This blog entry includes an example which illustrates how it is possible for a company to report profits in their annual financial statements when they sell less units than the breakeven point.

ILLUSTRATIVE EXAMPLE:

You are the management accountant of King Enterprises and you correctly calculated the breakeven point (in units) as follows:

Total fixed costs / Contribution per unit

= R4 800 000 / (R100 – R60)

= 120 000 units

During the year the company actually produced 150 000 units and sold 105 000 units. Although they sold less units than the breakeven point they are reporting a profit of R840 000 in their annual financial statements.

How is it possible for the company to report profits in their annual financial statements when they sell less units than the breakeven point?

Cost-volume-profit (CVP) analysis is consistent with the principles of variable costing and therefore only variable manufacturing costs are included in the value of inventory. Fixed manufacturing costs are treated as period costs and expensed in the period that they are incurred.

If the statement of comprehensive income is prepared using variable costing you will get the same results as the CVP analysis and the company will report a loss if they sell less units than the breakeven point:

Proof:

Breakeven point          = 120 000 units

Actual sales                 = 105 000 units

The company therefore sold 15 000 units less than the breakeven point.

The contribution per unit is R40 (R100 – R60).

The actual loss as per variable costing = R40 x 15 000 units = R600 000

It is important to note that when variable costing is used the full fixed manufacturing cost of R4 800 000 is expensed in the current period.

The fact that the company only sold 105 000 units but is reporting a profit of R840 000 in their annual financial statements is because financial statement reporting (in terms of IAS 2) uses absorption costing.

When absorption costing is used fixed manufacturing costs are included in the value of inventory (i.e. inventory includes both fixed and variable manufacturing costs). Remember when variable costing is used only variable manufacturing costs are included in the value of inventory. This means that the value of inventory will be higher when absorption costing is used.

In this example the company produced more units than what they sold (150 000 vs. 105 000) and as a result there are 45 000 units in closing inventory.  It is important that you understand if closing inventory is higher, cost of sales will be lower (closing inventory is deducted when calculating cost of sales) and consequently profits will be inflated.

The variable costing loss can therefore be reconciled to the absorption costing profit as follows:

It is important to note that when absorption costing is used the full fixed manufacturing cost of R4 800 000 is not expensed in the current period. Instead R1 440 000 is included in the value of closing inventory and the expense is deferred to the next period (this will form part of opening inventory when calculating cost of sales in the next period). As a result of this, profits in the current period are inflated by R1 440 000.

This is why management accountants prefer to use variable costing for decision making purposes.

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