By: Tracy Porter
Copyright 2007
£ Refurbishment 30,000 Weight training equipment 10,000 Sauna equipment 5,000 Total 45,000
Refurbishment and equipment costs are to be depreciated over a period of six years using the straight-line method, assuming a scrap value of £0 at the end of the period.
Depreciation is defined as “the measure of the cost or revalued amount of the economic benefits of the tangible fixed assets that have been consumed during the period”. The aim of depreciation in this context, therefore, “is to spread the cost of the asset over the life of the business” (The Financial Training Company, 2005:15).
There are at least seven ways to calculate depreciation, with the two most commonly used methods being the straight-line method and the reducing balance method (The Financial Training Company, 2005). The straight-line method is by for the most commonly used basis of depreciation; as well over 80% of major companies today have adopted it (Holmes et al, 2005).
The straight-line method of calculating depreciation identifies an equal depreciation charge in each period of the asset’s life and is calculated as follows:-
Annual charge = cost – residual value (if any)
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Useful economic life
In Maria’s case, the only two assets she intends to purchase are weight training equipment and sauna equipment. Although the refurbishment could be seen as an expense of the business, tenants’ improvements are items that can also be depreciated (Holmes et al, 2005). Although it is not known whether Maria owns the property or intends to rent it, the major cost of the refurbishment in this example will incur a depreciation charge.
In Maria’s case, therefore, the straight-line method of depreciation will be calculated as:-
Annual charge = £45,000 – £0.00 = £7,500 per year for six years
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6 years
The double entry accounting for Maria’s depreciation would appear as follows:-
Debit Bank Account Credit £ £ Year 1 Fixed Asset Acct 45,000 Debit Fixed Asset Account Credit £ £ Year 1 Bank Account 45,000 Debit Depreciation Expense Account Credit £ £ Year 1 Provision Account 7,500 Debit Provision for Accumulated Depreciation Credit £ £ Year 1 Dep Expense Acct 7,500
The £45,000 would be taken out of the bank as a credit and placed in the fixed asset account as a debit on the balance sheet. The depreciation expense account is an expense of the business and is therefore seen as a debit on the extended trial balance. The expense account would be cleared every year with the amount of £7,500 debited to the profit and loss account. The provision for accumulated depreciation account is a continuing account and would accumulate every year, being seen as a credit on the balance sheet.
The balance sheet for the six year period would appear as follows:-
Cost
Accumulated Net Book
depreciation Value
£ £ £
Year 1 45,000 7,500 37,500
Year 2 45,000 15,000 30,000
Year 3 45,000 22,500 22,500
Year 4 45,000 30,000 15,000
Year 5 45,000 37,500 7,500
Year 6 45,000 45,000 0
Referring back to the question regarding Maria’s proposed business, it has also been asserted that the recurring annual costs will be:-
£ Maintenance 3,000 Insurance 4,000 Total 7,000The above costs are considered to be indirect costs or overheads of the business because they cannot be traced directly and in full to the service that is being provided (University of Leicester, 2006).
The overheads that must be accounted for annually are:-
£ Depreciation expense 7,500 Maintenance expense 3,000 Insurance expense 4,000 Total 14,500
In the question, staff costs will vary according to the level of demand. It is expected that staff costs will average out at £100 per customer per year. An annual membership fee of £150 per year will be charged. It is envisaged that the staff costs will be considered direct costs because they can be traced in full to the service being provided. There was no mention of any indirect labour costs, which can include idle time, overtime, and bonuses (University of Leicester, 2006).
The labour costs are considered variable costs because they will vary in direct proportion to the level of business. The overheads, on the other hand, are fixed costs because they are costs that will be incurred regardless of the level of activity within the business.
In the example given, Maria would like to know how many members she will need to enroll every year before the business breaks even.
The first step that must be taken to determine how many members will need to enroll before Maria’s proposed business will break even is to determine the contribution, which measures the difference between the sales price of a unit and the variable costs of making and selling the unit (The Financial Training Company, 2005). In Maria’s case, one unit would be an annual membership fee.
The formula for calculating contribution is:-
£ Sales price X Less variable costs (X) Contribution XThe contribution for Maria’s proposed business would therefore be calculated as:-
£ Sales price (annual membership fee) 150 Less variable costs (staff per head) (100) Contribution 50Since the contribution has been found, the question of how many members will need to enroll before the proposed business breaks even can be found by determining the break-even point. The break-even point is defined as “the volume of sales at which neither a profit nor a loss is made, ie the volume of sales at which total contribution is equal to total fixed costs” (The Financial Training Company, 2005:66).
The formula for calculating the break-even point is as follows:-
Break-even point = Fixed costs
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Contribution per unit
Because fixed costs and contribution have previously been determined, the values only need to the put into the above formula as follows:-
Break-even point = 14,500 = 290
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50
The answer to the question, therefore, is that Maria would need to sell 290 annual memberships in order for the proposed business to break even.
This figure can be further verified by preparing an absorption costing statement for the hypothetical 290 annual memberships that Maria would need to sell:-
Profit statement – Absorption costing
£
Sales (290 annual memberships) 43,500
Less cost of sales (100 * 290 annual memberships (29,000)
Gross profit 14,500
Less fixed costs (14,500)
Profit for period 0
References
The Financial Training Company (2005). Unit 5: Maintaining Financial Records and Preparing Accounts: Pocket Notes, FTC Foulks Lynch Ltd: Wokingham, England
The Financial Training Company (2005). Unit 6: Recording and Evaluating Costs and Revenues: Pocket Notes, FTC Foulks Lynch Ltd: Wokingham, England
Holmes, G. et al (2005). Interpreting Company Reports and Accounts, 9th Edition, FT Prentice Hall: London, England
University of Leicester (2006). 2501 Accounting and Financial Statement Analysis 11th Edition, Learning Resources, Cheltenham.