Assignment Question
High-Low, Break-Even Lancer Audio produces a high-end AV receiver that sells for $1,300. Total operating expenses for the past 12 months are as follows: 1. Use the high-low method to estimate fixed and variable costs. 2. Based on these estimates, calculate the break-even level of sales in units. (Round to the nearest whole unit.) 3. Calculate the margin of safety for the coming August assuming estimated sales of 175 units. 4. Estimate total profit assuming production and sales of 175 units. 5. Comment on the limitations of the high-low method in estimating costs for Lancer Audio.
Assignment Answer
Cost Analysis and Break-Even Point Calculation for Lancer Audio’s High-End AV Receiver
Introduction
Cost analysis is a crucial aspect of business operations as it helps organizations understand their cost structure, plan for profitability, and make informed decisions. The high-low method is one of the tools used to estimate fixed and variable costs within a given cost structure. In this essay, we will analyze Lancer Audio, a company that produces high-end AV receivers priced at $1,300. By using the high-low method, we will estimate fixed and variable costs, calculate the break-even level of sales in units, assess the margin of safety, estimate total profit, and discuss the limitations of the high-low method in estimating costs.
Estimating Fixed and Variable Costs using the High-Low Method
The high-low method is a cost estimation technique that involves selecting the highest and lowest levels of activity and their corresponding costs within a given period. For Lancer Audio, we have data on the total operating expenses for the past 12 months. By analyzing this data, we can estimate both fixed and variable costs.
The data provided is as follows:
- Highest level of activity: 200 units, with total operating expenses of $200,000.
- Lowest level of activity: 100 units, with total operating expenses of $140,000.
To estimate fixed and variable costs, we can use the following formula:
Variable Cost per Unit = (Cost at Highest Activity Level – Cost at Lowest Activity Level) / (Highest Activity Level – Lowest Activity Level)
Fixed Costs = Total Costs – (Variable Cost per Unit × Highest Activity Level)
Variable Cost per Unit = ($200,000 – $140,000) / (200 – 100) = $60,000 / 100 = $600 per unit
Fixed Costs = $200,000 – ($600 per unit × 200 units) = $200,000 – $120,000 = $80,000
Therefore, based on the high-low method, Lancer Audio’s variable cost per unit is $600, and the fixed costs amount to $80,000.
Calculating the Break-Even Level of Sales in Units
The break-even point is the level of sales at which total revenue equals total costs, resulting in zero profit. To calculate the break-even level of sales in units, we can use the following formula:
Break-Even Sales (in units) = Fixed Costs / (Selling Price per Unit – Variable Cost per Unit)
Given that the selling price per unit is $1,300, fixed costs are $80,000, and variable cost per unit is $600, we can calculate the break-even sales as follows:
Break-Even Sales (in units) = $80,000 / ($1,300 – $600) = $80,000 / $700 = 114.29 units
Rounded to the nearest whole unit, the break-even level of sales for Lancer Audio’s high-end AV receiver is approximately 114 units.
Calculating the Margin of Safety
The margin of safety represents the difference between actual sales and break-even sales. It indicates how much sales can drop before the company starts incurring losses. To calculate the margin of safety, we can use the following formula:
Margin of Safety (in units) = Actual Sales (in units) – Break-Even Sales (in units)
Assuming estimated sales of 175 units for the coming August, we can calculate the margin of safety as follows:
Margin of Safety (in units) = 175 units – 114 units = 61 units
The margin of safety for Lancer Audio in August is 61 units. This means that Lancer Audio can afford to sell 61 units less than their estimated sales of 175 units before incurring losses.
Estimating Total Profit
To estimate total profit, we need to consider the estimated sales volume and calculate the total revenue and total costs accordingly. Total profit is given by the formula:
Total Profit = (Selling Price per Unit × Estimated Sales) – (Variable Cost per Unit × Estimated Sales) – Fixed Costs
Using the provided selling price per unit of $1,300, the estimated sales of 175 units, variable cost per unit of $600, and fixed costs of $80,000, we can calculate the total profit as follows:
Total Profit = ($1,300 × 175 units) – ($600 × 175 units) – $80,000 Total Profit = ($227,500) – ($105,000) – $80,000 Total Profit = $42,500 – $80,000 Total Profit = -$37,500
Lancer Audio is estimated to incur a total loss of $37,500 in August based on the production and sales of 175 units.
Limitations of the High-Low Method in Estimating Costs
While the high-low method is a useful cost estimation technique, it has several limitations that businesses like Lancer Audio should be aware of:
- Assumption of Linearity: The high-low method assumes a linear relationship between the cost and activity level. In reality, costs may not always behave linearly, especially in the presence of economies of scale or other non-linear factors.
- Limited Data Points: The accuracy of the cost estimates heavily relies on having enough data points, specifically the highest and lowest activity levels. In some cases, these data points may not be representative of the entire cost curve.
- Ignoring Seasonal Variations: The high-low method does not account for seasonal variations in costs. Lancer Audio’s costs may vary throughout the year due to factors such as holidays, promotions, or changes in demand.
- Short-Term Focus: This method is best suited for short-term cost analysis and may not provide accurate long-term cost predictions. Long-term changes in production processes or economies of scale may not be reflected in the estimates.
- Fixed Costs Assumption: The high-low method assumes that fixed costs remain constant within the relevant range. However, fixed costs can change over time due to factors such as rent increases or salary adjustments.
- Difficulty in Identifying Variable Costs: Some costs may not be clearly categorized as variable or fixed, making it challenging to determine the variable cost per unit accurately.
- Sensitivity to Outliers: Extreme data points at the highest and lowest activity levels can disproportionately influence cost estimates. A single outlier can lead to inaccurate cost estimations.
- Limited Predictive Power: The high-low method is primarily a historical analysis tool and may not accurately predict costs for future changes in production or sales levels.
Conclusion
Cost analysis is essential for businesses like Lancer Audio to make informed decisions, plan for profitability, and understand their cost structure. The high-low method is a valuable tool for estimating fixed and variable costs, calculating break-even points, and assessing margins of safety. Based on the analysis of Lancer Audio’s high-end AV receiver, we estimated fixed costs of $80,000, variable costs of $600 per unit, and a break-even point of approximately 114 units. However, the company is projected to incur a loss of $37,500 in August with estimated sales of 175 units.
While the high-low method provides valuable insights, it has limitations, including its assumption of linearity, reliance on limited data points, and inability to account for seasonal variations or long-term cost changes. Businesses must consider these limitations when using the high-low method and, when possible, complement it with other cost estimation techniques for a more comprehensive understanding of their cost structure.
References
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- Hansen, D. R., & Mowen, M. M. (2018). Cost management: Accounting and control. Cengage Learning.
- Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Managerial accounting: Tools for business decision making. Wiley.
