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Break Even Analysis: New vs Old Plant

The document analyzes the financial impact of a company upgrading to a new production plant versus keeping its old plant. It calculates key metrics like break-even point, contribution margin, operating leverage, and margin of safety for both plants across multiple years. While the new plant has a higher break-even sales level of $4.25M, it offers benefits like lower variable costs, higher profits at higher sales levels, and ability to achieve a 12% profit target at $6.07M in sales by 2017. However, there are also risks like potential losses if sales miss projections in the first year after upgrading. An important consideration is the company's risk tolerance for the potential upside against downside of the new plant investment.

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4 views5 pages

Break Even Analysis: New vs Old Plant

The document analyzes the financial impact of a company upgrading to a new production plant versus keeping its old plant. It calculates key metrics like break-even point, contribution margin, operating leverage, and margin of safety for both plants across multiple years. While the new plant has a higher break-even sales level of $4.25M, it offers benefits like lower variable costs, higher profits at higher sales levels, and ability to achieve a 12% profit target at $6.07M in sales by 2017. However, there are also risks like potential losses if sales miss projections in the first year after upgrading. An important consideration is the company's risk tolerance for the potential upside against downside of the new plant investment.

Uploaded by

prashantgargindia_93
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

Break Even point=Since variable exp=82% of sales, in order to achieve break even

point fixed expenses needs to be 18% of sales


Break even point is achieved = sales= fixed cost+variable cost
100%=18%+82%
Therefore, 450,000=18%
Breakeven point will be achieved at (450,000*100)/18=2,500,000

(a) Contribution format income statement (with old plant)


Year 2015
Sales

4,400,000

Less variable expenses (82% of sales)

3,608,000

Contribution margin

792,000

Less Fixed Expenses

450,000

Net income

342,000

Year 2016
Sales

4,840,000

Less variable expenses (82% of sales) 3,968,800


Contribution margin

871,200

Less Fixed Expenses

450,000

Net income

421,200

Year 2017
Sales

5,324,000

Less variable expenses (82% of sales) 4,365,680


Contribution margin

958,320

Less Fixed Expenses

450,000

Net income
(b) Operating leverage

508,320

2015
(4,400,000-3,608,000)/((4,400,000-3,608,000)-450,000)=2.32
2016
(4,840,000-3,968,800)/((4,840,000-3,968,800)-450,000)=2.07
2017
(5,324,000-4,365,680)/((5,324,000-4,365,680)-450,000)=1.89
Margin of safety
2015
=(4,400,000-2,500,000)/4,400,000=43.18%
2016
=(4,840,000-2,500,000)/4,840,000=48.35%
2017
=(5,324,000-2,500,000)/5,324,000=53.04%

Calculations with new plant


Break even point is achieved = sales= fixed cost+variable cost
100%=40%+60%
Therefore, 1,700,000=40%
Breakeven point will be achieved at (1,700,000*100)/40=4,250,000

(a) Contribution format income statement (with new plant)


Year 2015
Sales

4,600,000

Less variable expenses (60% of sales)

2,760,000

Contribution margin

1,840,000

Less Fixed Expenses

1,700,000

Net income

140,000

Year 2016
Sales

5,290,000

Less variable expenses (60% of sales) 3,174,800


Contribution margin

2,116,000

Less Fixed Expenses

1,700,000

Net income

416,000

Year 2017
Sales

6,083,500

Less variable expenses (60% of sales) 3,650,100


Contribution margin

2,433,400

Less Fixed Expenses

1,700,000

Net income

733,400

(b) Operating leverage


2015
(4,600,000-2,760,000)/((4,600,000-2,760,000)-1,700,000)=13.14
2016
(5,290,000-3,174,000)/((5,290,000-3,174,000)-1,700,000)=5.09
2017
(6,083,500-3,650,100)/((6,083,500-3,650,100)-1,700,000)=3.32
Margin of safety
2015
=(4,600,000-4,250,000)/4,600,000=7.61%
2016

=(5,290,000-4,250,000)/5,290,000=19.66%
2017
=(6,083,500-4,250,000)/6,083,500=30.14%

Misses the market in 2015 (without new plant)


Year 2015
Sales

3,200,000

Less variable expenses (82% of sales)

2,624,000

Contribution margin

576,000

Less Fixed Expenses

450,000

Net income

126,000

Misses the market in 2015 (with new plant)


Year 2015
Sales

3,200,000

Less variable expenses (60% of sales)

1,920,000

Contribution margin

1,280,000

Less Fixed Expenses

1,700,000

Net income

-420,000

12% target profit (new plant)


For achieving 12% target profit, the structure should be
Variable=60%
Fixed=28%

Profit=12%
Fixed cost=1,700,000=28%
Therefore, sales=6,071,429
The sales level will be reached on the year 2017.

12% target profit (old plant)


For achieving 12% target profit, the structure should be
Variable=82%
Fixed=6%
Profit=12%
Fixed cost=450,000=6%
Therefore, sales=7,500,000
The sales level will be reached on the year 2021.
Risks associated with new plant
(i)
(ii)
(iii)

The risk of loss increases due to higher break even point for the company.
The profitability may take a hit due to lower margin of safety in
comparison to old plant.
There is an opportunity cost associated in case company miss the market.

Merits associated with the new plant


(i)
(ii)

Operating leverage being higher proves beneficial in earning higher profits


from the incremental revenues
An important factor here is lower variable cost which helps in yielding
higher profits with increase in sales

Course of action for the management


(i)

(ii)

Decision to add a new plant depends on the expectation of growth in sales


to 15% in future. Net income Margin with new plant will be higher in 2017
in comparison to older plant.
Risk is associated with adding a new plant, and hence, the companys risk
appetite is very important before landing into a critical decision.

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