Introduction Grear Rafting Company, owned by Peggy Grear is a company that provides rafting services to rafters. Grear Rafting Company, henceforth referred to as Grear Rafting, has just gone through its first season in business on which it provided rafting services to 1,048 rafters for seven (7) days. During these seven (7) days, Grear Rafting also provided meals to the rafters three times a day, it also provides the rafts used during the season. During its first season, however, Grear Rafting experienced a loss.
Peggy Grear has enough savings to get Grear Rafting through another season or two of business, but Grear Rafting would have to shut its business down if it does not make a profit (Houston Baptist University, 2012). In this paper, I would show what Grear Rafting requires to break-even and make a profit. Grear Rafting’s income statement from its first season is shown below on Table 1. Table 1. Grear Rafting CompanyIncome StatementYear Ended December 31, 2012| Revenue | | $1,048,000| Rental Expense| (208,600)| |
Meals Expense| (314,400)| | Advertising Expense| (50,000)| | Compensation to Guides| (471,600)| | Salary Expense| (16,500)| | T-shirts and Hats Expense| (31,440)| | Office Utility Expense| (3,850)| | Gross Income (Loss)| | $(48,390)| Variable and Fixed Costs There are different types of costs associated with the running of Grear Rafting. In order to develop a plan for Grear Rafting to make a profit, it is necessary to identify those costs that can be changed, and those that cannot be changed. 1. Variable Cost:
A variable cost is a cost that increases in total as output increases and decreases in total as output decreases. (Rich et al, 2010). For example, cotton used in making cotton shirts is a variable cost. As a company makes more cotton shirts, it needs more cotton to produce the shirts. The variable costs incurred by Grear Rafting are: * Meals provided to rafters ($314,400): the rafting trip is for seven (7) days, so as more rafters use Grear Rafting’s services, Grear Rafting would incur more costs in providing meals to the rafters for the time period of seven (7) days.
If less rafters use Grear Rafting, the cost of providing meals would decrease. * Compensation paid to guides ($471,600): the compensation paid to the guides is paid on commission basis. Therefore, if more rafters use Grear Rafting’s services, the commission to the guides would increase, causing the compensation cost to increase as well, and if less rafters use Grear Rafting’s services, the compensation cost would also decrease. * T-shirts and hats provided to rafters ($31,440): the number of rafters that used Grear Rafting this season was 1,048.
This incurred the cost of t-shirts and hats of $31,440. If more rafters come in the next season, the cost of providing t-shirts and hats would also increase. So also, if fewer rafters come in the next season, the cost of providing t-shirts and hats would decrease. 2. Fixed Cost: A fixed cost is a cost that does not increase as total output increases and does not decrease as total output decreases. For example, the cost of property taxes on a factory stays the same no matter how much the factory produces.
The quantity produced does not have an effect on the cost of property taxes; they only change because the city or county government raises taxes (Rich et al, 2010). Fixed costs incurred by Grear Rafting in its first season include: * Rental cost of rafts and camping equipment ($208,600): the rafts and equipment are rented on an annual basis, and additional rafts and equipment are not available to Grear Rafting. Since the rafts and equipment are rented annually, the number of rafters does not affect the cost of the rafts and equipment because these are rented not based on the number of rafters expected, but based on what is available. Advertising expense ($50,000): the cost for advertising Grear Rafting does not depend on how many rafters use Grear Rafting. Advertising is a way to introduce the company to the public, and whatever advertising means Peggy Grear decides to use is billed to Grear Rafting no matter how many rafters it serves. * Salary of office manager ($16,500): the salary paid to the office manager is a fixed cost because no matter how many rafters come for the season, the salary is an established amount that is agreed upon by the manager and Peggy Grear.
Therefore, the cost of paying salary to the manager is fixed and is not based on how many rafters there are in the season. * Office utility expense ($3,850): this expense is a fixed cost because it is based on the utility that is used in the office and not on the number of rafters there are. Product and Period Costs 1. Product Cost: Product costs are costs, both direct and indirect, of producing a product in a manufacturing firm or of acquiring a product in a merchandising firm and preparing it for sale (Rich et al, 2010).
For example, the metal used in making a car, the hours put into making that car, and depreciation on equipment are product costs. The product costs incurred by Grear Rafting include: * Rental cost of rafts and camping equipment ($208,600): this is a product cost because the rafts and camping equipment are rented for the current season. These would be used during the rafting season at Grear Rafting. * Meals provided to rafters ($314,400): this is a product cost because the meals are provided for the rafters during the seven (7) days they are rafting.
The meals are not prepared for the long-run, but only for the space of time for the rafting season for Grear Rafting. * Compensation paid to guides ($471,600): the compensation paid to the guides is a product cost because the compensation is paid for the specific rafting season concerned; it is not a long term payment to the guides. * T-shirts and Hats provided to rafters ($31,440): this is a product cost because the t-shirts and hats provided to the rafters are purchased for the specific season based on how many rafters available. They are not purchased on a long-term basis. . Period Cost: Period costs are costs that are not carried in inventory; all costs that are not product costs. That is, all areas of the value chain except for production (Rich et al, 2010). For example, costs of advertising, salaries to the CEO, and research and development activities are not added to inventory, thereby making them period costs (Rich et al, 2010). The period costs incurred by Grear Rafting include: * Advertising expense ($50,000): the advertising cost is only incurred when Grear Rafting advertises the company for rafting services. Salary of office manager ($16,500): the salary of the office manager is a cost that does not deal with production, or in this case, with the activities of Grear Rafting during this season. * Office utility expense ($3,850): this is a period cost because the cost is expensed in the period it occurs. Break-Even Based on the information provided earlier, there are several changes Peggy Grear can make that would affect Grear Rafting’s ability to break-even or even make a profit. A breakeven point is the point where total revenues equal total cost, and net income is zero (0).
Break-even can be calculated in sales dollars and in units. Break-even is calculated by dividing total fixed cost by the price minus the variable cost per unit; and break-even in sales dollars is calculated by dividing total fixed expenses by the contribution margin ratio. The contribution margin ratio is the percentage of sales dollars remaining after variable costs are covered (Rich et al, 761). The table below is a contribution margin income statement from which we can understand how to calculate break-even. Table 2.
Grear Rafting CompanyContribution Margin Income StatementYear Ended December 31, 2012| Sales ($1,000 X 1,048)Total variable expenses Total contribution marginTotal fixed expenses Operating Income| Total$1,048,000 817,440 230,560 278,950 (48,390)| Per Unit$1,000 780 220 | Contribution Margin Income Statement Contribution margin is the difference between sales and variable expenses. It is the amount of sales revenue left over after all the variable expenses are covered that can be used to contribute to fixed expense and operating income (Rich et al, 758).
To calculate break-even, the Cost-volume-profit (CVP) analysis is needed. CVP analysis estimates how changes in costs, both variable and fixed, sales, volume, and price affect a company’s profit. CVP, an important tool used by managerial accountants, is used to reach important benchmarks such as a company’s break-even point. It is useful to organize costs into variable and fixed components for a CVP analysis. The contribution margin income statement format is based on the separation of costs into variable and fixed components. Table two (2) above shows the format for the contribution margin income statement.
When recast as an equation, the contribution margin income statement becomes more useful for solving CVP problems. The operating income equation can be expanded by expressing sales revenues and variable expenses in terms of unit dollar amounts and the number of units sold. So, the operating income equation becomes: Operating income = (Price x number of units sold) – (Variable cost per unit x Number of units sold) – Total fixed cost (Rich et al, 758). For a company to break-even, its operating income should equal zero (0). Grear Rafting’s break-even point will be calculated in units and in sales dollars.
For Grear Rafting to break-even, we need to consider the number of rafters that came for the past rafting season. Grear Rafting had 1,048 rafters in the past season; to be able to reach break-even, Grear Rafting needs approximately 1,268 rafters. This was determined by dividing the total fixed cost ($278,950) by the price per rafter ($1,000) minus the variable cost per unit ($780). To calculate the break-even point in sales dollars, total variable costs are defined as a percentage of sales rather than as an amount per unit sold. The break-even point in sales dollars for Grear Rafting is $1,268,000).
This was calculated by dividing the total fixed cost ($278,950) by the contribution margin ratio (22%) which was calculated by dividing the contribution margin per unit ($220) by the price per rafter ($1,000). The contribution margin per unit was calculated by subtracting the variable cost per unit ($780) from the price per rafter ($1,000). To determine how Grear Rafting can make a profit, there are several costs that need to be reduced. First, however, it is necessary to determine the number of rafters Grear Rafting needs to achieve a target income that would yield a profit.
If Grear Rafting’s target income is $49,000, then the number of units it needs to earn it can be calculated by adding the total fixed cost ($278,950) to the target income ($49,000) and dividing it by the price ($1,000) minus the variable cost per unit ($780). The number of units Grear Rafting needs to earn its target income is $1,490. 68 or approximately $1,491 rafters. Therefore, Grear Rafting’s margin of safety in units, which is calculated by subtracting break-even units (1,268) from sales (1,491), is 223 units, and ts margin of safety in sales dollars, which is calculated by subtracting the break-even volume ($1,268,000) from the revenue ($1,491,000), is $223,000. Recommendations Meals: The first cost that needs to be tackled is the cost of meals to the rafters. The cost of meals provided to the rafters in Grear Rafting’s first season cost $314,000. It can be deduced that Grear Rafting is spending a lot of money on meals for the rafters. To reduce the amount of money spent on meals, Grear Rafting could look for cheaper means of providing meals to the rafters. Impact of Recommendations Conclusion References