Lawnmower Engines LTD: A Simple Break-Even Point Diagram

4 Operations Management
Fi g ure 1 A simple break-even point diagram

Copyright © 2016. Kogan Page. All rights reserved. May not be reproduced in any form without permission from the publisher, except fair uses permitted under U.S. or applicable copyright law.
Amount
(£s) Sales revenue Profit
Break-even point
Fixed Cost + Variable Cost
Fixed
Cost Quantity at break-even point
Quantity (units) (or Time or Amount in £s)
The slope of the sales revenue line also has an effect on the break-even point and profit; however,
operations managers are usually concerned with reducing costs and allowing the sales managers
opportunities to offer discounts and lower prices while still making a reasonable profit.
All organizations grapple with these issues and making and maintaining a profitable business
can be hard work in the face of strong price competition. In the following case study we see a
successful business trying to establish the variable costs of making products and then attempting
to see how the business might gain a greater profit from a particular deal with a customer by
identifying costs that might be reduced.
We also see how apportioning maintenance and consumables to either fixed costs or variable
costs affects the break-even point.
Lawnmower Engines Ltd

A company, Lawnmower Engines Ltd, has a number of departments making lawnmowers, power
tools and hydraulic equipment. One department, the engine assembly department, assembles var-
ious types of two-stroke and four-stroke petrol engines. The engine assembly department
makes small compact engines and manufactures to order a number of small two-stroke and four-
stroke petrol engines used in lawnmowers and other applications such as quad bikes and small
electrical generators. The two-stroke engines are of relatively simple construction. All the com-
ponents for these engines are purchased from several suppliers and are of standard designs.
A commercial customer, Snow Mobiles Ltd, has contacted the company with a requirement
for a small engine for a new snow mobile. Snow Mobiles Ltd has noted that three engines meet
the requirements of the snow mobile in terms of power and physical size. However, Snow Mobiles
Ltd is only prepared to pay £220 per engine but requires 2500 engines a year.
Unfortunately, Lawnmower Engines Ltd does not know which engine will be the most profit-
able if it were to accept the Snow Mobiles Ltd’s offer but Lawnmower Engines has data for the
three engines as shown below in Table 1. Lawnmower Engines knows that the fixed costs of the
engine assembly department for making 2500 engines are approximately £40,000 per annum.
© Mike Simpson and Andrea Genovese, 2016

EBSCO Publishing : eBook Collection (EBSCOhost) - printed on 3/22/2020 4:33 PM via UNIVERSIDAD MILITAR NUEVA GRANADA
AN: 1335071 ; Simpson, Mike, Genovese, Andrea.; Case Study: Lawnmower Engines Ltd : Variable Costs, Break-even Points and Profit
Account: s1154353
Lawnmower Engines Ltd 5
Questions
Your job as the operations manager is to:

1 Calculate the variable costs of manufacture for the three engines listed in Table 1. Note: the
company works 250 days each year, a day is eight hours working and the company employs
ten people in the engine assembly department.
2 Calculate the break-even point for each engine in terms of number of units, as a percentage
of sales and in pounds sterling.
3 Which engine(s) would you recommend for the Snow Mobiles Ltd contract?
4 What is the effect of apportioning maintenance and consumables to fixed costs instead of
variable costs?
5 If Lawnmower Engines Ltd wanted to make £120,000 profit on the deal with Snow Mobiles
Ltd what would the unit variable cost of the chosen engine need to be? What would
Lawnmower Engines Ltd need to do to achieve that profit?
6 Comment on your answer by making recommendations to Lawnmower Engines Ltd sales
department concerning which engine(s) should be offered to the Snow Mobiles Ltd customer.
Note It is a useful exercise to make a spreadsheet up to do the calculations in this

case study.
Table 1 Data for manufacture of the three engines

Items Cost per unit Engine 1 Engine 2 Engine 3
Labour £10 per hour 4 hours 4 hours 5 hours
Test engineer £15 per hour 1 hour 1 hour 1 hour
Pistons £25 each 1 piston 2 pistons 2 pistons
Piston rings £1 each 3 required per piston 3 required per piston 3 required per piston
Connecting rod £15 each 1 required 2 required 2 required
Crank shaft – 1 × £20 1 × £35 1 × £40
Bearings £2 each 2 bearings 3 bearings 3 bearings
Long bolts £1 each 4 required 6 required 6 required
Short bolts £0.50 each 4 required 6 required 6 required
Cylinder head – 1 × £20 1 × £19 1 × £18
Gear box – 1 × £11 1 × £14 1 × £15
Seals £1.00 each 2 required 3 required 3 required
Machine maintenance £1,500 per annum – – –
Gloves, oil, wipes, £10,000 per annum – – –

overalls, etc
Note The test engineer is also a labour cost and should be included in the calculations.

Account: s1154353
Answers
1C
alculate the variable costs of manufacture for the three engines
listed in Table 1. Note: the company works 250 days each year, a day is
eight hours working and the company employs ten people in the
engine assembly department.
The variable costs (VC) are:
VC = Labour + materials + components/assemblies + maintenance + consumables
Engine 1:
Assume that maintenance and consumables can be included as variable costs and calculated
as a figure for each hour of labour.
Maintenance = £1500/(250 × 8 × 10) = £0.075 per hour of labour

Consumables = £10,000/(250 × 8 × 10) = £0.50 per hour of labour
Total per hour of labour is £0.575 per hour of maintenance and consumables
5 hours of labour gives £0.575 × 5 hrs = £2.875

6 hours of labour gives £0.575 × 6 hrs = £3.45
VC = 40 + 15 + 25 + 3 + 15 + 20 + 4 + 4 + 2 + 20 + 11 + 2 + 2.875 = £163.875
to make Engine 1.
Engine 2:
VC = 40 + 15 + 50 + 6 + 30 + 35 + 6 + 6 + 3 + 19 + 14 + 3 + 2.875 = £229.875

to make Engine 2.
Engine 3:
VC = 50 + 15 + 50 + 6 + 40 + 6 + 6 + 3 + 18 + 15 + 3 + 28 + 3.45 = £245.45

to make Engine 3.
Snow Mobiles Ltd is only prepared to pay £220 per engine (presumably because of the overall
cost of the snow mobile to the final customer) as a result only one engine (Engine 1) is profitable
for Lawnmower Engines Ltd. Engine 2 and Engine 3 will make a loss on each engine and should
not be offered to Snow Mobiles Ltd.
2C
alculate the break-even point for each engine in terms of number of
units and in pounds sterling.
Break-even point for Engine 1 (the other engines make a loss) can be calculated as follows:
Sales volume per annum = 2500 units × £220 = £550,000

Total annual variable costs = 2500 units × £163.875 per engine = £409,687.50
Fixed costs are given as £40,000 for manufacturing 2500 units.

Account: s1154353
Total contribution is calculated from:

Contribution = Sales volume - Variable costs = £550,000 - £409,687.50 = £140,312.50

Contribution per unit = £140,312.50/2500 units = £56.125
Fixed Cost × Sales volume £40,000 × £550,000
B/E point (£s) = = = £156,792.87
Total contribution £140,312.50
£156,792.87 × 100
As a percentage of sales = = 28.5 per cent
£550,000
Total Fixed Cost £40,000
B/E in Units is = = = 712.7 units (of Engine 1).
Contribution per unit £56.125
Profit = Sales revenue – (Total variable costs + Fixed costs)
Profit = £550,000 - (£409,687.50 + £40,000) = £100,312.50 for 2500 units of Engine 1
sold to Snow Mobiles Ltd
Table 2 Variable costs for the manufacture of the three engines

Items Cost per unit Engine 1 Engine 2 Engine 3
Labour £10 per hour £40.00 £40.00 £50.00
Test engineer £15 per hour £15.00 £15.00 £15.00
Pistons £25 each £25.00 £50.00 £50.00
Piston rings £1 each £3.00 £6.00 £6.00
Connecting rod £15 each £15.00 £30.00 £30.00
Crank shaft – £20.00 £35.00 £40.00
Bearings £2 each £4.00 £6.00 £6.00
Long bolts £1 each £4.00 £6.00 £6.00
Short bolts £0.50 each £2.00 £3.00 £3.00
Cylinder head One required £20.00 £19.00 £18.00
Gear box One required £11.00 £14.00 £15.00
Seals £1.00 each £2.00 £3.00 £3.00
Sub total for labour £161.00 £227.00 £242.00

and materials
Maintenance and consumables (spread over the number of man hours)
Machine maintenance £1,500 per annum £0.075 per hour £0.075 per hour £0.075 per hour
of labour = £0.375 of labour = £0.375 of labour = £0.45
Gloves, oil, wipes, £10,000 per annum £0.50 per hour £0.50 per hour £0.50 per hour
overalls, etc of labour = £2.50 of labour = £2.50 of labour = £3.00
Totals £163.875 £229.875 £245.45

Account: s1154353
Note The company works 250 days each year and a day is eight hours working. Note
that Lawnmower Engines Limited employs ten people. Thus there are 20,000
man hours available per annum for making engines in the engine assembly depart-
ment.
Note With ten employees the maintenance and consumables costs can be spread
over a man hour (including the test engineer’s time too).
3 Which engine(s) would you recommend for the Snow Mobiles Ltd
contract?
Only Engine 1 is proﬁtable in that it costs £163.875 to make each engine and so only Engine 1 should
be sold to Snow Mobiles Ltd.
4 What is the effect of apportioning maintenance and consumables to

fixed costs instead of variable costs?
Note Only Engine 1 is profitable and so we can do the calculations for Engine 1.
Maintenance = £1500 pa
Consumables = £10,000 pa
Total = £1500 + £10,000 = £11,500 pa
There are 20,000 hours available for making engines (ie 250 days × 8 hours × 10 people) but
when the costs are allocated to variable costs only 12,500 hours are used for making Engine 1
for Snow Mobiles Ltd. (Note that the £40,000 fixed costs is allocated to 2500 engines.) Thus:
(12,500 hours/20,000 hours) × £11,500 = £7187.50 is the fixed costs associated with
maintenance and consumables for 2500 engines.
Thus, we can modify our calculations for Engine 1, as follows:
With maintenance and consumables taken as fixed costs:

Total fixed costs = £40,000 + £7187.50 = £47,187.50
Variable cost per unit = £161.00 (without the maintenance and consumables)
Total variable cost = £161.00 × 2500 units = £402,500
Total sales = 2500 units × £220 = £550,000
Total contribution = Sales value - Total variable costs = £550,000 - £402,500 = £147,500
Contribution per unit = Selling price per unit - Variable costs per unit =
£220 - 161.00 = £59.00

Account: s1154353
Total Fixed Cost × Sales value £47,187.50 × 550,000

B/E = = = £175,953.39
Total contribution £147,500

Break-even point = £175,953.39 (or 31.99% or 799.78 units)
Profit = Sales - Fixed cost - Variable costs = £550,000 - £47,187.50 - £402,500 = £100,312.50
Thus, the break-even point increases if the maintenance and consumables are allocated as fixed
costs but the profit remains the same (refer to Figure 1).
5 I f Lawnmower Engines Ltd wanted to make £120,000 profit on the

deal with Snow Mobiles Ltd what would the unit variable cost of
the chosen engine need to be? What would Lawnmower Engines Ltd
need to do to achieve that profit?
Using the calculations to establish what the variable cost per unit should be in order to make
a certain desired level of profit (before interest and taxation) is useful for operations managers.
We use the figures for Engine 1 as this engine will make a profit.
Profit = Sales value - Total variable costs - Fixed costs
Rearranging this equation gives:
Total variable costs = Sales value - Fixed costs - Profit

Variable cost per unit = (Sales - Fixed cost - Profit)/Number of units produced
Thus, for the example with maintenance and consumables as variable costs and with a desired
£120,000 profit required on 2500 units sold of Engine 1, we get:
VC per unit = (£550,000 - 40,000 - 120,000)/2500 units = £156.00 per unit

Note this is a reduction in variable costs of (£163.875 - £156.00) = £7.875
Thus, for the example above with maintenance and consumables as fixed costs and with a
desired £120,000 profit required on 2500 units sold, we get:
VC per unit = (£550,000 - £47,187.50 - £120,000)/2500 units = £153.125 per unit

Note this is a reduction in variable costs per unit of (£161.00 - £153.125) = £7.875 required
to achieve a profit of £120,000.
Thus, for a desired profit of £120,000 the variable cost per unit needs to be reduced by £7.875
regardless of the way the maintenance and consumables are allocated.
Thus, we find that the way the costs for maintenance and consumables are allocated (a) as
variable costs or (b) as fixed costs; does not affect the way we might think of reducing the variable
costs to achieve a certain specified profit because the value that the unit variable costs needs to
be reduced is the same (£7.875) no matter which way the maintenance and consumables are
allocated as costs.

Account: s1154353
6C
omment on your answer by making recommendations to Lawnmower
Engines Ltd sales department concerning which engine(s) should be
offered to the Snow Mobiles Ltd customer.

Engine 1 costs £163.875 to make and will be profitable, making a contribution of £56.125
per engine. (Note: Unit contribution = Unit sales price - Unit variable costs = P - VCu.)
Engine 2 costs £229.875 to make and would make a loss of £9.875 per engine.
Engine 3 costs £245.45 to make and would make a loss of £25.45 on each engine.
Engine 2 and Engine 3 should not be offered to Snow Mobiles Ltd.
Only one engine is feasible to sell to Snow Mobiles Ltd., Engine 1, which costs £163.875 to
make and will sell at £220 and make £56.125 contribution on each engine. Engine 1 will become
profitable for the company after 712.7 units have been made and sold to Snow Mobiles Ltd for
£220 each, or £156,792.87 of sales have been made of this engine at £220 per engine with an
expected profit of £100,312.50 overall.
Annual sales are expected to be £550,000 to Snow Mobiles Ltd., or 2500 units of Engine 1
and a contract should be drawn up for £220 per unit of Engine 1 with a specified minimum
order of 2500 units per annum. This will be a profitable contract for Lawnmower Engines Ltd.
but if the operations manager can reduce the variable cost of making Engine 1 by £7.875 it is
possible to make £120,000 profit. Therefore, alternative materials, methods of manufacture and
alternative sources of cheaper components should be sought to reduce the costs of making
Engine 1 and in the longer term reducing the costs of making all the engines.
While this result does not tell you which items in the bill of materials (BOM) to target to try
and reduce the cost it does give an estimate of the amount the variable cost needs to be reduced.
Much more detailed analysis of the costs of each item in the product bill of materials would
need to be carried out in order to identify ways of driving down the (variable) costs of making
the item. It should be noted that £7.875 is approximately 4.8 per cent of the cost of making
the product and could be a feasible cost reduction if the methods of manufacture were changed
to a cheaper method; or if substitute materials or alternative suppliers could be found for some
of the components in the product.
The engine assembly department has the capacity to make 2500 units of Engine 1 because
making 2500 units of Engine 1 only uses 12,500 hours per annum (5 hours per unit × 2500
units). Note that ten people working eight hours a day for 250 days gives 20,000 man hours.
Finally
Operations managers are very interested in the details of variable costs because these provide
crucial information about the amount of labour, raw materials, components, assemblies, sub
assemblies, consumables and maintenance that go into making a particular product. These variable
cost figures may be used in setting the base price for selling the products to customers (bearing
in mind the products do need to compete on price with other offerings in the market place).
These variable cost figures can also be reduced when redesigning products and various tech-
niques such as value analysis, value engineering, cost reductions via de-specifying certain non-
critical parts, using different suppliers or using alternative materials or alternative production
methods can be used to drive overall variable costs down. Such cost reductions can be very
useful in lowering the break-even point and making more profit for the company or even lead
to price reductions when required in order to compete with other, similar products in the market.
Similarly, lowering the amount of stock and work in progress in the factory can also lower the
costs and lower the break-even point for the company.

Account: s1154353
However, the biggest part of the variable cost to a company is usually labour costs and if the
company also has high fixed costs (ie has a lot of managers and administrators with salaries,
expensive rents, high council taxes or business rates, etc) then the company can find that the
break-even point is very high and the business is not very profitable (see Figure 1).
The break-even point is different if the maintenance and consumables are treated as fixed
costs instead of variable costs; although the profit remains the same if everything else remains
the same. If the break-even point were to be used as a key performance indicator (KPI) for the
business then the maintenance and consumables should be treated in exactly the same way for
each customer order. Maintenance and consumables are usually treated as variable costs because
they vary directly with the number of units produced.
It is possible for companies like Lawnmower Engines Ltd to manufacture themselves out of
business by making finished goods and putting them into the finished goods warehouse. If these
goods do not sell then the company has spent all the money on making the products (variable
costs) and managing the business (fixed costs) and the combination of costs may mean that,
if the company does not have cash flow from selling other products, the company could go into
debt and eventually go out of business. Thus, costs are a big issue in any business, including
service businesses. Although calculating variable costs, fixed costs and break-even points might
be a bit more complicated for some service businesses the same approach can be used.

Account: s1154353

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4 Operations Management

Fi g ure 1 A simple break-even point diagram

Fixed Cost + Variable Cost

Quantity (units) (or Time or Amount in £s)

Lawnmower Engines Ltd

© Mike Simpson and Andrea Genovese, 2016

Your job as the operations manager is to:

Note It is a useful exercise to make a spreadsheet up to do the calculations in this

Table 1 Data for manufacture of the three engines

Labour £10 per hour 4 hours 4 hours 5 hours

Test engineer £15 per hour 1 hour 1 hour 1 hour

Pistons £25 each 1 piston 2 pistons 2 pistons

Connecting rod £15 each 1 required 2 required 2 required

Crank shaft – 1 × £20 1 × £35 1 × £40

Bearings £2 each 2 bearings 3 bearings 3 bearings

Long bolts £1 each 4 required 6 required 6 required

Short bolts £0.50 each 4 required 6 required 6 required

Cylinder head – 1 × £20 1 × £19 1 × £18

Gear box – 1 × £11 1 × £14 1 × £15

Seals £1.00 each 2 required 3 required 3 required

Machine maintenance £1,500 per annum – – –

Gloves, oil, wipes, £10,000 per annum – – –

© Mike Simpson and Andrea Genovese, 2016

VC = Labour + materials + components/assemblies + maintenance + consumables

Maintenance = £1500/(250 × 8 × 10) = £0.075 per hour of labour

5 hours of labour gives £0.575 × 5 hrs = £2.875

VC = 40 + 15 + 50 + 6 + 30 + 35 + 6 + 6 + 3 + 19 + 14 + 3 + 2.875 = £229.875

VC = 50 + 15 + 50 + 6 + 40 + 6 + 6 + 3 + 18 + 15 + 3 + 28 + 3.45 = £245.45

Sales volume per annum = 2500 units × £220 = £550,000

© Mike Simpson and Andrea Genovese, 2016

Total contribution is calculated from:

Contribution = Sales volume - Variable costs = £550,000 - £409,687.50 = £140,312.50

Table 2 Variable costs for the manufacture of the three engines

Labour £10 per hour £40.00 £40.00 £50.00

Test engineer £15 per hour £15.00 £15.00 £15.00

Pistons £25 each £25.00 £50.00 £50.00

Piston rings £1 each £3.00 £6.00 £6.00

Connecting rod £15 each £15.00 £30.00 £30.00

Crank shaft – £20.00 £35.00 £40.00

Bearings £2 each £4.00 £6.00 £6.00

Long bolts £1 each £4.00 £6.00 £6.00

Short bolts £0.50 each £2.00 £3.00 £3.00

Cylinder head One required £20.00 £19.00 £18.00

Gear box One required £11.00 £14.00 £15.00

Seals £1.00 each £2.00 £3.00 £3.00

Sub total for labour £161.00 £227.00 £242.00

Maintenance and consumables (spread over the number of man hours)

Totals £163.875 £229.875 £245.45

© Mike Simpson and Andrea Genovese, 2016

4 What is the effect of apportioning maintenance and consumables to

Thus, we can modify our calculations for Engine 1, as follows:

With maintenance and consumables taken as fixed costs:

© Mike Simpson and Andrea Genovese, 2016

Total Fixed Cost × Sales value £47,187.50 × 550,000

Total contribution £147,500

5 I f Lawnmower Engines Ltd wanted to make £120,000 profit on the

Profit = Sales value - Total variable costs - Fixed costs

Rearranging this equation gives:

Total variable costs = Sales value - Fixed costs - Profit

VC per unit = (£550,000 - 40,000 - 120,000)/2500 units = £156.00 per unit

VC per unit = (£550,000 - £47,187.50 - £120,000)/2500 units = £153.125 per unit

© Mike Simpson and Andrea Genovese, 2016

offered to the Snow Mobiles Ltd customer.

VC = 40 + 15 + 50 + 6 + 30 + 35 + 6 + 6 + 3 + 19 + 14 + 3 + 2.875 = £229.875

VC = 50 + 15 + 50 + 6 + 40 + 6 + 6 + 3 + 18 + 15 + 3 + 28 + 3.45 = £245.45

5 I f Lawnmower Engines Ltd wanted to make £120,000 profit on the