Break-even and the Ethics of Estimating Costs
The break-even point tells a company the number of units or the amount of revenue that it must sell or earn in order to pay for all of its costs. At this point, the company has neither profit nor loss. Companies have two main types of costs: variable costs and fixed costs. Variable costs are those costs that vary with the number of units produced. Examples of variable costs are direct labor, direct materials and overhead. Fixed costs are those costs that a company incurs that do not depend on production. For example, most selling, and all administrative costs are fixed. A company must pay these costs even if it does not have any production activity.
The formulas for computing break-even follow:
B/E (# units) = . Fixed Cost .
Contribution Margin
B/E (Sales) = . Fixed Cost .
Contribution Margin Ratio
If you will notice, both formulas use something called Contribution Margin. Contribution Margin represents the amount of revenue available after all variable costs have been paid for. It represents what is left over to pay for the fixed costs. The Contribution Margin ratio is the percentage Revenue that the Contribution Margin represents.
Read the following ethical dilemma.
Spillproof Company produces molded plastic cup holders for automobiles. Below is a summary of its Contribution Margin Income Statement from last year:
- Revenues: $5,750,000
- Variable costs: $3,850,000
- Fixed costs: $2,00,000
- Net Loss: ($100,000)
Because the company's CEO is very concerned about the firm's net losses, she asks the production manager if there are any ways in which they can reduce costs.
A few weeks later, the production manager returns with a proposal to reduce variable costs to 53% of revenues by lowering the cost estimates that the company uses for environmental clean-up costs. Some years the company has to perform waste clean-up and other years it does not. Either way, the company records this estimated cost as part of Variable Cost since it is based on the number of units produced.
The CEO likes the new projected net income and new break-even point, but is concerned that this change in the estimate will misrepresent the potential liability. The manager disagrees. He feels that the company will not be violating any laws by changing their estimate, and that there is only a possibility of environmental costs in the future anyway.
Requirements for your Main thread post:
1. Calculate the CURRENT breakeven revenues using the current Contribution Margin Income Statement information above. Show us your work!
2. Re-calculate the breakeven revenues if variable costs are 53% of revenues. Show us your work!
3. Calculate Spillproof's projected Net Income/Loss. Show us your work!
Discuss the following:
- What are the ethical issues involved in this case? Explain your answer.
- Do you feel that the Production Manager is acting improperly or immorally? Why or why not? Please explain your response.
- What stakeholders would be affected if the CEO implemented the Production Managers suggestions? Why?
- What should the CEO do?