break-even point in units of output. Find the sales revenue of these units. If the cost of the component parts is increased to 14, what is the new contribution per unit? Find the new break-even point in units and in sales revenue. Exercise 6 Downies plc makes quilts and has budgeted the following figures for an output of 20,000 units: Total fixed costs 198,400 Selling price per unit 85 Variable costs per unit 54 (a) (b) (c) (d) Calculate the contribution per quilt. Find the break-even point in (i) units and (ii) sales revenue. What is the margin of safety in (i) units and (ii) sales revenue? If fixed costs were decreased to 179,800 what would be the new breakeven point in (i) units and (ii) sales revenue? ACCOUNTING AND FINANCE 33

BREAK-EVEN ANALYSIS Exercise 7 J Jones has supplied the following figures: Variable costs per unit: materials 36 wages 15 expenses 3 Selling price per unit 78 Total fixed costs 60,000 (a) (b) (c) (d) How much is the contribution per unit? Find the break-even point in units. What would be the sales revenue of these units? Calculate the profit at output levels of 3,000 and 4,000 units. Exercise 8 Outdoor Relaxing plc produces loungers and hopes to sell 1,000 in the coming year. The following figures are forecast: Selling price per unit 52 Variable costs per unit 28 Total fixed costs 13,920 (a) (b) (c) Calculate the contribution per unit. Find the break-even point in (i) units and (ii) sales revenue. Calculate the profit at output levels of 640 and 720 units. 34 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 9 Deeside Woodworkers produces clocks and the following figures are available: Selling price per unit 80 Variable costs per unit 55 Total fixed costs 12,000 (a) (b) Calculate the contribution per clock. Find the break-even point in units and in sales revenue. (c) Calculate the profit achieved at the following output levels: 500 and 600 units. (d) (e) If the selling price is increased to 85 while costs remain the same, what is the new contribution per clock? Find the new break-even point in units and in sales revenue. Exercise 10 A leather company produces briefcases and has provided the following data: Total fixed costs 19,800 Variable costs per unit: materials 30 fastenings and locks 12 wages 25 Selling price per unit 139 You are required to find the following: (a) (b) (c) contribution per unit break-even point in units and in sales revenue profit at output levels of 300 and 400 units (d) the output level required to give a profit of 7,920. ACCOUNTING AND FINANCE 35

BREAK-EVEN ANALYSIS Exercise 11 The following figures relate to ornamental trees supplied by nurserymen J & M Dawson, who have fixed costs of 6,480: Selling price per tree 36 Variable costs per tree 20 (a) (b) (c) (d) Find the contribution per unit. Find the break-even point in units and in sales revenue. How many trees would need to be sold in order to achieve the following profit levels: 1,360 and 5,040? How much is the profit at output levels of 450 and 580 units? Exercise 12 Soundsleep plc produces beds which sell at 580 each. The following details of costs have been supplied: Variable costs per unit: materials 80 component parts 120 wages 100 Total fixed costs 686,000 (a) (b) (c) (d) Find the contribution per unit. Find the break-even point in units and in sales revenue. How many beds would need to be sold in order to achieve the following profit levels: 16,800 and 64,400? How much is the profit at output of 5,000 units? 36 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Contribution in break-even analysis: suggested solutions to exercises Exercise 1 A Anderson B Benson C Cameron (a) Selling price per unit 6.00 8.50 11.80 Variable costs per unit 3.00 4.50 6.80 Contribution per unit 3.00 4.00 5.00 (b) BEP = fixed costs unit contribution 4,500 3 6,400 4 17,500 5 = 1,500 = 1,600 = 3,500 units units units (c) Sales revenue 1,500 x 6 1,600 x 8.50 3,500 x 11.80 = 9,000 = 13,600 = 41,300 Exercise 2 (a) Contribution per unit = selling price variable costs = 40 22 = 18 fixed costs (b) Break-even point = unit contribution = 63,000 18 = 3,500 units (c) Sales revenue = 40 x 3,500 units = 140,000 (d) Margin of safety (i) = sales break-even point = 8,000 3,500 units = 4,500 units (ii) = 40 x 4,500 units = 180,000 ACCOUNTING AND FINANCE 37

BREAK-EVEN ANALYSIS Exercise 3 (a) Contribution per unit = selling price variable costs = 850 480 = 370 (b) Break-even point = = fixed costs unit contribution 81,400 370 = 220 units (c) Sales revenue = 850 x 220 units = 187,000 (d) Margin of safety (i) = sales break-even point = 400 220 units = 180 units (ii) = 850 x 180 units = 153,000 38 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 4 (a) Contribution per shirt = selling price variable costs = 21 11 = 10 fixed costs (b) Break-even point = unit contribution 33,000 = 10 = 3,300 units (c) Sales revenue = 21 x 3,300 units = 69,300 (d) Contribution per shirt = 22 11 = 11 (e) Break-even point 33,000 = 11 = 3,000 units (f) Sales revenue = 22 x 3,000 units = 66,000 ACCOUNTING AND FINANCE 39

BREAK-EVEN ANALYSIS Exercise 5 (a) Contribution per unit = selling price variable costs = 34 18 = 16 (b) Break-even point = fixed costs unit contribution = 8,960 16 = 560 units (c) Sales revenue = 34 x 560 units = 19,040 (d) New contribution = 34 20 = 14 (e) New break-even point = 8,960 14 = 640 units Sales revenue = 34 x 640 = 21,760 40 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 6 (a) Contribution per quilt = selling price variable costs = 85 54 = 31 (b) Break-even point (i) = = fixed costs unit contribution 198,400 31 = 6,400 units (ii) = 85 x 6,400 quilts = 544,000 (c) Margin of safety (i) = 20,000 6,400 units = 13,600 units (ii) = 85 x 13,600 units = 1,156,000 (d) New break-even point (i) 179,800 = 31 = 5,800 units (ii) = 85 x 5,800 = 493,000 ACCOUNTING AND FINANCE 41

BREAK-EVEN ANALYSIS Exercise 7 (a) Contribution per unit = selling price variable costs = 78 54 = 24 (b) Break-even point fixed costs = unit contribution = 60,000 24 = 2,500 units (c) Sales revenue = 78 x 2,500 units = 195,000 (d) Output BEP Margin of Profit level (units) safety (units) (units) 3,000 2,500 500 500 x 24 = 12,000 4,000 2,500 1,500 1,500 x 24 = 36,000 42 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 8 (a) Contribution per unit = selling price variable costs = 52 28 = 24 (b) Break-even point (i) = fixed costs unit contribution = 13,920 24 = 580 units (ii) = 52 x 580 units = 30,160 (c) Output BEP Margin of Profit level (units) safety (units) (units) 640 580 60 24 x 60 = 1,440 720 580 140 24 x 140 = 3,360 ACCOUNTING AND FINANCE 43

BREAK-EVEN ANALYSIS Exercise 9 (a) Contribution per clock = 80 55 = 25 (b) Break-even point = = = 480 clocks Sales revenue = 80 x 480 = 38,400 (c) Output BEP Margin of Profit level (units) safety (units) (units) 500 480 20 20 x 25 = 500 600 480 120 120 x 25 = 3,000 (d) New contribution = 85 55 = 30 (e) New break-even point = fixed costs unit contribution 12,000 25 12,000 30 = 400 units Sales revenue = 85 x 400 = 34,000 44 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 10 (a) Contribution per unit = selling price variable costs = 139 67 = 72 fixed costs (b) Break-even point = unit contribution 19,800 = 72 = 275 units Sales revenue = 139 x 275 units = 38,225 (c) Output BEP Margin of Profit level (units) safety (units) (units) 300 275 25 72 x 25 = 1,800 400 275 125 72 x 125 = 9,000 (d) Total contribution required = fixed costs + profit = 19,800 + 7,920 = 27,720 Unit contribution = 72 total contribution Output required = unit contribution = 27,720 72 = 385 units ACCOUNTING AND FINANCE 45

BREAK-EVEN ANALYSIS Exercise 11 (a) Contribution per unit = selling price variable costs = 36 20 = 16 (b) Break-even point fixed costs = unit contribution 6,480 = 16 = 405 units Sales revenue = 36 x 405 units = 14,580 (c) Fixed Profit Total Unit Output costs required contribution contribution required required 6,480 1,360 7,840 16 7,840 16 = 490 units 11,520 6,480 5,040 11,520 16 16 = 720 units (d) Output BEP Margin of Profit level (units) safety (units) (units) 450 405 45 16 x 45 = 720 580 405 175 16 x 175 = 2,800 46 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise 12 (a) Contribution per unit = selling price variable costs = 580 300 = 280 fixed costs (b) Break-even point = unit contribution 686,000 = 280 = 2,450 units Sales revenue = 580 x 2,450 units = 1,421,000 (c) Fixed Profit Total Unit Output costs required contribution contribution required required 686,000 16,800 702,800 280 702,800 = 2,510 units 280 750,400 686,000 64,400 750,400 280 = 2,680 units 280 (d) Output BEP Margin of Profit level (units) safety (units) (units) 5,000 2,450 550 280 x 550 = 154,000 ACCOUNTING AND FINANCE 47

BREAK-EVEN ANALYSIS Contribution in break-even analysis: extension exercises Exercise E1 Wondersew produces sewing machines that are sold at 1,200 each. The following costs are incurred. Fixed costs 157,500 Variable costs: materials 80 component parts 350 wages 140 You are required to calculate the following: (a) the contribution per sewing machine (b) the break-even point in units and sales revenue (c) the profit at output levels of 320 and 425 units (d) the output level required to give a profit of 75,600 (e) the new contribution per unit if the selling price is reduced to 1,095 (f) the break-even point at the new selling price (g) the new output level required to give the same profit of 75,600. Exercise E2 Scotstoun Display Stands estimates that it can sell 2,000 display stands at 200 each. The costs of production are shown below. Variable costs per unit: materials 80 labour 40 Total fixed costs 96,000 You are required to find: (a) the break-even point in units and in sales revenue (b) the profit at the following levels of production: 1,400 units and 2,000 units (c) the new break-even point if the selling price is increased by 10% (d) the new profit at output levels of 1,400 and 2,000 units. 48 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise E3 Stonehaven Clocks makes alarm clocks and has supplied the following figures. Output 6,000 clocks Total fixed costs 60,000 Selling price per clock 37 Variable costs per clock: materials 6 component parts 4 labour 12 You are required to calculate the following: (a) the break-even point in units and sales revenue (b) the present profit figure. Stonehaven Clocks is considering increasing output to 8,000 clocks and estimates that the cost of materials per unit will be reduced to 5. Calculate: (c) the new break-even point in units and sales revenue (d) the new profit figure. ACCOUNTING AND FINANCE 49

BREAK-EVEN ANALYSIS Contribution in break-even analysis: suggested solutions to extension exercises Exercise E1 (a) Contribution per unit = selling price variable costs = 1,200 570 = 630 fixed costs (b) Break-even point = unit contribution 157,500 = 630 = 250 units Sales value = 1,200 x 250 units = 300,000 (c) Output BEP Margin of Profit level (units) safety (units) (units) 320 250 70 630 x 70 = 44,100 425 250 175 630 x 175 = 110,250 (d) Total contribution required = fixed costs + required profit = 157,500 + 75,600 = 233,100 Unit contribution = 630 total contribution Output required = unit contribution 233,100 = 630 = 370 units (e) New contribution = 1,095 570 = 525 (f) New break-even point 157,500 = 525 = 300 units 50 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS (g) Total contribution required = 233,100 Unit contribution = 525 Output required 233,100 = 525 = 444 units ACCOUNTING AND FINANCE 51

BREAK-EVEN ANALYSIS Exercise E2 (a) Unit contribution = 200 120 = 80 fixed costs Break-even point = = unit contribution 96,000 80 = 1,200 units Sales revenue = 1,200 x 200 = 240,000 (b) Profit = (output BEP) x unit contribution Output 1,400 units 2,000 units 1,400 1,200 2,000 1,200 200 x 80 800 x 80 16,000 64,000 (c) New selling price = 220 New contribution = 220 120 = 100 New break-even point = 96,000 100 = 960 units New sales revenue = 960 x 220 = 211,200 (d) New profit Output 1,400 units 2,000 units 1,400 960 2,000 960 440 x 100 1,040 x 100 44,000 104,000 52 ACCOUNTING AND FINANCE

BREAK-EVEN ANALYSIS Exercise E3 (a) Unit contribution = 37 22 = 15 Break-even point = = fixed costs unit contribution 60,000 15 = 4,000 units Sales revenue = 4,000 x 37 = 148,000 (b) Profit = (6,000 BEP) x 15 = (6,000 4,000) x 15 = 2,000 x 15 = 30,000 (c) New variable costs = 21 New contribution = 37 21 = 16 60,000 New break-even point = 16 = 3,750 units Sales revenue = 3,750 x 37 = 138,750 (d) New profit = (8,000 BEP) x 16 = (8,000 3,750) x 16 = 4,250 x 16 = 68,000 ACCOUNTING AND FINANCE 53

54 ACCOUNTING AND FINANCE

Section Two Profit Maximisation Contents Profit maximisation - limiting factor, summary note, tasks, suggested solutions 57-64 Exercises 1-12 with suggested solutions 65-88 Extension exercises 1-3 with suggested solutions 89-94 ACCOUNTING AND FINANCE 55

56 ACCOUNTING AND FINANCE

SECTION TWO PROFIT MAXIMISATION Profit maximisation: limiting factor Most businesses are set up with a view to making a profit, preferably as high a profit as possible. Maximising profit simply means making as much profit as possible from the resources available. This is usually achieved by making as much as can be sold if demand for a product is limited there is no point in making more even though it may be possible to do so. Sometimes demand for a product may be high but production may be limited by factors such as: scarcity of materials scarcity of labour limited machine capacity limited number of machines limited space. These factors are called limiting factors (or key factors). If a limiting factor exists, management will have to decide which level of output will make most profit, taking into account the limiting factor. Instead of studying the contribution per unit, contribution must be considered in the light of the limiting factor. Example Two products, A and B, are being produced and details are as follows: A B Contribution per unit 12 12 Number of labour hours per unit 4 2 Number of units demanded 10,000 12,000 Total labour hours available 60,000 hours Total fixed costs 160,000 ACCOUNTING AND FINANCE 57

PROFIT MAXIMISATION If demand is to be satisfied the total number of labour hours required would be: Product A Product B 10,000 x 4 + 12,000 x 2 40,000 + 24,000 = 64,000 hours The number of labour hours required is 64,000 but only 60,000 labour hours are available. Since there is a shortage of 4,000 hours, labour is the limiting factor. How will this problem be solved? Should one or both products be cut back? B has a lower unit contribution than A so should only B be reduced? Before a decision is taken, the contribution per labour hour must be examined. A B Contribution per unit 12 12 Number of labour hours 4 2 Contribution per labour hour 3 6 Only now can the order of priority be decided. Since the product giving the highest contribution per labour hour is B, the full demand for B will be met and the production of A will be cut by 4,000 hours. Production will be planned thus: 1 Product B 24,000 hours/2 = 12,000 units 2 Product A 60,000 24,000 hours = 36,000 hours/4 = 9,000 units How much profit will be made? A B Total Number of labour hours 36,000 24,000 60,000 Contribution per labour hour 3 6 Total contribution 3 x 36,000 6 x 24,000 108,000 144,000 252,000 Less fixed costs 160,000 Profit (maximised) 92,000 58 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Task 6 Skye Weavers plc produces 2 items, rugs and scarves. Figures available are as follows: Total labour hours available 20,000 Total fixed costs 200,000 Product Rugs Scarves Selling price per unit 80 20 Variable costs per unit 40 8 Labour hours per unit 2 1 Number of units demanded 5,000 12,000 Use the accompanying worksheet to carry out the following tasks: (a) (b) (c) (d) (e) (f) (g) (h) Compare the hours available with the hours required to find the shortage of labour hours. What is the limiting factor for Skye Weavers plc? Calculate the contribution per labour hour for each product. Show the order of priority for production. Give a reason for your answer. Show how many labour hours would be used in the production of both rugs and scarves. Find the total contribution from rugs and scarves. Subtract the total fixed costs to find the profit from production. How many scarves and rugs would be made in the hours in (e)? ACCOUNTING AND FINANCE 59

PROFIT MAXIMISATION Task 6: worksheet Rugs Scarves Total (a) Units demanded 5,000 12,000 Labour hours per unit...... Total labour hours required......... Labour hours available... Shortage of labour hours... (b) The limiting factor is... (c) Contribution per unit...... Labour hours per unit...... Contribution per labour hour...... (d) Order of priority: first second Reason...... (e) Labour hours available for production...... 20,000 (f) Contribution per labour hour (from (c) above)...... Total contribution......... (g) Total fixed costs... Profit... (h) Scarves and rugs made...... 60 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Suggested solution to task 6 Rugs Scarves Total (a) Units demanded 5,000 12,000 Labour hours per unit 2 1 Total labour hours required 10,000 12,000 22,000 Labour hours available 20,000 Shortage of labour hours 2,000 (b) The limiting factor is labour hours (c) Contribution per unit 40 12 Labour hours per unit 2 1 Contribution per labour hour 20 12 (d) Order of priority: first: rugs second: scarves Reason Rugs have higher contribution per labour hour, which is the limiting factor. The demand for rugs must therefore be met if possible. (e) Labour hours available for production 10,000 10,000 20,000 (f) Contribution per labour hour (from (c) above) 20 12 Total contribution 200,000 120,000 320,000 (g) Total fixed costs 200,000 Profit 120,000 (h) Scarves and rugs made 5,000 10,000 ACCOUNTING AND FINANCE 61

PROFIT MAXIMISATION Task 7 Islay Woodcarvers plc makes 3 products, X, Y and Z, and has provided the following information: Total machine hours available 22,000 Total fixed costs 140,000 Product X Y Z Selling price per unit 26 48 58 Variable cost per unit 16 32 40 Number of machine hours per unit 1 2 1.5 Number of units demanded 4,000 6,000 5,000 Use the accompanying worksheet to carry out the following tasks: (a) (b) (c) (d) (e) (f) (g) (h) Compare the hours available with the hours required to find the shortage of machine hours. What is the limiting factor for Islay Woodcarvers plc? Calculate the contribution per machine hour for each product. Show the order of priority for production. Give a reason for your answer. Show how many machine hours would be used in the production of each of the 3 products. Find the total contribution. Find the total profit. How many of each product would be made in the hours in (e)? 62 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Task 7: worksheet X Y Z Total (a) Units demanded......... Machine hours per unit......... Total machine hours required............ Machine hours available... Shortage of machine hours... (b) The limiting factor is... (c) Contribution per unit......... Machine hours per unit......... Contribution per machine hour......... (d) Order of priority: first: second: Reason...... (e) Machine hours available for production............ (f) Contribution per machine hour......... Total contribution............ (g) Less total fixed costs... Profit... (h) Number of units made......... ACCOUNTING AND FINANCE 63

PROFIT MAXIMISATION Suggested solution to task 7 X Y Z Total (a) Units demanded 4,000 6,000 5,000 Machine hours per unit 1 2 1.5 Total machine hours required 4,000 12,000 7,500 23,500 Machine hours available 22,000 Shortage of machine hours 1,500 (b) The limiting factor is machine hours (c) Contribution per unit 10 16 18 Machine hours per unit 1 2 1.5 Contribution per machine hour 10 8 12 (d) Order of priority: first: Z second: X third: Y Reason: Highest contribution per machine hour must take priority, followed by second highest if profit is to be maximised because machine hours are the limiting factor. (e) Machine hours available for production 4,000 10,500 7,500 22,000 (f) Contribution per machine hour 10 8 12 Total contribution 40,000 84,000 90,000 214,000 (g) Less total fixed costs 140,000 Profit 74,000 (h) Number of units made 4,000 5,250 5,000 64 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Limiting factor: exercises Exercise 1 The total number of labour hours available in AB Components is 20,000. The firm has provided the following additional figures for products X and Y: X Y (Per unit) Contribution 4 6 Labour hours 2 2 Units demanded 5,000 7,000 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) the contribution per labour hour for each product the order of priority for production the labour hours available for each product the number of units of each product that can be made. ACCOUNTING AND FINANCE 65

PROFIT MAXIMISATION Exercise 2 The total number of labour hours available in Quality Doors plc is 5,500. The firm has provided the following additional figures for 2 designs, Georgian and Victorian: Georgian Victorian (Per unit) Selling price 150 200 Variable costs 60 100 Labour hours 1.5 2 Units demanded 2,000 1,500 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) (f) the contribution per unit for each product the contribution per labour hour for each product the order of priority for production the labour hours available for each product the number of units of each product that can be made. 66 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 3 City Shirts plc produces 3 designs Classic, City and Casual for which 18,000 machine hours are available. The following figures have been provided: Classic City Casual (Per unit) Selling price 28 30 22 Variable cost 13 16 10 Machine hours 0.5 0.5 0.5 Units demanded 10,000 12,000 16,000 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made. ACCOUNTING AND FINANCE 67

PROFIT MAXIMISATION Exercise 4 County Suits plc produces 3 designs Kelso, Selkirk and Melrose for which 2,200 machine hours are available. The following figures have been provided: Kelso Selkirk Melrose (Per unit) Selling price 360 280 250 Variable cost 180 140 100 Machine hours 5 3.5 3 Units demanded 200 300 180 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made. 68 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 5 Scottish Greenhouses plc makes 2 products Dunkeld and Aberfeldy. Total fixed costs are 400,000 and 5,000 labour hours are available. The following figures are available: Dunkeld Aberfeldy (Per unit) Selling price 1,200 800 Variable costs 600 360 Labour hours 5 4 Units demanded 400 800 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per labour hour for each product the order of priority for production the labour hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. ACCOUNTING AND FINANCE 69

PROFIT MAXIMISATION Exercise 6 Rockers Ltd makes 2 styles of chair Relax and Relax-plus for which 1,800 machine hours are available. Total fixed costs amount to 30,000. The following additional information has been provided: Relax Relax-plus (Per unit) Selling price 130 150 Variable costs 70 90 Machine hours 1.5 2 Units demanded 800 400 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. 70 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 7 Caledonian Souvenirs produces 3 quality souvenirs, Moray, Dornoch and Beauly. They are all hand-made and a total of 8,000 labour hours is available. Total fixed costs amount to 180,000. Sales demand for the products is expected to be: Moray Dornoch Beauly 2,000 units 1,600 units 1,000 units. The following figures are also available: Moray Dornoch Beauly (Per unit) Selling price 120 200 150 Variable costs 60 110 80 Labour hours 2 1.5 2 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per labour hour for each product the order of priority for production the labour hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. ACCOUNTING AND FINANCE 71

PROFIT MAXIMISATION Exercise 8 West Coast Models plc has a labour supply with a limit of 2,020 hours available. It produces 3 different model boats Class 1, Class 2 and Class 3 and its fixed costs amount to 8,000. The following figures have also been supplied: Class 1 Class 2 Class 3 (Per unit) Selling price 480 420 320 Variable cost 300 240 200 Labour hours 20 18 15 Units demanded 20 40 80 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per labour hour for each product the order of priority for production the labour hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. 72 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 9 Troon Models, which has a total of 7,000 machine hours available, produces 3 items, coded A, B and C. Total fixed costs are 90,000. The following figures have been supplied: A B C (Per unit) Selling price 12 30 24 Variable cost 8 15 12 Machine hours 0.25 0.5 0.5 Units demanded 6,000 8,000 4,000 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. ACCOUNTING AND FINANCE 73

PROFIT MAXIMISATION Exercise 10 The expected demand for the toys made by Terry & Son is as follows: Model 100: Model 200: Model 300: 2,000 units 5,000 units 4,000 units Two machines are available, each with a capacity limited to 3,000 hours per year. Total fixed costs amount to 70,000. The following figures have also been supplied: Model 100 Model 200 Model 300 (Per unit) Selling price 25 20 42 Variable cost 15 12 26 Machine hours 0.5 0.25 1 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. 74 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 11 The following information has been supplied by Davidson & Williams: total fixed costs: 40,000 labour hours available: 6,500 Product A B C D (Per unit) Selling price 40 10 18 8 Variable cost 20 6 12 3 Labour hours 2 0.5 1 0.25 Units demanded 1,000 3,000 2,200 4,800 You are required to find the following: (a) the labour hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per labour hour for each product the order of priority for production the labour hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. ACCOUNTING AND FINANCE 75

PROFIT MAXIMISATION Exercise 12 Conservatory Decor makes 4 styles of candleholder single, 2-candle, 3-candle and 5-candle and it has a total of 1,400 machine hours available. Fixed costs amount to 14,000. The following additional figures have been supplied: Single 2-candle 3-candle 5-candle (Per unit) Machine hours 0.25 0.25 0.5 0.5 Variable cost 8 13 15 18 Selling price 15 18 26 30 Units demanded 1,600 600 1,400 500 You are required to find the following: (a) the machine hours required to meet current demand (b) (c) (d) (e) (f) (g) (h) the contribution per unit for each product the contribution per machine hour for each product the order of priority for production the machine hours available for each style the number of units of each style that can be made the total contribution the profit after deduction of fixed costs. 76 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Limiting factor: suggested solutions to exercises Exercise 1 X Y Total (a) Labour hours required 2 hours x 5,000 2 hours x 7,000 10,000 hours 14,000 hours 24,000 hours (b) Contribution per unit 4 6 Labour hours per unit 2 2 Contribution per labour 4 6 hour 2 2 2 3 (c) First: Y (highest contribution per labour hour) Second: X (d) Labour hours 6,000 hours 14,000 hours 20,000 hours available (20,000 14,000) (e) Units produced 6,000 hours 2 hours 14,000 hours 2 hours 3,000 units 7,000 units ACCOUNTING AND FINANCE 77

PROFIT MAXIMISATION Exercise 2 Georgian Victorian Total (a) Labour hours required 1.5 hours x 2,000 2 hours x 1,500 3,000 hours 3,000 hours 6,000 hours (b) Contribution per unit 150 60 200 100 (selling price variable costs) 90 100 (c) Contribution per labour hour 90 100 1.5 hours 2 hours 60 50 (d) First: Georgian (highest contribution per labour hour) Second: Victorian (e) Labour hours 3,000 2,500 5,500 available (5,500 3,000) (f) Units produced 3,000 hours 1.5 hours 2,500 hours 2 hours 2,000 units 1,250 units 78 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 3 Classic City Casual Total (a) Machine hours 0.5 x 10,000 0.5 x 12,000 0.5 x 16,000 required 5,000 hours 6,000 hours 8,000 hours 19,000 hours (b) Contribution 28 13 30 16 22 10 per unit 15 14 12 (c) Contribution per machine hour 15 14 12 0.5 0.5 0.5 30 28 24 (d) First: Classic Second: City Third: Casual (e) Machine hours 5,000 hours 6,000 hours 7,000 hours 18,000 hours available (18,000 11,000) (f) Units produced 5,000 0.5 6,000 0.5 7,000 0.5 10,000 units 12,000 units 14,000 units ACCOUNTING AND FINANCE 79

PROFIT MAXIMISATION Exercise 4 Kelso Selkirk Melrose Total (a) Machine hours 5 hours x 200 3.5 hours x 300 3 hours x 180 required 1,000 hours 1,050 hours 540 hours 2,590 hours (b) Contribution 360 180 280 140 250 100 per unit 180 140 150 (c) Contribution per machine hour 180 5 140 3.5 150 3 36 40 50 (d) First: Melrose Second: Selkirk Third: Kelso (e) Machine hours 610 hours 1,050 hours 540 hours 2,200 hours available (2,200 1,590) (f) Units produced 610 5 1,050 3.5 540 3 122 units 300 units 180 units 80 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 5 Dunkeld Aberfeldy Total (a) Labour hours 5 hours x 400 4 hours x 800 required 2,000 hours 3,200 hours 5,200 hours (b) Contribution 1,200 600 800 360 per unit 600 440 (c) Contribution per labour hour 600 440 5 4 120 110 (d) First: Dunkeld Second: Aberfeldy (e) Labour hours 2,000 3,000 5,000 available (5,000 2,000) (f) Units produced 2,000 5 3,000 4 400 units 750 units (g) Contribution per labour hour 120 110 Labour hours 2,000 3,000 Total contribution 120 x 2,000 110 x 3,000 240,000 330,000 570,000 (h) Fixed costs 400,000 Profit 170,000 ACCOUNTING AND FINANCE 81

PROFIT MAXIMISATION Exercise 6 Relax Relax-plus Total (a) Machine hours required 1.5 hours x 800 2 hours x 400 1,200 hours 800 hours 2,000 hours (b) Contribution 130 70 150 90 per unit 60 60 (c) Contribution per machine hour 60 60 1.5 2 40 30 (d) First: Relax Second: Relax-plus (e) Machine hours 1,200 600 1,800 available (1,800 1,200) (f) Units produced 1,200 1.5 600 2 800 units 300 units (g) Contribution per machine hour 40 30 Machine hours 1,200 600 Total contribution 48,000 18,000 64,000 (h) Fixed costs 30,000 Profit 34,000 82 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 7 Moray Dornoch Beauly Total (a) Labour hours 2 hours x 2,000 1.5 hours x 1,600 2 hours x 1,000 required 4,000 hours 2,400 hours 2,000 hours 8,400 hours (b) Contribution 120 60 200 110 150 80 per unit 60 90 70 (c) Contribution per labour hour 60 90 70 2 1.5 2 30 60 35 (d) First: Dornoch Second: Beauly Third: Moray (e) Labour hours 3,600 hours 2,400 hours 2,000 hours 8,000 hours available (8,000 4,400) (f) Units produced 3,600 2 2,400 1.5 2,000 2 1,800 units 1,600 units 1,000 units (g) Total contribution 30 x 3,600 60 x 2,400 35 x 2,000 108,000 144,000 70,000 322,000 (h) Fixed costs 180,000 Profit 142,000 ACCOUNTING AND FINANCE 83

PROFIT MAXIMISATION Exercise 8 Class 1 Class 2 Class 3 Total (a) Labour hours 20 hours x 20 18 hours x 40 15 hours x 80 required 400 hours 720 hours 1,200 hours 2,320 hours (b) Contribution 480 300 420 240 320 200 per unit 180 180 120 (c) Contribution per labour hour 180 180 120 20 18 15 9 10 8 (d) First: Class 2 Second: Class 1 Third: Class 3 (e) Labour hours 400 hours 720 hours 900 hours 2,020 hours available (2,020 1,120) (f) Units produced 400 20 720 18 900 15 20 units 40 units 60 units (g) Total contribution 9 x 400 10 x 720 8 x 900 3,600 7,200 7,200 18,000 (h) Fixed costs 8,000 Profit 10,000 84 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 9 A B C Total (a) Machine hours 0.25 hours x 6,000 0.5 hours x 8,000 0.5 hours x 4,000 required 1,500 hours 4,000 hours 2,000 hours 7,500 hours (b) Contribution 12 8 30 15 24 12 per unit 4 15 12 (c) Contribution per machine hour 4 15 12 0.25 0.5 0.5 16 30 24 (d) First: B Second: C Third: A (e) Machine hours 1,000 hours 4,000 hours 2,000 hours 7,000 hours available (7,000 6,000) (f) Units produced 1,000 0.25 4,000 0.5 2,000 0.5 4,000 units 8,000 units 4,000 units (g) Total contribution 16 x 1,000 30 x 4,000 24 x 2,000 16,000 120,000 48,000 184,000 (h) Fixed costs 90,000 Profit 94,000 ACCOUNTING AND FINANCE 85

PROFIT MAXIMISATION Exercise 10 Model 100 Model 200 Model 300 Total (a) Machine hours 0.5 x 2,000 0.25 x 5,000 1 x 4,000 required 1,000 hours 1,250 hours 4,000 hours 6,250 hours (b) Contribution 25 15 20 12 42 26 per unit 10 8 16 (c) Contribution per machine hour 10 8 16 0.5 0.25 1 20 32 16 (d) First: Model 200 Second: Model 100 Third: Model 300 (e) Machine hours 1,000 hours 1,250 hours 3,750 hours 6,000 hours available (6,000 2,250) (f) Units produced 1,000 0.5 1,250 0.25 3,750 1 2,000 units 5,000 units 3,750 units (g) Total contribution 20 x 1,000 32 x 1,250 16 x 3,750 20,000 40,000 60,000 120,000 (h) Fixed costs 70,000 Profit 50,000 86 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise 11 A B C D Total (a) Labour hours 2 x 1,000 0.5 x 3,000 1 x 2,200 0.25 x 4,800 required 2,000 hours 1,500 hours 2,200 hours 1,200 hours 6,900 hours (b) Contribution 40 20 10 6 18 12 8 3 per unit 20 4 6 5 (c) Contribution per labour hour 20 4 6 5 2 0.5 1 0.25 10 8 6 20 (d) First: D Second: A Third: B Fourth: C (e) Labour hours 2,000 hours 1,500 hours 1,800 hours 1,200 hours 6,500 hours available (6,500 4,700) (f) Units produced 2,000 2 hours 1,500 0.5 hours 1,800 1 hour 1,200 0.25 hours 1,000 units 3,000 units 1,800 units 4,800 units (g) Total contribution 10 x 2,000 8 x 1,500 6 x 1,800 20 x 1,200 20,000 12,000 10,800 24,000 66,800 (h) Fixed costs 40,000 Profit 26,800 ACCOUNTING AND FINANCE 87

PROFIT MAXIMISATION Exercise 12 Single 2-candle 3-candle 5-candle Total (a) Machine hours 0.25 x 1,600 0.25 x 600 0.5 x 1,400 0.5 x 500 required 400 hours 150 hours 700 hours 250 hours 1,500 hours (b) Contribution 15 8 18 13 26 15 30 18 per unit 7 5 11 12 (c) Contribution per machine hour 7 5 11 12 0.25 0.25 0.5 0.5 28 20 22 24 (d) First: Single Second: 5-candle Third: 3-candle Fourth: 2-candle (e) Machine hours 400 hours 50 hours 700 hours 250 hours 1,400 hours available (1,400 1,350) (f) Units produced 400 0.25 50 0.25 700 0.5 250 0.5 1,600 units 200 units 1,400 units 500 units (g) Total contribution 28 x 400 20 x 50 22 x 700 24 x 250 11,200 1,000 15,400 6,000 33,600 (h) Fixed costs 14,000 Profit 19,600 88 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Limiting factor: extension exercises Exercise E1 Forth Valley Products uses machines that are equally suitable for making any of its products. There is a total machining capacity of 22,000 hours and total fixed costs are 360,000. Sales demand for its 4 products is expected to be as follows: J: 18,000 units K: 16,000 units L: 20,000 units M: 10,000 units. The following additional data is also given: Product Selling Variable Machine price costs hours (per unit) (per unit) (per unit) J 24 18 0.25 K 18 10 0.25 L 25 13 0.5 M 20 12 0.5 Using the above information, you are required to carry out the following tasks. (a) (b) (c) (d) (e) (f) (g) Calculate the contribution per unit of the limiting factor. Decide which product(s), if any, should be cut back. Give a reason for your choice. Calculate how many machine hours are necessary to satisfy current demand. Calculate how many machine hours will be used for making each of the 4 products in order to maximise profit. Calculate the total contribution and the final profit from this output. How many units of each product will be made? Find the sales revenue of these units. ACCOUNTING AND FINANCE 89

PROFIT MAXIMISATION Exercise E2 Main & Morrison plc have a limited labour force that provides 4,200 labour hours per year. Four products are made in the factory, which has fixed costs of 70,000. Maximum demand for the 4 products is expected to be as follows: A: 200 units B: 150 units C: 400 units D: 320 units. Budgeted figures for the 4 products have been supplied. Product Variable Selling Labour costs price hours (per unit) (per unit) (per unit) A 160 300 4 B 110 230 3 C 225 350 5 D 175 295 4 Answer each of the following questions. (a) (b) (c) (d) (e) (f) (g) How many labour hours are necessary to meet current demand? Why is it essential to calculate this figure? Can current demand be met with existing resources? If current demand cannot be met, state which product(s) should be cut back, showing calculations to support your answer. Calculate the number of labour hours available for each product. Calculate the number of units that will be produced. Calculate the maximum contribution and profit obtainable from this level of output. What is the sales revenue of the units produced? 90 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise E3 Crieff Wood Products plc produces 4 styles of garden seat de Luxe Double, Standard Double, de Luxe Single and Standard Single for which demand is expected to be 200, 500, 100 and 150 units, respectively. The number of labour hours available is 3,300 and fixed costs total 50,000. The following figures are available. Product Selling Materials Wages Labour price cost cost hours (per unit) (per unit) (per unit) (per unit) de Luxe Double 250 40 70 5 Standard Double 182 30 48 4 de Luxe Single 180 28 56 4 Standard Single 130 25 36 3 Answer each of the following questions. (a) (b) (c) (d) (e) (f) The limiting factor is labour. Explain what is meant by the limiting factor. Calculate the labour hours needed to satisfy current demand. Compare your answer with the number of hours available and calculate the shortage of hours. Find the contribution per unit and the contribution per labour hour for each style. Calculate the labour hours to be spent on each style in order to maximise profit. Calculate the total contribution and maximum profit from your suggested output. Calculate the total sales revenue of the output. ACCOUNTING AND FINANCE 91

PROFIT MAXIMISATION Suggested solutions to extension exercises Exercise E1 J K L M Total (a) Contribution 24 18 18 10 25 13 20 12 per unit 6 8 12 8 Contribution per machine hour 6 0.25 8 0.25 24 32 24 16 12 0.5 8 0.5 (b) Product M should be cut back because it has the lowest contribution per labour hour. Machine hours are scarce (only 22,000 are available) therefore the products given priority are those with the highest contribution per unit of the limiting factor. (c) Machine hours 0.25 x 18,000 0.25 x 16,000 0.5 x 20,000 0.5 x 10,000 required 4,500 hours 4,000 hours 10,000 hours 5,000 hours 23,500 hours (d) Machine hours 4,500 hours 4,000 hours 10,000 hours 3,500 hours 22,000 hours available (22,000 18,500) (e) Total 24 x 4,500 32 x 4,000 24 x 10,000 16 x 3,500 contribution 108,000 128,000 240,000 56,000 532,000 Less fixed costs 360,000 Profit 172,000 (f) Units produced 4,500 0.25 4,000 0.25 10,000 0.5 3,500 0.5 18,000 units 16,000 units 20,000 units 7,000 units (g) Sales revenue 24 x 18,000 18 x 16,000 25 x 20,000 20 x 7,000 432,000 288,000 500,000 140,000 1,360,000 92 ACCOUNTING AND FINANCE

PROFIT MAXIMISATION Exercise E2 A B C D Total (a) Labour hours 4 hours x 200 3 hours x 150 5 hours x 400 4 hours x 320 required 800 hours 450 hours 2,000 hours 1,280 hours 4,530 hours This figure must be calculated when labour is in scarce supply. It will tell the firm whether or not there are enough labour hours to fully meet current demand. If not, a level of output will have to be fixed to maximise profit within the limitations. (b) No. Only 4,200 hours are available but 4,530 are required to meet current demand. (c) Contribution 300 160 230 110 350 225 295 175 per unit 140 120 125 120 Contribution per labour hour 140 4 120 3 125 5 35 40 25 30 120 4 Product C should be cut back because it has the lowest contribution per labour hour. (d) Labour hours 800 hours 450 hours 1,670 hours 1,280 hours 4,200 hours available (4,300 2,530) (e) Units produced 800 4 450 3 1,670 5 1,280 4 200 units 150 units 334 units 320 units (f) Total 35 x 800 40 x 450 25 x 1,670 30 x 1,280 contribution 28,000 18,000 41,750 38,400 126,150 Less fixed costs 70,000 Profit 56,150 (g) Sales revenue 300 x 200 230 x 150 350 x 334 295 x 320 60,000 34,500 116,900 94,400 305,800 ACCOUNTING AND FINANCE 93

PROFIT MAXIMISATION Exercise E3 (a) The limiting factor is a resource that is in short supply, e.g. labour. This means that production has to be planned so that the highest possible profit will be made from the existing labour supply. Output levels will be such that those products which give the highest contribution per labour hour will be given priority. (b) de Luxe Double Standard Double de Luxe Single Standard Single Total Labour hours 5 hours x 200 4 hours x 500 4 hours x 100 3 hours x 150 required 1,000 hours 2,000 hours 400 hours 450 hours 3, 850 hours Labour hours available 3,300 hours Shortage 550 hours (c) Contribution 250 110 182 78 180 84 130 61 per unit 140 104 96 69 Contribution per labour hour 140 5 104 4 28 26 24 23 96 4 69 3 (d) Labour hours 1,000 hours 2,000 hours 300 hours 3,300 hours available (3,300 3,000) (e) Total 28 x 1,000 26 x 2,000 24 x 300 contribution 28,000 52,000 7,200 87,200 Less fixed costs 50,000 Profit 37,200 (f) Units produced 200 units 500 units 75 units Sales revenue 250 x 200 182 x 500 180 x 75 50,000 91,000 13,500 154,500 94 ACCOUNTING AND FINANCE

Section Three Financial Analysis Contents Summary note and examples 97-103 Exercises 1-16 with suggested solutions 104-131 Extension exercises 1-3 with suggested solutions 132-144 ACCOUNTING AND FINANCE 95

96 ACCOUNTING AND FINANCE

SECTION THREE FINANCIAL ANALYSIS Ratios and percentages At the end of each financial year Final Accounts are prepared that show the firm s profitability and its financial position at that date. These accounts are a record of the firm s performance and, by themselves, have limited use since they give no indication of whether the results are favourable or unfavourable. For example, they show the profit/loss figure but there is nothing to indicate whether that figure is satisfactory for the firm concerned. The assets are listed in the Balance Sheet but, again, there is nothing to show that they are being used effectively for example, is a bank balance of 10,000 a healthy sign and is an overdraft of 5,000 unhealthy? Management needs to know whether or not: (i) performance is satisfactory (ii) performance is showing improvement on previous years (iii) there are problem areas that should be investigated. It may also be desirable to compare figures with those of competitors or with the average for the industry. A straightforward comparison of figures is usually unhelpful. A profit of 20,000 may be acceptable for one firm but entirely unacceptable for another: if it is related to the capital employed it becomes more meaningful. A return of 20,000 on capital of 100,000 (20%) is obviously better than a return of 20,000 on capital of 200,000 (10%). Ratios and percentages are therefore normally used for the purpose of comparison. Parties who would be interested in the firm s ratios are: owners/shareholders who want to see how profitable their investment is potential creditors such as suppliers and banks who would be interested to know if the firm is credit worthy staff who are interested in wage rates, bonuses and profit-sharing, which must be considered in the light of profitability companies interested in take-over bids who want to see profitability and efficient use of assets. The main types of ratio are those relating to profitability and liquidity. ACCOUNTING AND FINANCE 97

FINANCIAL ANALYSIS Profitability Profitability ratios show how successful a firm is in relation to capital and sales revenue. Example 1 Year 1 Year 2 Capital at start 20,000 22,000 Add net profit 4,000 5,500 24,000 27,500 Less drawings 2,000 3,000 Capital at end 22,000 24,500 Return on capital employed = net profit opening capital x 100 1 Return on capital employed Year 1 Year 2 4,000 20,000 x 100 1 5,500 22,000 = 20% = 25% x 100 1 This ratio shows there has been adequate return on investment. In the second year profit has increased and the improved ratio indicates that assets have been more effectively employed. This may be due to factors such as economic purchasing procedures, increased advertising and reduced expenses. 98 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Example 2 Year 1 Year 2 Sales 60,000 80,000 Less cost of goods sold 40,000 50,000 Gross profit 20,000 30,000 Less expenses 8,000 12,000 Net profit 12,000 18,000 Gross profit % = gross profit sales x 100 1 Gross profit % Year 1 Year 2 20,000 60,000 x 100 1 30,000 80,000 = 33.3% = 37.5% x 100 1 Gross profit arises from buying and selling stock and the gross profit % shows how much of every 100 of sales is profitable. It is possible for sales volume to increase without a corresponding increase in profitability. In Year 2 there has been an increase in profitability. This may have arisen from buying stock at a lower price because of influences such as a change of buying policy or a change in market prices. On the other hand, it may be the result of selling at an increased price without any increase in costs. ACCOUNTING AND FINANCE 99

FINANCIAL ANALYSIS net profit Net profit % = x sales 100 1 Net profit % Year 1 Year 2 12,000 60,000 = 20% = 22.5% total expenses 100 Expenses % = x sales 1 x 100 1 18,000 80,000 x 100 1 Expenses % Year 1 Year 2 8,000 60,000 x 100 1 12,000 80,000 = 13.3% = 15% x 100 1 The net profit % and the expenses % are linked because net profit is the result of deducting expenses from gross profit. The improvement in gross profit ratio is reflected to some extent in the net profit % but there has been an increase in expenses. There may have been an increase in advertising costs, wages or other running costs and these would be examined to see if they can be reduced. 100 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Liquidity Liquidity ratios show whether the firm can meet its liabilities when they are due. Generally, current assets should cover current liabilities. Potential creditors and lenders will not support a firm whose current liabilities are greater than its current assets and the firm may be forced to close because it is bankrupt. Working capital finances the day-to-day trading and if a firm tries to boost sales to a level beyond its capacity, working capital is reduced. This is called overtrading and is a common reason for insolvency. Example 3 Year 1 Year 2 Current assets: stock 2,000 5,000 debtors 2,500 5,000 bank 1,500 6,000 10,000 Current liabilities: creditors 3,000 8,000 bank 3,000 3,000 11,000 Current ratio = current assets current liabilities Current ratio Year 1 Year 2 6,000 3,000 10,000 11,000 = 2:1 = 0.9:1 The current ratio has fallen in Year 2 and the firm is now unable to meet the debts that are due within the next few months. This may be because the increased stock level has been financed by borrowing from the bank or because increased credit sales mean a higher debtors figure. ACCOUNTING AND FINANCE 101

FINANCIAL ANALYSIS Example 4 Year 1 Year 2 Total credit sales 60,000 75,000 Average debtors 2,000 4,000 Debtors collection period debtors = sales x 365 days Debtors collection period Year 1 Year 2 2,000 x 365 4,000 x 365 60,000 75,000 = 12 days = 19 days The debtors collection period is how long on average it has taken debtors to pay for their goods. In Year 2 they have been allowed 7 days longer than in Year 1 therefore credit control policy may need to be investigated. It may be that sales were only increased by allowing longer credit to customers. Example 5 Year 1 Year 2 Total credit purchases 50,000 60,000 Average creditors 3,000 2,500 Creditors payment period creditors = x 365 days purchases Creditors payment period Year 1 Year 2 3,000 x 365 2,500 x 365 50,000 60,000 = 21 days = 15 days This ratio shows how long the firm is taking on average to pay for its credit purchases. In Year 2 the time has been shortened by 6 days which means that creditors have tightened their credit terms. It is also possible that the firm is not making full use of the credit facilities available to it and is paying too quickly. 102 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Example 6 Year 1 Year 2 Stock at start 14,000 12,000 Add purchases 40,000 49,000 Goods available 54,000 61,000 Less stock at end 12,000 10,000 Cost of goods sold 42,000 51,000 Rate of stock turnover = cost of goods sold average stock Rate of stock turnover Year 1 Year 2 42,000 13,000 51,000 11,000 = 3.2 times = 4.6 times The rate of stock turnover gives the number of times stock has been changed during the year. The stock figure used is the average of the stock figures available the opening and closing stocks divided by 2. A firm with a fast-moving stock (for example a bakery) will have a very high rate of stock turnover while one with a slow-moving stock (for example a furniture supplier) will have a low figure. In Year 2 the rate of stock turnover has increased because a lower amount of stock is being held while output has risen. Further investigation would show if this trend was favourable and has led to higher profits. ACCOUNTING AND FINANCE 103

FINANCIAL ANALYSIS Financial analysis: exercises Exercise 1 From the following information calculate the return on capital employed for each year. Year 1 Year 2 Year 3 Capital at start 50,000 54,000 60,000 Add profit 5,000 8,100 15,000 55,000 62,100 75,000 Less drawings 1,000 2,100 1,500 Capital at end 54,000 60,000 73,500 Exercise 2 Copy and complete the following table. Calculate the return on capital employed for each year. Year 1 Year 2 Year 3 Capital at start 100,000 Add profit 25,000 24,000 21,000 125,000 Less drawings 5,000 4,000 Capital at end 155,000 104 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 3 Use the information below to calculate the following for each year: (a) gross profit % (b) net profit % (c) expenses %. Year 1 Year 2 Year 3 Sales 60,000 72,000 96,000 Less cost of goods sold 40,000 54,000 67,200 Gross profit 20,000 18,000 28,800 Less expenses 8,000 7,200 9,600 Net profit 12,000 10,800 19,200 Exercise 4 Copy and complete the following table then calculate gross profit %, net profit %, expenses % and rate of stock turnover. Year 1 Year 2 Year 3 Sales 120,000 160,000 220,000 Less cost of goods sold 90,000 132,000 Gross profit 32,000 Less expenses 18,000 8,000 Net profit 66,000 ACCOUNTING AND FINANCE 105

FINANCIAL ANALYSIS Exercise 5 Trading and Profit and Loss Accounts for year ended 31 March Year 1 Year 2 Sales 80,000 94,000 Less cost of sales Stock at start 6,000 8,000 Add purchases 50,000 69,800 56,000 77,800 Less stock at end 8,000 48,000 12,000 65,800 Gross profit 32,000 28,200 Less expenses 16,000 11,280 Net profit 16,000 16,920 Calculate the following ratios for each year: (a) gross profit % (b) net profit % (c) expenses % (d) rate of stock turnover. 106 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 6 Trading and Profit and Loss Accounts for year ended 31 July Year 1 Year 2 000s 000s 000s 000s Sales 120 140 Less cost of sales Stock at start 8 6 Add purchases 70 74 78 80 Less stock at end 6 72 10 70 Gross profit 48 70 Less expenses 18 28 Net profit 30 42 Calculate the following ratios for each year and give one possible reason for any increase/decrease in Year 2: (a) gross profit % (b) net profit % (c) expenses % (d) rate of stock turnover Exercise 7 Using the following information, calculate the debtors collection period and the creditors payment period for each of the 3 firms. Black White Gray Credit purchases 100,000 48,000 235,000 Credit sales 150,000 75,000 342,500 Average creditors 10,000 2,400 14,500 Average debtors 12,000 3,500 13,200 ACCOUNTING AND FINANCE 107

FINANCIAL ANALYSIS Exercise 8 Use the following figures to calculate the debtors collection period and the creditors payment period for each year and comment on any increase/decrease in the ratios in Year 2. Year 1 Year 2 Credit sales 88,500 96,800 Credit purchases 54,200 68,800 Average debtors 4,600 7,200 Average creditors 2,600 2,500 Exercise 9 From the following Balance Sheet extracts calculate the current ratio for each year and suggest a reason for any differences that have arisen. Balance Sheet as at 28 February Year 1 Year 2 Year 3 CURRENT ASSETS Stock 4,000 3,000 4,000 Debtors 2,500 1,600 1,400 Bank 4,000 1,400 10,500 6,000 5,400 CURRENT LIABILITIES Creditors 3,500 3,000 3,200 Bank 4,000 3,500 3,000 7,200 108 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 10 Study the ratios given for Years 1 and 2 then give one possible reason for each of the differences that have arisen. Year 1 Year 2 (a) Return on capital employed 18% 18.5% (b) Gross profit % 30% 40% (c) Net profit % 20% 22% (d) Current ratio 2:1 2.5:1 (e) Debtors collection period 25 days 32 days ACCOUNTING AND FINANCE 109

FINANCIAL ANALYSIS Exercise 11 Study the following set of final accounts provided by D Matthews and calculate the ratios listed below. (a) Gross profit % (b) Net profit % (c) Expenses % (d) Return on capital employed (e) Rate of stock turnover (f) Current ratio (g) Debtors collection period (h) Creditors payment period Trading and Profit and Loss Accounts for year ended 31 December Sales 48,000 Less cost of goods sold Stock at start 2,000 Add purchases 36,800 Goods available 38,800 Less stock at end 2,800 36,000 Gross profit 12,000 Less expenses 4,800 Net profit 7,200 110 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 11 (cont d) Balance Sheet as at 31 December FIXED ASSETS Machinery 12,200 Delivery van 3,800 16,000 CURRENT ASSETS Stock 2,800 Debtors 2,000 Bank 1,000 Cash 200 6,000 LESS CURRENT LIABILITIES Creditors 2,800 NET CURRENT ASSETS 3,200 TOTAL ASSETS 19,200 FINANCED BY Capital at start 12,000 Add net profit 7,200 19,200 ACCOUNTING AND FINANCE 111

FINANCIAL ANALYSIS Exercise 12 You have been given the final accounts of A S Wilson and the following figures and for the average firm in this type of business: (a) gross profit % 27% (b) net profit % 9.5% (c) return on capital employed 16% (d) rate of stock turnover 8 times (e) current ratio 2:1 From the final accounts prepare ratios similar to those above and in each case give one possible reason for the difference (if any) between A S Wilson s figures and those of the average firm. Trading and Profit and Loss Accounts for year ended 30 June Sales 40,000 Less cost of goods sold Stock at start 4,000 Add purchases 32,000 Goods available 36,000 Less stock at end 6,000 30,000 Gross profit 10,000 Less expenses 6,000 Net profit 4,000 112 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 12 (cont d) Balance Sheet as at 30 June FIXED ASSETS Machinery 20,000 Delivery van 12,000 32,000 CURRENT ASSETS Stock 6,000 Debtors 8,000 14,000 LESS CURRENT LIABILITIES Creditors 10,000 Bank 2,000 12,000 NET CURRENT ASSETS 2,000 TOTAL ASSETS 34,000 FINANCED BY Capital at start 30,000 Add net profit 4,000 34,000 ACCOUNTING AND FINANCE 113

FINANCIAL ANALYSIS Exercise 13 (a) From the information below calculate the following figures: (i) gross profit % (ii) net profit % (iii) current ratio (iv) debtors collection period (v) creditors payment period (vi) rate of stock turnover Trading and Profit and Loss Accounts for year ended 30 September 000s 000s Sales 60 Less cost of goods sold Stock at start 4 Add purchases 40 Goods available 44 Less stock at end 8 36 Gross profit 24 Less expenses 12 Net profit 12 114 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 13 (cont d) Balance Sheet as at 30 September 000s 000s 000s FIXED ASSETS Motor lorry 36 Machinery 10 46 CURRENT ASSETS Stock 8 Debtors 6 14 LESS CURRENT LIABILITIES Creditors 8 Bank 2 10 TOTAL ASSETS 4 FINANCED BY Capital at start 40 Add net profit 12 52 Less drawings 2 50 50 (b) Compare your answers with the figures given below for the average business in this line and give one possible reason for each difference shown. (i) Gross profit % 40% (ii) Net profit % 25% (iii) Current ratio 1.5:1 (iv) Debtors collection period 30 days (v) Creditors payment period 90 days (vi) Rate of stock turnover 7 times ACCOUNTING AND FINANCE 115

FINANCIAL ANALYSIS Exercise 14 The following final accounts have been supplied by Western Builders plc. You are required to calculate the following ratios for both years and comment on any difference: (a) gross profit % (b) net profit % (c) return on capital employed (d) debtors collection period (e) current ratio. Trading and Profit and Loss Accounts for year ended 31 December Year 1 Year 2 000s 000s 000s 000s Sales 300 400 Less cost of goods sold Stock at start 30 25 Add purchases 200 260 Goods available 230 285 Less stock at end 25 205 20 265 Gross profit 95 135 Less expenses 20 25 Net profit 75 110 116 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 14 (cont d) Balance Sheets as at 31 December Year 1 Year 2 000s 000s 000s 000s 000s 000s FIXED ASSETS Premises 500 450 Plant and machinery 200 280 Delivery vehicles 100 800 160 890 CURRENT ASSETS Stock 25 20 Debtors 16 18 Bank 0 41 15 53 LESS CURRENT LIABILITIES Creditors 14 8 Bank 2 16 25 0 8 45 TOTAL ASSETS 825 935 FINANCED BY Capital at start 750 825 Add net profit 75 110 825 935 ACCOUNTING AND FINANCE 117

FINANCIAL ANALYSIS Exercise 15 The following information has been provided by the directors of Rannoch Heating plc. Calculate each of the following ratios for both years and suggest one possible reason for any differences: (a) gross profit % (b) net profit % (c) expenses % (d) rate of stock turnover (e) creditors payment period (f) current ratio. Trading and Profit and Loss Accounts for year ended 30 April Year 1 Year 2 000s 000s 000s 000s Sales 500 400 Less cost of goods sold Stock at start 25 15 Add purchases 275 250 Goods available 300 265 Less stock at end 15 285 20 245 Gross profit 215 155 Less expenses 50 50 Net profit 165 105 118 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 15 (cont d) Balance Sheets as at 30 April Year 1 Year 2 000s 000s 000s 000s 000s 000s FIXED ASSETS Premises 100 150 Machinery 120 220 Vehicles 150 370 120 490 CURRENT ASSETS Stock 15 20 Debtors 8 22 Bank 12 35 0 42 LESS CURRENT LIABILITIES Creditors 18 26 Bank 0 18 17 14 40 2 TOTAL ASSETS 387 492 FINANCED BY Capital at start 222 387 Add net profit 165 105 387 492 ACCOUNTING AND FINANCE 119

FINANCIAL ANALYSIS Exercise 16 You have been given the following information by the management of Musicmakers plc. Trading and Profit and Loss Accounts for year ended 10 April Year 1 Year 2 000s 000s 000s 000s Sales 180 220 Less cost of goods sold Stock at start 11 9 Add purchases 98 114 Goods available 109 123 Less stock at end 9 100 13 110 Gross profit 80 110 Less expenses 20 40 Net profit 60 70 (a) (b) You are required to calculate the following ratios for each of the 2 years: (i) gross profit % (ii) net profit % (iii) expenses % (iv) rate of stock turnover. Give one possible reason for any differences that have arisen in the ratios between the two years. The following Balance Sheets have also been supplied. 120 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 16 (cont d) Balance Sheets as at 30 April Year 1 Year 2 000s 000s 000s 000s 000s 000s FIXED ASSETS Premises 55 Machinery 100 110 Vehicles 70 70 Office equipment 30 40 CURRENT ASSETS 200 275 Stock 9 13 Debtors 5 11 Bank 8 22 0 24 LESS CURRENT LIABILITIES Creditors 12 9 Bank 10 10 19 5 TOTAL ASSETS 210 280 FINANCED BY Capital at start 150 210 Add net profit 60 70 210 280 (c) (i) Calculate the return on capital employed for Years 1 and 2 and give one reason for any difference in the figures. (ii) Calculate the debtors collection period for both years. Has this figure shown any improvement? (iii) Calculate the creditors payment period for each year. What does this ratio mean? (iv) Calculate the current ratio for each year. Why is this ratio considered to be very important? ACCOUNTING AND FINANCE 121

FINANCIAL ANALYSIS Financial analysis: suggested solutions to exercises Exercise 1 Year 1 Year 2 Year 3 Return on capital employed 5,000 x 100 50,000 8,100 x 100 54,000 15,000 x 100 60,000 = 10% = 15% = 25% Exercise 2 Year 1 Year 2 Year 3 Capital at start 100,000 120,000 140,000 Add profit 25,000 24,000 21,000 125,000 144,000 161,000 Less drawings 5,000 4,000 6,000 Capital at end 120,000 140,000 155,000 Return on capital employed 25,000 x 100 100,000 24,000 x 100 120,000 21,000 x 100 140,000 = 25% = 20% = 15% Exercise 3 Year 1 Year 2 Year 3 Gross profit % 33.3% 25% 30% Net profit % 20% 15% 20% Expenses % 13.3% 10% 10% 122 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 4 Year 1 Year 2 Year 3 Sales 120,000 160,000 220,000 Less cost of goods sold 90,000 128,000 132,000 Gross profit 30,000 32,000 88,000 Less expenses 18,000 8,000 22,000 Net profit 12,000 24,000 66,000 Gross profit % 25% 20% 40% Net profit % 10% 15% 30% Expenses % 15% 5% 10% Exercise 5 Year 1 Year 2 (a) Gross profit % (b) Net profit % (c) Expenses % (d) Average stock Rate of stock turnover 32,000 x 100 80,000 = 40% = 30% 16,000 x 100 80,000 = 20% = 18% 16,000 x 100 80,000 = 20% = 12% 6,000 x 8,000 2 28,200 x 100 94,000 = 7,000 = 10,000 48,000 7,000 16,920 x 100 94,000 11,280 x 100 94,000 8,000 x 12,000 2 65,800 10,000 = 6.85 times = 6.58 times ACCOUNTING AND FINANCE 123

FINANCIAL ANALYSIS Exercise 6 (a) Gross profit % Year 1 Year 2 48 x 100 120 70 x 100 140 = 40% = 50% An increase in the gross profit % may be due to: selling at a higher price buying at a lower price a change in the sales mix. (b) Net profit % 30 x 100 120 42 x 100 140 = 25% = 30% The increase in the net profit % is probably due to the increase in the gross profit %. It is a smaller increase and this may be because of a rise in expense costs such as advertising. (c) Expenses % 18 x 100 120 28 x 100 140 = 15% = 20% Selling and administration expenses such as advertising, discounts allowed, salaries, etc. may have risen. (d) Average stock Rate of stock turnover 8 + 6 2 = 7 = 8 72 7 6 + 10 2 70 8 = 10.3 times = 8.75 times The rate of stock turnover has dropped which shows that although sales have increased, a higher stock is being held. Stock must therefore be turning over more slowly because of a decrease in actual sales volume. 124 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 7 Debtors collection period Creditors payment period Black White Gray 12,000 x 365 150,000 = 29 days = 17 days = 14 days 10,000 x 365 100,000 3,500 x 365 75,000 2,400 x 365 48,000 13,200 x 365 342,500 14,500 x 365 235,000 = 36/37 days = 18 days = 22/23 days Exercise 8 Year 1 Year 2 Debtors collection period 4,600 x 365 88,500 7,200 x 365 96,800 = 19 days = 27 days The increase in the debtors collection period may indicate that credit control within the firm has become slack. This may be deliberate to encourage trade but it should be investigated to see if it can be improved. Creditors payment period 2,600 x 365 54,200 2,500 x 365 68,800 = 17/18 days = 13 days The creditors payment period has decreased, which indicates that creditors are expecting their customers to pay more promptly. It is possible that cash discounts have been offered to encourage this. ACCOUNTING AND FINANCE 125

FINANCIAL ANALYSIS Exercise 9 Year 1 Year 2 Year 3 Current ratio 10,500 3,500 6,000 3,000 5,400 7,200 = 3:1 = 2:1 = 0.75:1 Year 1 Year 2 Year 3 Current ratio is very high a high level of stock may be being carried but there is also a fairly high bank balance which could perhaps be put to better use. This ratio is more normal and acceptable. All current assets have been reduced considerably and some of the bank balance may have been used to buy fixed assets such as machinery. The firm can no longer pay the debts that will shortly fall due. The bank overdraft may have been caused by purchase of a fixed asset when the firm could not afford it. Exercise 10 (a) (b) Return on capital employed has improved only slightly, probably due to the increase in the net profit %. Gross profit % has increased considerably, either because selling price has been increased or because the cost price has been decreased by getting better terms or changing suppliers. (c) The net profit % has not increased in accordance with the gross profit %, which suggests that expenses have risen more than is acceptable. This should be investigated to eliminate the trend. (d) (e) Current ratio has increased but it was satisfactory in Year 1. The creditors figure may be lower or it may be that a greater proportion of sales are on credit, thus increasing the debtors figure. Debtors collection period is 7 days longer, which indicates that there is a problem with debtors. There is a greater risk of bad debts when the collection period is too long. 126 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 11 (a) Gross profit % 12,000 x 100 48,000 = 25% (b) Net profit % 7,200 x 100 48,000 = 15% (c) Expenses % 4,800 x 100 48,000 = 10% (d) Return on capital employed 7,200 x 100 12,000 = 60% (e) Rate of stock turnover 36,000 x 100 2,400 = 15 times [average stock = 2,000 + 2,800 2 ] (f) Current ratio 6,000 2,800 = 2.1:1 (g) Debtors collection period 2,000 x 365 48,000 = 15 days (h) Creditors payment period 2,800 x 365 36,800 = 27 days ACCOUNTING AND FINANCE 127

FINANCIAL ANALYSIS Exercise 12 (a) Gross profit % 10,000 x 100 40,000 = 25% Lower than average 27%. Reason: possibly lower selling price (different market, different sales mix) or higher cost price (poor purchasing procedures, missing trade discounts). (b) Net profit % 4,000 x 100 40,000 = 10% Slightly higher than average 9.5%. Reason: expenses are being kept under control. (c) Return on capital employed 4,000 x 100 30,000 = 13.3% Lower than average 16%. Reason: capital may not be being used efficiently a large amount seems to be tied up in stock and debtors. (d) Rate of stock turnover 30,000 5,000 = 6 times [average stock = 4,000 + 6,000 ] 2 Lower than average 8 times. Reason: sales activity may be slowing down and stock piling up. (e) Current ratio 14,000 12,000 = 1.16:1 Much lower than average 2:1 dangerously low. Reason: both debtors and creditors figures are high, resulting in poor cash flow and an overdraft at the bank. (Creditors and overdraft result in interest charges.) 128 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 13 (a) (i) Gross profit % 24,000 x 100 60,000 = 40% (ii) Net profit % 12,000 x 100 60,000 = 20% (iii) Current ratio 14,000 10,000 = 1.4:1 (iv) Debtors collection period 6,000 x 365 60,000 = 36/37 days (v) Creditors payment period 8,000 x 365 40,000 = 73 days (vi) Rate of stock turnover 36,000 6,000 = 6 times (b) (i) (ii) (iii) (iv) (v) (vi) 4,000 + 8,000 [average stock = ] 2 No difference. Lower: expenses too high, need to be investigated. Slightly lower: creditors figure seems rather high; money is lying out in debtors that could be brought in to clear overdraft. Longer: credit policy too slack; perhaps no provision has been made for bad debts. Shorter than average: does not seem to be taking full advantage of the very long term of credit generally allowed. Slower: old stock may be carried and included in figures. ACCOUNTING AND FINANCE 129

FINANCIAL ANALYSIS Exercise 14 Year 1 Year 2 (a) Gross profit % 95,000 x 100 300,000 135,000 x 100 400,000 = 31.7% = 33.75% This ratio has risen slightly either because of a rise in selling prices or a fall in cost prices. (b) Net profit % 75,000 x 100 300,000 = 25% = 27.5% 110,000 x 100 400,000 This ratio has risen slightly more than the gross profit %, which suggests that expenses have been kept in check. (c) Return on capital employed 75,000 x 100 750,000 = 10% = 13.3% 110,000 x 100 825,000 The increase in net profit is reflected in a slightly higher return, which suggests that sales activity has risen. (d) Debtors collection period 16,000 x 365 300,000 18,000 x 365 400,000 = 19 days = 16 days Debtors are settling their accounts more quickly either because of a tightening of credit procedures or because greater incentives are being allowed for prompt payment. (e) Current ratio 41,000 16,000 53,000 8,000 = 2.6:1 = 6.6:1 The first year was more satisfactory although even then the ratio was a little high. The high current ratio means that the firm is well able to meet its short-term debts but the high current assets figure must be examined money lying in the bank could be put to work in the business or invested where it would earn a higher rate of interest. 130 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise 15 (a) Gross profit % Year 1 Year 2 215,000 x 100 500,000 155,000 x 100 400,000 = 43% = 38.75% This ratio has fallen because the cost of the goods sold is higher, perhaps because of a general rise in prices or a change of supplier. (b) Net profit % 165,000 x 100 500,000 105,000 x 100 400,000 = 33% = 26.25% This ratio has also fallen because of the fall in gross profit but also because expenses have remained the same despite a lower sales figure. (c) Expenses % 50,000 x 100 500,000 = 10% = 12.5% 50,000 x 100 400,000 Economies have not been made in running expenses despite the fact that sales were lower. (d) Rate of stock turnover 285,000 20,000 245,000 17,500 = 14.3 times = 14 times (e) (f) There is little change in the number of times stock is turning over in the year. Creditors payment period = 24 days = 38 days The firm is taking advantage of longer credit periods from its suppliers, but must take care not to lose out on discounts. Current ratio 18,000 x 365 275,000 35,000 18,000 = 1.9:1 = 1.05:1 26,000 x 365 250,000 42,000 40,000 The current ratio has gone from being satisfactory to risky. The high debtors figure means a probability of bad debts arising. High creditors and overdraft are possibly costing money. ACCOUNTING AND FINANCE 131

FINANCIAL ANALYSIS Exercise 16 (a) Year 1 Year 2 (i) Gross profit % 80,000 x 100 110,000 x 100 180,000 220,000 = 44% = 50% (ii) Net profit % (iii) Expenses % (iv) Rate of stock turnover 60,000 x 100 180,000 = 33% = 32% 20,000 x 100 180,000 = 11% = 18% 100,000 10,000 70,000 x 100 220,000 40,000 x 100 220,000 110,000 11,000 = 10 times = 10 times (b) (i) (ii) (iii) (iv) Gross profit % has increased because of lower purchase prices or increased selling prices. Net profit % has not increased in proportion to gross profit % because expenses have been allowed to increase. As in (ii), expenses have risen out of proportion to the increased sales. No difference. 132 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS (c) (i) Return on capital employed 60,000 x 100 150,000 = 40% = 33% 70,000 x 100 210,000 (ii) The increased expenses have caused this ratio to fall despite increased sales. Debtors collection period 5,000 x 365 180,000 11,000 x 365 220,000 = 10 days = 18 days No, debtors are taking longer to settled their bills in Year 2. (iii) Creditors payment period 12,000 x 365 98,000 9,000 x 365 114,000 = 45 days = 29 days (iv) This ratio shows the credit period allowed to Musicmakers plc by suppliers. Current ratio 22,000 12,000 24,000 19,000 = 1.8:1 = 1.3:1 This ratio is important because it indicates the firm s ability to settle its short-term debts. Current assets should ideally be about twice as much as current liabilities but this varies from firm to firm. If current assets do not cover current liabilities, the firm may be in danger of going bankrupt and having to close. ACCOUNTING AND FINANCE 133

FINANCIAL ANALYSIS Financial analysis: extension exercises Exercise E1 The following figures have been supplied by H Cowan, who is concerned at the fall in profits. Balance Sheets as at 31 December Year 1 Year 2 FIXED ASSETS Premises 60,000 60,000 Machinery 12,000 7,000 Vehicles 10,000 8,000 Office equipment 82,000 3,000 78,000 CURRENT ASSETS Stock 4,000 6,250 Debtors 2,000 4,000 Bank 2,000 8,000 1,250 11,500 LESS CURRENT LIABILITIES Creditors 7,000 4,500 Bank 1,000 7,000 TOTAL ASSETS 83,000 85,000 FINANCED BY Capital at start 70,000 83,000 Add net profit 14,400 3,200 84,000 86,200 Less drawings 1,400 1,200 83,000 85,000 Answer each of the following questions. (a) How much is the return on capital employed for each year? (b) Give one possible reason for the fall in this ratio. (c) Suggest 2 possible remedies for falling profits. (d) What is the current ratio for each year? (e) Which current ratio is considered to be more satisfactory? (f) Explain the danger of a current ratio that is too low. (g) Give a reason for the fall in value of the machinery and the vehicles. 134 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise E2 The following figures have been prepared by M Davidson for the 2 years ended 31 May. Trading and Profit and Loss Accounts for year ended 31 May Year 1 Year 2 Sales 40,000 48,000 Less cost of goods sold Stock at start 2,500 4,500 Add purchases 32,000 32,700 Goods available 34,500 37,200 Less stock at end 4,500 30,000 5,200 32,000 Gross profit 10,000 16,000 Less expenses 8,000 12,000 Net profit 2,000 4,000 (a) (b) Calculate the following ratios for both years: (i) gross profit % (ii) net profit % (iii) rate of stock turnover. Answer each of the following questions. (i) Give one possible reason for the change in the gross profit %. (ii) (iii) In which year was M Davidson more economical with expenses for the sales level? Give a reason for your answer. What is meant by rate of stock turnover? ACCOUNTING AND FINANCE 135

FINANCIAL ANALYSIS Exercise E2 (cont d) M Davidson has also supplied the following Balance Sheets. Balance Sheet as at 31 May Year 1 Year 2 FIXED ASSETS Premises 8,000 7,000 Machinery 7,000 12,000 Vehicles 4,000 19,000 3,000 22,000 Office equipment CURRENT ASSETS Stock 4,000 4,000 Debtors 5,250 4,500 Bank 3,750 13,000 500 9,000 LESS CURRENT LIABILITIES Creditors 4,500 3,000 Bank 5,500 10,000 3,000 3,500 6,500 2,500 TOTAL ASSETS 22,000 24,500 FINANCED BY Capital at start 21,000 22,000 Add net profit 2,000 4,000 23,000 26,000 Less drawings 1,000 1,500 22,000 24,500 (c) (d) Using the above information and your answers to (a), calculate the following ratios: (i) return on capital employed (ii) current ratio (iii) debtors collection period (iv) creditors payment period. Answer each of the following questions. (i) The ideal current ratio is considered to be 2:1. Suggest one possible reason for Davidson s fairly low current ratio. (ii) What is meant by debtors collection period and what could be offered to customers to try to improve this figure? 136 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise E3 The management of Quality Doors plc has provided the figures below. Trading and Profit and Loss Accounts for year ended 31 August Year 1 Year 2 000s 000s 000s 000s Sales 200 240 Less cost of goods sold Stock at start 2 4 Add purchases 146 184 Goods available 148 188 Less stock at end 4 144 8 180 Gross profit 56 60 Less expenses 36 26 Net profit 20 34 ACCOUNTING AND FINANCE 137

FINANCIAL ANALYSIS Exercise E3 (cont d) Balance Sheets as at 31 August Year 1 Year 2 000s 000s 000s 000s 000s 000s Cost Agg Book Cost Agg Book Dep Value Dep Value FIXED ASSETS 100 12 88 134 16 118 CURRENT ASSETS Stock 4 8 Debtors 10 12 Bank 5 19 2 22 LESS CURRENT LIABILITIES Creditors 7 7 6 6 NET CURRENT ASSETS 12 16 TOTAL ASSETS 100 134 FINANCED BY Capital at start 80 100 Add net profit 20 34 100 134 (a) You are required to calculate the following ratios for both years and give one possible reason for any differences that have arisen between the two years. (i) Gross profit % (ii) Net profit % (iii) Expenses % (iv) Rate of stock turnover (v) Return on capital employed (vi) Current ratio (vii) Debtors collection period (viii) Creditors payment period 138 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise E3 (cont d) (b) Answer each of the following questions. (i) (ii) (iii) Why is it important for the firm to know the current ratio? What is meant by the rate of stock turnover? How does the calculation of ratios help in showing if a firm s performance is satisfactory for its line of business? ACCOUNTING AND FINANCE 139

FINANCIAL ANALYSIS Financial analysis: suggested solutions to extension exercises Exercise E1 (a) Return on capital employed Year 1 Year 2 14,400 x 100 3,200 x 100 70,000 83,000 = 20.6% = 3.9% (b) (c) Sales may have fallen unexpectedly; increase in costs; increase in expenses. An advertising campaign may increase sales; economies in expenditure; market research to find new products; change suppliers. (d) Current ratio Year 1 Year 2 8,000 11,500 7,000 4,500 = 1.14:1 = 2.5:1 (e) (f) (g) Year 2 is more satisfactory. A low current ratio means that the firm is in danger of being unable to pay its short-term debts, in which case it will be bankrupt. The charge for depreciation is the reason for the fall in value of these assets. 140 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise E2 (a) (i) Gross profit % (ii) Net profit % Year 1 Year 2 10,000 x 100 40,000 = 25% = 33.3% 2,000 x 100 40,000 16,000 x 100 48,000 4,000 x 100 48,000 = 5% = 8.3% (iii) Rate of stock turnover 30,000 3,500 32,000 4,850 = 8.6 times = 6.6 times (b) (i) (ii) (iii) Selling prices have increased or cost prices have decreased. In Year 1: the difference between gross profit % and net profit % (the expenses %) is 20% in Year 1 and 25% in Year 2. Rate of stock turnover means the number of times that stock is bought in and sold in a year. (c) (i) (ii) (iii) (iv) Return on capital employed Current ratio Debtors collection period Creditors payment period 2,000 x 100 21,000 = 9.5% = 18% 13,000 10,000 = 1.3:1 = 1.4:1 5,250 x 365 40,000 = 48 days = 34 days 4,500 x 365 32,000 4,000 x 100 22,000 9,000 6,500 4,500 x 365 48,000 3,000 x 365 32,700 = 51 days = 33 days ACCOUNTING AND FINANCE 141

FINANCIAL ANALYSIS Exercise E2 (cont d) (d) (i) (ii) Davidson has bought new machinery for which it seems he had to borrow money. The debtors collection period is the average time taken by debtors to settle their bills. Cash discounts could be offered to encourage prompt payment. 142 ACCOUNTING AND FINANCE

FINANCIAL ANALYSIS Exercise E3 (a) Year 1 Year 2 (i) Gross profit % 56,000 x 100 200,000 = 28% = 25% 60,000 x 100 240,000 Reason: although the sales figure hasincreased, purchases have cost proportionately more, resulting in a decrease in gross profit %. (ii) Net profit % 20,000 x 100 200,000 34,000 x 100 240,000 = 10% = 14.2% Reason: this ratio has increased because expenses have fallen even though sales were higher. (iii) Expenses % 36,000 x 100 200,000 26,000 x 100 240,000 = 18% = 10.8% Reason: expenses are lower although turnover has increased. (iv) Rate of stock turnover 144,000 3,000 180,000 6,000 = 48 times = 30 times Reason: a slowing down in sales activity means that stock is not being replenished so often. The stock figure may therefore include obsolete stock that is still being carried. (v) Return on capital employed 20,000 x 100 80,000 = 25% = 34% 34,000 x 100 100,000 Reason: this ratio has increased because the net profit % has increased. (vi) Current ratio 19,000 7,000 22,000 6,000 = 2.7:1 = 3.7:1 Reason: the current ratio is higher because of the high stock level being carried. ACCOUNTING AND FINANCE 143

FINANCIAL ANALYSIS Exercise E2 (cont d) (vii) Debtors collection period No change. 10,000 x 365 200,000 12,000 x 365 240,000 = 18 days = 18 days (viii) Creditors payment period 7,000 x 365 146,000 6,000 x 365 184,000 = 18 days = 12 days Reason: creditors are tightening their credit control policies and debts must be settled more quickly. (b) (i) (ii) (iii) The current ratio shows whether or not the firm is able to settle debts that will fall due within the next few months. If it cannot pay these it may be insolvent and have to close. Rate of stock turnover means the number of times the stock is turned over or bought in and sold in a year. A firm can compare its own ratios with those of its competitors or with those of an average firm in the same line of business. 144 ACCOUNTING AND FINANCE