Surprisingly, it is pretty easy to answer these questions...If you know how.
In fact, those who become good at this can answer these questions in their heads. Here is how it is done…
Here is the formula you can use to solveevery break-even problem. SP -VC CM -FC NI
Here is what “SP” means: SP = Selling Price -VC CM -FC NISelling Price is usually stated on a per unit basis. Forexample, A football might sell for $25.00, a car mightsell for $25,000, and a 50’ yacht might sell for$250,000.
“VC” means: SP -VC = Variable Cost CM -FC NIThere will be a more detailed discussion on variable cost,but for now… variable costs are costs such as labor tobuild or assemble the product and the materials used inthe product. They are costs that increase or decrease inproportion to how many product units are made or sold.
“CM” means: SP -VC CM = Contribution Margin -FC NISelling price less the cost to make or buy the productequals the contribution margin. For example, suppose acompany sells a football for $25.00 and it costs thecompany $15.00 to make the football. The contributionmargin would be $10.00.
“FC” means: SP -VC CM -FC = Fixed Costs NIFixed costs are those costs that stay the sameregardless of how many products are sold or made (withina reasonable range of sales or production). Someexamples may include property taxes, administrator’ssalaries, and insurance.
“FC” means: SP -VC CM -FC NI = Net IncomeNet income is simply the contribution margin minus fixedcosts. The break-even point is when net income equalszero.
Here is specific info on how to solve these problems: SP List selling price on a per unit basis. -VC CM -FC NIMost of the time you will know what a product sells for.Sometimes you might you might be told that sales areexpected to be $250,000 and it is expected that saleswill be 10,000 units. With that information, it is easy tofind the per unit sales price. If it is impossible todetermine what the per unit selling price is, do not worry. It is still possible to solve these types of problems.
Step #1: If possible, list the Selling Price (SP) on a perunit basis. For example, suppose our company makes high-end custom running shoes. The total sales is expected to be $1,000,000 and we expect to make 5,000 shoes. The selling price per unit = $200 per pair of shoes. SP $200 -VC CM -FC NI
Step #2: If possible, list the Variable Costs (VC) on a perunit basis. In our running shoes example, suppose the cost of materials and the labor to make the 5,000 shoes totals $200,000. That would be $40 per pair of shoes. SP $200 -VC 40 CM -FC NI
Step #3: Calculate the Contribution Margin on a Per Unit Basis The contribution margin is simply Sales Price – Variable Cost. SP $200 -VC 40 CM 160 -FC NI
Step #4: Include the Total Fixed Costs in the Formula Fixed costs must be listed on a grand total basis. Do not use fixed cost on a per unit basis. For example, in our custom running shoe example, the total fixed cost = $600,000 SP $200 -VC 40 CM 160 -FC 600,000 NI
Step #5: What We Have So FarRight now the numbers in the formula might look a littlestrange. Everything except Fixed Costs are listed on a perunit basis and so it would not make any sense to subtract$600,000 from $160. That would not tell us anything useful.However, the information in this format can tell us somethingvery interesting: The Breakeven Point. SP $200 -VC 40 CM 160 -FC 600,000 NI
Step #6: Breakeven PointFinding the breakeven point is simple. You need to realize that each pair ofshoes sold contributes $160 towards covering fixed costs and making a profit.In order to breakeven, you just need to cover your fixed costs. Here is howyou figure it out. SP $200 -VC 40 CM 160 -FC 600,000 NI The breakeven point = Total fixed costs divided by the contribution margin. $600,000 / $160 = 3,750 units This means, that if we make 3,750 pairs of shoes, the company will just cover its fixed costs and have a net income of zero. The company will just breakeven. It is important to know that the answer is in units and not $.
How Many Do We Need to Sell to Make a $300,000 Profit?This is also easy. Include the $300,000 desired profit in the formula. SP $200 -VC 40 CM 160 -FC 600,000 NI 300,000Instead of just covering fixed costs, we want to make an additional $300,000.This means that we need a total of $900,000. Here is how you calculate thenumber of pairs of shoes that need to be sold. $900,000 / $160 = 5,625 unitsIf the company can sell 5,625 units, it will make a profit of $300,000.
Other Ways of Saying the Same Thing Sometimes a problem might specify percentages rather than dollars. If that is the case, Selling Price is always listed as 100%. SP 100% -VC 20% CM 80% -FC 600,000 NIEverything still works the same. If you want to find the breakeven point, justdivide fixed costs be the Contribution Margin. $600,000 / 80% = $750,000This time the breakeven point is listed in $ and not units.
Other Ways of Saying the Same Thing Sometimes problems will be given in a combination of dollars and percentages. Usually the problems are still easy to figure out. For example, from the information given, can you figure out the contribution amount in either % or $? SP $400 -VC 30% CM ? -FC NIIf the Variable Costs are 30%, the Contribution Margin will be 70%. It all needsto add up to 100%. Also, the Variable costs are 30% of the Selling Price and sovariable costs = $120. The Contribution Margin must equal $280. From there itis simple to find the breakeven point.
A closer Look At Variable CostsAs you can see, the math is simple. The tricky part for students isrecognizing variable costs. Once you see how to do it, it is pretty simple.The Key: If a cost goes up proportionally with increased sales orproduction, the cost is probably a variable cost. Of course the opposite istrue also. Costs that go down proportionally with decreased sales orproduction are also probably variable costs.Let’s take the custom running shoe as an example. As more running shoesare made and sold the following costs are going to go up…Leather and fabricRubber for the bottom of the shoesShoestringsShoe boxesLabor to make the shoesElectricity to run the shoe machinesGlue to hold parts of the shoe togetherSales person commission if paid according to the quantity soldEtc. (You might be able to think of more variable costs.)
Variable Costs on a per Unit BasisIn order to solve breakeven problems, you need to be able to recognizevariable costs and then be able to assign variable costs on a per unit basis.For example: if a business plans on spending $60,000 on shoe leather andfabric, and at the same time, plans to make 5,000 shoes, the cost of shoeleather and fabric would = $12 per shoe. Getting the variable cost on a perunit basis is important. That is how the formula in all of the previousslides works.
Adding Up Variable CostsSo now you know that shoe leather and fabric is $12 per shoe. For eachvariable cost you need to find the variable cost per unit and then add upthem up for a grand total. (each cost is per pair of shoes basis)Leather and fabric $12.00Rubber for the bottom of the shoes 1.00Shoestrings .50Shoe boxes .50Labor to make each pair of shoes 20.00Electricity to run the shoe machines .50Glue to hold parts of the shoe together .50Sales person commission if paid according to the quantity sold 5.00 Total Variable Cost per pair of shoes $40.00You would use $40 as “VC” in the formula to find the breakeven point.Just as we have been doing in the previous examples.
A Fixation on Fixed CostsFixed costs remain relatively unchanged as sales and production increasesor decreases. For example: the custom running shoe factory producesbetween 4,000 and 8,000 shoes a year. This range is the normal operatingrange of the factory.As for fixed costs, take property taxes on the factory building. Each yearthe property taxes are $5,000. It does not matter if production is slow orfast. The property taxes remain the same (fixed).Another example might be the president’s salary. The president has asalary of $100,000 per year. The president’s salary is set by the board ofdirectors and does not change as production changes.Any cost that does not change as sales and production increases ordecreases, is called a fixed cost. A fixed cost should stay relatively thesame as long as the business is operating in its normal operating range.Make sure you find the Total Fixed Costs and not the fixed cost per unit.In order to make the formula work correctly, you need to have a grandtotal of fixed costs. The total fixed costs is usually a pretty big number.
The EndClick the “Back” button once or twice to end this Power Point Slide Show SP -VC CM -FC NI