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Breakeven Analysis


1.   Introduction

Wellington Ltd is a boot manufacturing and it is currently selling its principal product ”„Napoleon”¦ to three major outlets in the UK.  The present capacity is 3,200 pairs of boot per year but it is under-utilized as the budget for the next year is 1,400 pairs with a loss of £10,300.  The company is expecting sales to increase by approximately 350 pairs of boots each year due to the expanding of market. 

At the same time, Fortunately Super Boot Ltd is approaching Wellington to produce 500 pairs test order of higher-grade product with Super Boot ”„own label”¦ and subsequent orders would depend on how successful the test is. 

This report is to analyse the two options of either selling Napoleons or Super Boot, to outline options that are available and to draw conclusion with recommendations in order to aid the management of Wellington Ltd to make final decision.

2.   Data Summary for the Analysis

The following table has summarized all the data for the analysis:

 

Napoleon

Super Boot

Selling Price

£75

£85

Variable Cost

£39.5

(£55,300/1,400)

£55

(£39.5+£15+£1-£0.50)

Contribution per unit

(Unit selling price ”V Unit variable cost)

£35.5

(£75-£39.5)

£30

(£85-£55)

Contribution margin

(Contribution/Selling price)

47%

35%

Fixed Cost

£60,000

£47,000

(£60,000-£17,000+£20,000/5)

Breakeven point units

(Fixed costs/contribution per unit)

1,690 pairs

(£60,000/£35.5)

1,567 pairs

(£47,000/£30)

3.   Analysis of Present Position against the Option of Selling Super Boot Only

A profit-volume graph is produced as below to compare the two options: 

Option 1: Remain present position to continue selling only Napoleon

Option 2: Selling only the Super Boot

The profit-volume graph shows that option 2 (selling only Super Boot) leads to faster increases in profits as output grows, and gives smaller losses if output is below breakeven. 

However, the two lines are not parallel and they will eventually meet at a point that the profits are same at the same volume of sales.  After this point, option 1 (selling only Napoleon) will make more profits than option 1.  Hence, this graph is not sufficient to make a decision in longer-term.

4.   Options Available

In order to make an accurate decision, the potential profitability over the next five years for both options are calculated using the following formula:

NP = Px ”V (a + bx)

Where:

NP =       net profit

x = volume of sales

P = selling price

b = unit variable cost

a = total fixed costs

The assumptions for this calculation of potential profits are made as following:

(1)   The selling price, unit variable costs and total fixed costs remain constant for the next five years.

(2)   Wellington Ltd will only produce single product (either Napoleon or Super Boot) in the next five years.

(3)   The sales increments for Napoleon are the same prediction as the management, ie to increase approximately 350 pairs of boots each year.

(4)   The Super Boot market test is successful, sales of Super Boots in Year 1 is 1,400 pairs with the potential for growth thereafter similar to Napoleon for easy comparison.

The potential profits are shown in the following table and figure:

 

Year 1

Year 2

Year 3

Year 4

Year 5

Volume sales (pairs)

1,400

1,750

2,100

2,450

2,800

Napoleon potential profits (£)

(10,300)

2,125

14,550

26,975

39,400

Super Boot potential profits (£)

(5,000)

5,500

16,000

26,500

37,000

With the above table and figure, the following options are available:

Option 1: Remain the present position to continue selling only Napoleon

According to the information, Napoleon can generate more potential profits than Super Boot starting year 3.  It is a safer business as Napoleon is the company”¦s own brand and they may use other strategies to build additional market shares that is favourable to the company for the long-term.  The cost would involve heavily in marketing Napoleon and this cost is an unknown factor for investigation.

Option 2: Selling only the Super Boot

Although the potential profits for Super Boot starts to be less than Napoleon in year 3, the company does not need to worry about the marketing strategy of the products and solely focus on the production.  The cost is that the company would lose its edge when Fortunately Super Boot Ltd has any financial problems or withdrawal of any orders.

Option 3: Selling both the Napoleons and Super Boot

The present capacity of the company is 3,200 pairs of boots per year.  Based on the sales forecast, the capacity will still be under-utilized in the five-year time.  The management can consider to selling both the Napoleons and Super Boot in order to fully utilize the capacity and maximize profits.  However, doing this way might lose the economies of scale that gained from selling only one product.

5.   Conclusion and Recommendations

As a conclusion, selling Napoleon only will generate more profits in the long-term while selling Super Boot only will generate more profits in the short-term.  Both options are not the best as the capacity of 3,200 pairs of boots per year are still under-utilized.  Therefore, it is recommended the company to choose Option 3: selling both the Napoleons and Super Boot simultaneously.  The following factors should be considered for this option: 

(1)   The company should negotiate and agree a sales volume each year with Fortunately Super Boot Ltd to protect the company interests and to ensure the capacity is fully utilized. 

(2)   As mentioned, the company should consider the problem of economies of scale.  Thus, the management should evaluate whether the costs will be increased and the capacity will be decreased for making two products.  That is, it is necessary to re-evaluate all options when the data for option 3 is available before any final decision. 

(3)    It is suggested that sensitivity analysis should be done to test how the result will be changed if the original estimates or the underlying assumptions change. 

(4)   Note that there is bound to be uncertainty about future sales and hence this decision is reached will depend to some extent on the management”¦s attitude to risk.


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