535handout_2 - IS/PM 535 Handout#2 Handbook of Budgeting...

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1 IS/PM 535 Handout #2 Handbook of Budgeting, Fourth edition, by Robert Rachlin (ed), John Wiley & Sons, 1999 from 24x7 books free access Chapter 7: Break-Even And Contribution Analysis As A Tool In Budgeting, by Jay H. Loevy 7.1 Introduction. The budgeting process is the manager's primary tool for dealing with future uncertainty. In developing a period budget, managers must make certain assumptions of cause and effect: "Unit sales will increase 10% because of overall demand for the product, assuming that sales prices can be held to a 5% increase." "Gross profit percentage can be maintained despite a 6% increase in purchase costs." "Sales demand will hold steady unless there is a war in Abyssinia." Although they cannot do anything about Abyssinian affairs, managers can, to some degree, influence purchase costs, sales volume, and selling prices. How well they understand their relationship and the effect on the enterprise will largely determine the effectiveness of the business plan. This chapter describes the relationship of cost, volume, and price as well as certain techniques for integrating these considerations into the budgeting process. 7.2 Break-Even Analysis. Perhaps the best way to understand the cost–volume– profit relationship is to examine the technique commonly referred to as break-even analysis. The name is unfortunate. Except for certain situations, such as the start-up of a new business or the determination of when to pull the plug on losing operations, managers are not particularly interested in pinpointing break-even volume. The planning effort is directed toward maximizing profit, and where the break-even point happens to fall is academic. Nevertheless, the techniques used to determine break-even are useful, because they help us understand the interplay of cost, price, and volume. There are two cost elements in break-even analysis: fixed costs and variable costs. These are illustrated in Exhibit 7.1 . In this example, the fixed cost of $100 remains the same regardless of volume. The minute the doors are opened, $100 is incurred. Thus, at zero volume the chart indicates $100 of cost. The variable cost is $0.10 per unit. At a volume of 1,000 units, the total cost is $200, calculated as follows: Exhibit 7.1. Break-even analysis Doubling the volume to 2,000 units will add only $100 to total cost, since the fixed cost remains at $100. This calculation, simple though it is, illustrates the basic functioning of costs. It lies at the heart of break-even analysis and contribution analysis. Since the treatment of costs as fixed or variable is critical to the analysis, it will be useful to define and illustrate these terms.
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2 (a) Fixed Costs. Fixed costs are those cost elements that are expected to remain at a constant level regardless of the volume of business. In reality, no cost is fixed forever. It is considered fixed only under a given set of conditions. For example, the fixed cost connected with a one-shift manufacturing operation would change if the company were to go to a
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535handout_2 - IS/PM 535 Handout#2 Handbook of Budgeting...

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