Case Study On Cost Volume Profit Analysis And Fortescue Metals Group -

Questions: 1. Why is an uderstanding of cost behaviour important (e.g. fixed costs, variable costs, etc.). 2. Explain the meaning of contribution, and break-even analysis and discuss their usefulness. 3. Break-even/CVP analysis seems to be a great tool. Does it have any weaknesses? 4. Analyse FMG 2014 and 2015 Annual Reports and discuss the factors that influence the miners break-even costs. 5. Analyse the iron ore industry market and discuss which iron ore comapanies are at most risk. Answers: 1. Importance of Understanding of Cost Behaviour The relationship between an activity and its cost is known as cost behaviour. It is important to study cost behaviour because it helps the manager in making decisions regarding the preparation of budgets, production, etc. Basically, there are three types of cost behaviour namely, fixed costs, variable costs, and mixed cost.[1] Behaviour of a cost is significant for managers to have a clear understanding of overall cost structure of the company. Economies of scale, a level of profitable price for the products, and break-even point can also be determined with the help of cost behaviour. Additionally, it is also beneficial for managers to forecast budget as well as cash flow for the business, analyze the various fluctuations, (monthly and quarterly) and identify the variances from the forecast done.[2] Cost, which does not change on changing sales volume or the production, is known as fixed cost or period cost. It includes costs related to machinery, buildings, rent, salary, etc.[3] Fixed costs are helpful in reduction of cost for the business, if the level of production is high. It can act as the barrier to entry for new competitors, if a company has high fixed cost in the industry. 2. Meaning Usefulness of Contribution and Break-even analysis Break-even analysis: It is a way to analyze the point at which revenue equals the cost associated with the revenue. It has various uses such as decision making related to buying and manufacturing. If variable cost is less as compared to the prices paid to suppliers then the company should be prepared for manufacturing the products in the company only else via-a-verse.[7] Break-even analysis helps a company in taking decisions regarding production planning that can give maximum contribution in fixed cost as well as profit. In addition to this, it is important for financial structure planning of the firm and significant tool for controlling the cost which cannot be unnoticed. It is also helpful in decision-making to financial management when the condition of uncertainty arises.[8] Moreover, a margin of safety can be determined by break-even analysis. The calculation becomes quick and easy with the use of Break-even analysis that is helpful in making quick estimations. Break-even point can be presented as below figure: 3. Weaknesses of Break-even/ CVP Analysis Break-even point, no-loss point or zero profit point is a point where firms neither earn profit nor face any loss. It helps the owner of business and managers for the covering expenses of the business after which the business will generate profit in a sales needed. The sales volume required to break-even is known as break-even analysis.[9] It is helpful for managers for understanding the business proposition viability but it has also various weaknesses such as difficulty in calculating break-even for that business who is dealing with more than one product[10]. It is unrealistic to have straight line representation of costs and revenue. It is sometimes impossible to have same fixed cost and sales price for the different level of the production. With the use of break even method, a margin of safety is ignored that is offered by convertible for making the payment of the principal amount on maturity.[11] Changes taking place frequently in the product selling price can affect the reliabil ity of break-even analysis. Sometimes, data can be inaccurate or misleading that can lead to incorrect break-even forecasts.[12] It has no scope of keeping stock as it is assumed that total output produced will be sold. Many times, it oversimplifies the situation of a business such as average revenue and variable costs are considered for the calculation but in real life there will be more considerable variations. From the above-stated weakness, it can be said that it is a planning aid and should not be used for decision-making tool.[13] 4. Factors influencing the miners break-even costs The cost of sales was $US 6051 in 2015 and $US 6078 in 2014. From the data collected, it is noted that Fortescue's break-even point fell more than the other miners, by $US48.10 a tonne. There are many factors that influence the break-even costs such as market demand, cash cost, quality, sales volume, price per unit reduction in direct labour cost, variable cost, and fixed cost. Miners break-even cost is influenced by cash cost, quality consideration, and freight. Quality consideration of Fortescue Metals Group (FSUGY) has grades below 58% with 100% fines production. In freight, Fortescue is closer to the end market so only its grades and fines production led to a discount on the benchmark prices.[14] Fortescue was aiming for a $US36 a tonne break-even in the year 2015 but tracking at around $US37. UBS puts Fortescue's break-even at $US39 a tonne.[15] The sustainability is protected by Fortescue by reducing costs that helped to lower its cash costs that dropped to $US14.79 in December quarter 2015 from $US15.80 in March quarter 2015. Key components of miners' break-evens such as mine-site cash costs were controlled by the company that were the fourth largest contributor to the collective reduction in break-even levels, the declining contribution is about $US4.30 a tonne to the collective $US32.10 a tonne.[16] As on 30 June 2015, cash and cash equivalents were US$2,381 million as compared to 30 June 2014, it was US$2,398 million. Operating cash flows for the financial year 2015 were US$2,037 million and in the year 2014, it was US$6,248 million. Companys interest and finance cost paid was US$605 million and US$853 million in 2015 and 2014 respectively showing a reduction in interest an finance cost paid. Dividend payments were of US$343 million in 2015 and US$581 million in 2014 that also includes the payment of a final dividend of 10 Australian cents.[17] From the above, it can be said that cost of break-even point has declined in the year 2015 as compared to previous year that was influenced by cash cost, quality consideration, and freight. As stated by Nev Power, chief executive of the Fortescue, the biggest opportunity for reduction of the break-even cost was finance instead of its mining operations, mainly with the interest repayments reduction.[18] 5. Iron ore industry market analysis and companies at most risk For analysis of iron ore industry, porters five forces are evaluated as below: Threat of new entrants: Barrier to entry is high in iron ore industry because high set up cost is needed with many government rules and regulations for leasing and licensing. Bargaining power of suppliers: Suppliers bargaining power is high as there are very few suppliers who can supply the specialist equipments required by the company. This industry has suppliers in labour, materials, energy, shipping, and energy costs for which negligible substitutes are available. Therefore, the bargaining power of suppliers is strong[19]. Bargaining power of buyers: There is moderate to low bargaining power of buyers as there are many substitutes which are not available in large quantity. Rivalry among industry: There is medium or low threat of rivalry due to less number of competitors. Threat of substitutes: It is medium to low in this industry because there are many substitutes as raw material products available in the market.[20] Grange Resources (54), BC Iron (52), Anglo American (51) and Atlas Iron (46) are the iron ore companies who are among the most risk facing companies because they have high break-even prices. It indicates that companies are unable to manage various costs such as variable, fixed, semi-variable cost, etc.[21]. References A $US40 iron ore price will actually help BHP and Rio. The Australian. Last modified: December 02, 2015, Annual Report 2014, Fortescue Metals Group (FMG), Last modified: 2014, Annual Report 2015, Fortescue Metals Group (FMG), Last modified: 2014, Bebbington, Jan, Jeffrey Unerman, and Brendan O'Dwyer.Sustainability accounting and accountability. UK: Routledge, 2014. Bevis, Herman W.Corporate Financial Accounting in a Competitive Economy (RLE Accounting). UK: Routledge, 2013. Collier, Paul M.Accounting for managers: Interpreting accounting information for decision making. USA: John Wiley Sons, 2015. Droms, William G., and Jay O. Wright.Finance and accounting for nonfinancial managers: All the basics you need to know. UK: Basic Books, 2015. DRURY, C. M.Management and cost accounting. Germany: Springer, 2013. Easton, P. D., Wild, J. J., Halsey, R. F., and McAnally, M. L. Financial accounting for MBAs. UK: Cambridge Business Publishers, 2013. Edwards, J. R.A History of Financial Accounting (RLE Accounting) (Vol. 29). USA: Routledge, 2013.