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Break-even Analysis: Assignment One.
Complete Mini Case #2. In parts "a" to "c," clearly label the calculation of the required ratios and solve using Excel. Use formulas to calculate the ratios and format the cells to insert a comma if there is more than three numbers. Round to the nearest whole number. In each part summarize your analysis in a concise management statement not to exceed 100 words each.
Problem.
Camping USA inc. has only been operating for 2 years in the outskirts of Albuquerque, N.M. and is a new manufacturer of a top of the line camping tent. You are starting an internship as assistant to the chief financial officer of the company, and the owner and CEO, tome Charles has decided that this is the right time to know more about the business and financial risks his company must deal with. For this, the CFO has asked you to prepare an analysis to support him in his next meeting with Tom Charles a week from today.
To make the required calculations, you have put together the following data regarding the cost structure of the company:
Output level120,000 units
Operating assets $6,000,000
Operating asset turnover12 times
Return on operating assets48%
Degree of operating leverage10 times
Interest Expense$720,000
Tax Rate42%
The CFO has instructed you to first determine the break 0 even pint in units of output for the company. He requires that you prepare supporting documents, which demonstrate how you arrived at your conclusion and can facilitate his review of your work. Accordingly, you are required to have the information needed to prepare an analytical income statement for the company to be presented to the CFO. In a format that is acceptable for a meeting discussion with the CEO, you also need to prepare the answers to the following questions:
a.What is the firm's break-even point in sales dollars?
b.If sales should increase by 40 percent, by what percentage would EBT and net income increase?
2.COMPUTE BREAK-EVEN POINT:
STEP 1:Compute the operating profit margin:
Operating profit Margin [M] x Operating Asset Turnover =
Return on Operating Assets.
M x 12 = 48%
M = 4%
STEP 2:Compute the sales level associated with the given output level:
Operating Assets x Operating Asset Turnover = Sales
$6,000,000 x 12 = Sales
Sales = $72,000,000
STEP 3:Compute EBIT:
Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$72,000,000 x 4% = EBIT
EBIT = $2,880,000
STEP 4:Compute revenue before fixed costs:
EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed Costs
$2,880,000 x 10 = Revenue before Fixed Costs
Revenue before Fixed Costs = $28,800,000
STEP 5:Compute total variable costs:
Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable Costs
$72,000,000 - $28,800,000 = Total Variable Costs
Total Variable Costs = $43,200,000
STEP 6:Compute total fixed costs:
Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$28,800,000 - $2,880,000 = Fixed Costs
Fixed Costs = $25,920,00
STEP 7:Find selling price per unit (P) and variable cost per unit (V):
P=Sales [STEP 2] / Output in Units
P=$72,000,000 / 120,000 units
P =$600
V=Total Variable Costs [STEP 5] / Output in units
V=$43,200,000 / 120,000 units
V=$360
STEP 8:Compute break-even point (in units):
QB=Fixed Costs [STEP 6] / (P - V) [STEP 7]
QB=$25,920,000 / ($600 - $360)
QB=108,000
After determining the break-even point using the preceding approach described, the students have the information necessary to prepare an analytical income statement as follows:
Sales / [STEP 2] / $72,000,000(Variable Costs) / [STEP 5] / (43,200,000)
Revenue before Fixed Costs / [STEP 4] / $28,800,000
(Fixed Costs) / [STEP 6] / (25,920,000)
EBIT / [STEP 3] / $2,880,000
(Interest Expense) / (720,000)
Earnings before Taxes / $2,160,000
(Taxes @ 42%) / (907,200)
Net Income / $1,252,800
Thereafter, the students have the data they need to answer questions a - e as follows:
a.Degree of Financial Leverage:
DFLEBIT=EBIT / (EBIT - Interest)
DFLEBIT=$2,880,000 / (2,880,000 - 720,000)
DFLEBIT=1.333
b.Degree of Combined Leverage:
DCLs=DOLs x DFLEBIT
DCLs=10 x 1.333
DCLs=13.33
c.Break-even point in sales dollars:
S* = F / [1 - (VC / S)]
S* = $25,920,000 / [1 - ($43,200,000 / $72,000,000)]
S* = $64,800,000
d.If sales increase 40%, by what percent would EBT increase?
% increase in EBT=% increase in Sales x DCLS
% increase in EBT=40% x 11.28
% increase in EBT=533%
e.Analytical Income Statement to verify
Sales / $100,800,000(Variable Costs) / (60,480,000)
Revenue before Fixed Costs / $40,320,000
(Fixed Costs) / (25,920,000)
EBIT / $14,400,000
(Interest Expense) / (720,000)
Earnings before Taxes / $13,680,000
(Taxes @ 42%) / (5,745,600)
Net Income / $7,934,400)
It may be useful to develop the following proof to assist in explaining the interrelationships of the various values:
% change in EBT=(EBTafter - EBTbefore) / EBTbefore
% change in EBT=($7,934,400 - $1,252,800) / $1,252,800
% change in EBT=533%
a)
The Break-even Point is the level of output that allows the firm to cover all of its variable expenses. The Breakeven Point (in sales dollars or units) is a very important figure because it is this figure that enables the manager to make a decision as to whether or not the firm should stay in business. To calculate the Breakeven Point in sales dollars, we first calculate the Contribution Margin which equals Sales price minus Variable Costs; then we divide the Contribution Margin by Sales to obtain the Contribution Margin Ratio; and finally we divide the Fixed Costs by the Contribution Margin Ratio.
b)
As per the attached excel sheet, a 40% increase in sales would result in a 533% increase in Earnings before Taxes (EBT). The percentage increase in EBT is calculated by multiplying the percentage increase in sales by the combined leverage (the product of financial and operating leverage). One thing to note here is that due to the employment of operating leverage (use of fixed operating costs in the firm’s cost structure) any percentage change in change in sales results in a much greater percentage fluctuation in the earnings before tax. Operating leverage therefore should be handled with care, a good financial manager should be very careful when introducing fixed costs into the capital structure.