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You are on page 1of 21

average and marginal costs, contribution, contribution

margin, unit and dollar breakeven analysis.

Marketing Metrics Reference: Chapter 3

Fixed and Variable Costs

Definition

Fixed Costs (FC): Costs that remain unchanged with volume sold.

Examples include rent for facilities, management salaries, and most

advertising media.

Definition

Variable Costs (VC): Costs that change with volume sold. Examples

include material used to construct a product, commissions paid to

salespeople, and packaging costs. Variable costs are usually assumed

to be relatively constant on a per-unit basis.

Distinguish Variable Costs from Fixed Costs

Definition

Total Costs = Total Fixed Costs + Total Variable Costs

Total costs ($)

(change at a constant

rate)

(don’t change with

units sold)

0

Units

Note visually how variable costs as well as total costs increase with units sold while

fixed costs remain constant.

Fixed or Variable?

FIXED OR VARIABLE?

Fixed Variable

More on Variable Costs

Definitions

Unit Variable Cost = Total Variable Costs for 1 Unit of Production

Total Variable Costs = Unit Variable Costs * Units Sold

Variable Mfg. Costs 2 20 200 2,000

Packaging Material 3 30 300 3,000

Unit Variable Cost 5 5 5 5

Total Variable Costs 5 50 500 5,000

In this example, the unit variable cost equals the variable mfg cost ($2) plus the

packaging material ($3). The unit variable cost remain constant at $5 as volume

increases, while total variable costs increase with volume sold.

Insight

Often, variable costs will decrease with volume. This might occur due to

impacts such as volume discounts or economies of scale.

Average Costs

AVERAGE COSTS

Definitions

Total Costs = FC + VC = Fixed Costs + (Unit Var. Cost * Units Sold)

Average Costs = Total Costs / Units Sold

Fixed Costs 500 500 500 500

Variable Mfg. Costs 2 20 200 2,000

Packaging Material 3 30 300 3,000

Total Variable Costs 5 50 500 5,000

Total Costs 505 550 1,000 5,500

Average Cost 505 55 10 5.50

Now let’s add fixed costs to our example. As the number of units sold increases,

fixed costs stay fixed at $500, unit variable costs remain constant at $5, total

variable costs increase with each additional unit sold, and the average cost per

unit decreases as more units are sold.

Marginal vs. Variable Cost

Insight

A brief digression for those remembering Economics 101

Marginal Costs vs. Variable Costs

produce an additional unit; variable cost analysis usually assumes

constant marginal cost.

• Over a wide range of output, the unit variable costs may not change.

Therefore the marginal cost of producing an additional unit and the

variable cost for that range will be the same.

• Over some range, variable costs might change (discounts from

suppliers for a larger order of packaging materials, for example) but

still would not be considered fixed costs.

Revenues and Profits

Up to now, we’ve been discussing costs. Let’s add revenues to the equation.

Total Revenues equals the selling price x unit sales. Total Contribution is the

difference between revenues and variable costs. The Profit (or loss if negative)

is the difference between total revenues and total costs.

Definitions

Total Revenues = Selling Price * Units Sold

Total Contribution = Total Revenues – Total Variable Costs

Profit (or Loss if negative) = Total Revenues – Total Costs

or Profit = Total Contribution – Fixed Costs

Total Revenues 12 120 1,200 12,000

Total Variable Costs 5 50 500 5,000

Total Contribution 7 70 700 7,000

Fixed Costs 500 500 500 500

Profit (Loss) -493 -430 200 6,500

Revenues and Profits

Adding revenues and profits to our total cost / units graph, visually, might

look something like this:

Total Revenues

Total Costs

Profit!

Total costs ($)

0

Units

• The firm becomes profitable where total revenues crosses total costs

• Since fixed costs don’t change over the short-term, they may be “sunk” costs

Contribution

CONTRIBUTION

Definitions

Unit Contribution = Selling Price per unit – Variable Cost per unit

Contribution Margin % = Unit Contribution / Selling Price per unit

Total variable costs and revenues ($)

Total Revenues

. . . minus

Total Contribution

0

Units

Take a moment to consider why unit contribution might be meaningful…

MBTN | Management by the Numbers 10

Contribution: Sample Problems

Unit Contribution is significant because it measures a net inflow of

funds to a company as additional units are sold.

Question 1: If a firm receives $12 revenue from each unit it sells, and pays

$5 per unit in variable costs, then what is the contribution of each unit?

Answer:

Unit Contribution = $12 - $5

Unit Contribution = $7

Contribution: Sample Problems

Question 2: If a firm realizes $50 in total contribution by selling 10 units of

a product at a selling price of $20, what is the unit variable cost per unit?

Answer:

And that Unit Contrib. = Selling Price per unit - Variable Cost per unit

$50 = Unit Contribution * 10

Unit Contribution = $50 / 10

Unit Contribution = $5

Unit Variable Cost = $20 - $5

Unit Variable Cost = $15

Contribution: Sample Problems

Question 3: If a firm receives $100 revenue from selling 5 units of a

product, and pays $25 in total variable costs, then what is the contribution and

contribution margin (%) of each unit?

Answer:

We know that Total Revenues = Selling Price per unit * Units Sold

$100 = SP * 5; Selling Price = $20

$25 = Unit Variable Costs * 5; Unit Variable Costs = $5

Unit Contribution = $20 - $5 = $15

Contribution Margin % = $15 / $20 = 75%

Contribution Analysis

CONTRIBUTION ANALYSIS

Some of the types of questions that contribution analysis can

help answer include:

Target unit volumes:

• Will the additional contribution cover our fixed costs and make a

“profit”?

• We want to sell 10,000 units. Will the contribution cover our fixed

costs?

How much can we afford to pay marketing to sell an additional unit?

• If an advertisement cost $1,000, how many units will we need to

sell to make it worthwhile?

• What kinds of commission programs are feasible for our

salespeople?

Breakeven

BREAKEVEN

Bug fix

Breakeven Volume in Dollars

Total Revenues

Profit!

Total costs ($)

0

Units Break-even Volume in Units

Breakeven

BREAKEVEN

• Not a loss, but zero

• Selling enough to just cover fixed costs

• Where a business becomes profitable

• Each sale contributes to covering a portion of fixed costs

• The amount each sales contributes to covering fixed

costs is the difference between unit price (revenue) and

unit variable costs (e.g. unit contribution)

• Marketers (and CFOs) like to know how high sales have

to be to “breakeven” (e.g. where do we become

profitable?)

Breakeven Formulas

BREAKEVEN FORMULAS

Two types of breakeven analysis:

Unit Breakeven = How many unit sales need to be made to cover fixed costs?

Revenue Breakeven = What level of sales are needed to cover fixed costs?

Definitions

Unit Breakeven = Fixed Costs / Unit Contribution

Unit Breakeven = Fixed Costs / (Selling Price – Variable Cost)

Revenue Breakeven = Fixed Costs / Contribution Margin %

Revenue Breakeven = Fixed Costs / (Unit Contribution / Selling Price)

With either measure it is simple to calculate the other, using price to convert.

Revenue Breakeven = Breakeven in units * Unit Price

Breakeven in Units = Dollar Breakeven / Unit Price

Also Target Profit Breakeven = (Fixed Costs+Target Profit) / Contrib Margin %

Breakeven: Sample Problems

Question 1: Mickey’s Mousetraps wants to know how many of its “Magic

Mouse Trappers” it needs to sell in order to breakeven. The product sells for

$20, it costs $5 per unit to make, and the company’s fixed costs are $30,000.

Answer:

We know that Breakeven (units) = Fixed Costs / (Selling Price – Var. Cost)

Breakeven (units) = $30,000 / ($20 - $5)

Breakeven (units) = 2,000 mousetraps

Breakeven: Sample Problems

Question 2: Mickey’s Mousetraps wants to know how many dollars worth of

its “Deluxe Mighty Mouse Trappers” it needs to sell in order to break-even on

costs. Again, the product sells for $20, it costs $5 per unit to make, and the

company’s fixed costs are $30,000.

Answer:

We know that Breakeven (units) = Fixed Costs / (Selling Price – Var. Cost)

and that Breakeven (revenues) = Breakeven units * price

Breakeven (units) = $30,000 / ($20 - $5)

Breakeven (units) = 2,000 mousetraps

Breakeven (revenues) = 2,000 * $20 = $40,000

Breakeven: Sample Problems

Question 3: Swiss entrepreneur Herr Zeitgeist buys watch faces from Italy

for 5 Euros, buys watch mechanisms for 15 Euros from Spain, and hires

assembly in Portugal for 10 Euros per watch. His only other expense is

100,000 Euros he pays the Zuricher Flughafen ad agency to place ads in in-

flight magazines to build the Zeitgeist brand.

Herr Zeitgeist sells each watch for 50 Euros to airport duty-free shops, earning

the retailer an 80% margin. What is his breakeven volume?

Answer:

We know that Breakeven (units) = Fixed Costs / (Selling Price – Var. Cost)

By reading the information provided, we see that fixed costs are 100,000

Euros, and variable costs are 5+15+10 = 30 Euros per watch.

Breakeven - Further Reference

Marketing Metrics by Farris, Bendle, Pfeifer and

Reibstein, 2nd edition, pages 65-108 (Chapter 3).

- And -

Profit Dynamics (core MBTN module). This module

builds on the breakeven analysis to volume – price

interactions and their impact on profits.

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