USE OF THE GENERALIZED BREAKEVEN

FORMULA WHEN COSTS DO NOT CHANGE

• This part will examine in detail how the GBE formula can be used.
• It is assumed that the price modifcation is being considered in a situation where the price
change will not cause, or be associated with, any changes in either fixed costs or per-unit
variable costs.
• With no change in fixed costs, the ∆FC term in the formula becomes zero
• With no change in per-unit variable costs, the ∆CM factor becomes the change in price (∆P).
• Ex. P-VC. The symbol P stands for the new price, and VC stands for the new variable costs:
P○ stands for old price, and VC○ stands for the old variable costs:

∆CM = (P-VC) - (P○ - VC○)

If the variable costs do not change (i.e VC = VC○), then ∆CM becomes equal to ∆P.

∆CM = (P-P○) = ∆P
• In situation where neither fixed costs nor per-unit variable costs do not change, the
breakeven sales level calculated from the GBE formula will be affected by three factors:
– Difference in Price
– BS and
– CM○

• It will be seen that the unit breakeven sales level can often be more easily evaluated
when thought of as a percent of base sales level and multiplying by 100:

%BE = (BE/BS)X100
 Factors that affect GBE Formula in Computing the Breakeven Sales Level
Price Change
• the decision of the manager to
increase or decrease the price
to increase profit
Base Sales
• If there is predictable change in
size of the market
• Price change by the major
competitor
Contribution Margin
• It considers similar sized
company
• The investment of the
competitor to the latest
technology keeping their labor
cost low
• The difference in price-change
decision is due to the
differences in contribution
margin
• Low contribution margins
favor price increase and high
contribution margins favor
price decrease
 Sam's Sales Data

Sales = 1000 hours/month

Current Price = $40
Variable Cost = $28 per hour
Fixed Cost = $2,400
 The Prospective Price Change
1. Sam's Janitorial Services is a small company that provides office cleaning services for
local businessess. Sales have been fairly constant at 1,000 hours per month, so the
proprietor, Sam Milstone, expects that sales will continue at the level next month if the
does not change his price. Sam's current price is $40 per hour, his variable costs are
$28 per hour, and his monthly fixed costs are $2,400. Sam first wondered if he might
be able to increase profits by lowering price. He used the GBE formula to calculate the
breakeven sales level for a price reduction of 20 percent to $32 per hour.

.
BE = {0-[$32-$40)X1,000 hours]} / $32 - $28)
= -(-8,000)/$4
BE = 2,000 hours
• Decreasing Sam’s price would result in an increase in sales, but BE computation indicates
that his sales level would have to increase by more than 2,000 hours per month before his
profits would start to increase.
• In other words, at sales of 3,000 units, Sam would just breakeven.
• If Sam felt that there was not that much price sensitivity in his market, a 200% sales increase
seemed completely impossible.
2. Sam next wondered if a smaller price decrease would be more realistic. He used the
GBE formula to calculate the breakeven sales level for a price reduction of 10%, to $36
per hour:

BE = {0-[$36-$40)X1,000 hours]} / $36 - $28)

= - (-$4,000) / $8
= 500 hours

• This breakeven sales meant that once his sales surpassed 1,500 hours per month (a 50%
increase in sales), then his profits would begin to increase.
• This seemed reasonable, but Sam still felt uncomfortable. A 50% sales increase seemed a
lot for a price decrease of only 10%.
3. Sam’s next step was to consider the possibility that he might be able to increase profits
by raising his price a little. He used the GBE formula to calculate the breakeven sales
level for a price increase of 10%, to $44 per hour:

BE = {0-[$44-$40)X1,000 hours]} / ($44 - $28)

= - ($4,000) / $16
= -250 hours

• A breakeven of -250 hours meant that if the price increase caused sales to drop by that
amount, to 750 hours per month, Sam’s gross profits would be exactly the same as they
were before the price change. This means that Sam would have a -250 hours per month of
sales cushion.
• If sales decreased by less than 250 hours per month, then Sam’s profits would be greater
than before the price change. If sales decreased by more than 250 hours per month, then
Sam would have exceeded his sales cushion, and would have less profit than before the
price change.
• Sam felt that most of his clients trusted him to do reliably good work and that it seemed
unlikely that he would lose 250 hours per month from a modest $4 per hour price increase.

4. Sam wondered if a larger price increase might be even better. He used the GBE
formula to calculate the breakeven sales level for a price increase of 20%, to $48 per
hour:

BE = {0-[$48-$40)X1,000 hours]} / $48 - $28)

= -($8,000) / $20
= - 400 hours

• This BE sales level meant that if Sam lost less than 400 hours per month, his profits would
be higher than before the price change. If his sales decreased by more than 400 hours per
month, then his profits would be lower than before the price change.
• Sam recognized that a sales decrease of 400 hours is a lot. However, he also knew that
several of his largest clients were price-sensitive. If the $8 per hour price increase caused
them to leave, then he would lose more than 40% of his sales.
 Effect of Price Change on Breakeven Sales Level

Price Change BE

20% ↓ ($32) 2,000 (200%)

10% ↓ ($36) 500 (50%)

10% ↑ ($44) * -250 (-25%)

20% ↑ ($48) -400 (-40%)

• The example illustrates basic logic of using breakeven analysis to assist in
price-modifications.
• It involves computing the breakeven sales level for various prospective price
changes and comparing this breakeven against an estimate of the likely
actual sales response.

• Both price increases and price decreases should be investigated; each is

capable of producing increases in gross profits.

• It is usually wise to investigate several levels of price change for each of the
two price-change directions (increase/decrease).
Base Sales

• It can be reasonable to assume that the current sales level is the sales level
that will continue if no price modification is made. Current sales can be used
as an estimate of base sales.

• Situations exist however, where the base sales will differ from current sales.

• Examples of this situation is where there is a predictable change in the size

of the market.
• In the Sam’s Cleaning Service Illustration, let’s say that the amount of office space in his
market area will increase by 20% next year when several new office buildings will be
completed. Even if Sam makes no price change, it can be expected that his sales will
increase by 20% next year.

• Thus for a breakeven calculation for a prospective price change that would be implemented
next year, the base sales would be 1,200 hours per month, rather than the current sales level
of 1,000 hours.

• If Sam wanted to consider putting off until next year the 10% price increase, the breakeven
calculation would be:

BE = {0-[($44-$40) x 1,200 hours]}/($44 - $28)

= - ($4,800)/$16
= -300 hours
• Note that this refers to a decrease from 1,200 hours per month - his total sales would have to
be above 900 hours for the price increase to be profitable.

• Another example where the base sales will differ is a price change by a major competitor.
• If Sam’s largest competitor implemented a 10% price decrease, Sam might estimate that
keeping his price unchanged would result in a 20% loss of sales, to 800 hours per month. In
this case, the base sales for the breakeven calculation would be 800 hours. If Sam is
considering matching his competitor’s 10% price decrease, he could use the GBE formula as
follows:

BE = {0-[($36-$40) x 800 hours]} / ($36-$28)

= - (-$3,200) / $8
= 400 hours
• This breakeven sales level indicates that Sam should not match his competitor’s price
decrease. Sam is better off to forego the price change and allow his sales to decrease to
800 hours.
 Effect of Base Sales on Breakeven Sales Level

Price Change Base Sales BE

10% ↑ 1,000 -250

10% ↑ 1,200 -300

10% ↓ 1000 500

10% ↓ 800 400

Contribution Margin
• Say that one of Sam’s competitor’s is a similar-sized company called JaniTech, Inc. This
company has invested in the latest machinery for cleaning offices, and thus, they are able to
keep their labor costs to a bare minimum.
• Let’s assume that, like Sam’s company, JaniTech charges customers $40 per hour and has a
base sales level of 1,000 units per month. However, unlike Sam’s company, JaniTech’s
variable costs are $16 per hour and its monthly fixed costs are $14,400.
• If JaniTech used the GBE formula to consider the four prospective price changes that Sam
considered, the breakeven sales levels would be as follows:

A price reduction of 20%, to $32 per hour: A price reduction of 10%, to $36 per hour:
BE = {0 - [($32 - $40) x 1,000]} / ($32 - $16) BE = {0 - [($36 - $40) x 1,000]} / ($36 - $16)
= - (-$8,000) / $16 = - (-$4,000) / $20
= 500 hours = 200 hours
A price increase of 10%, to $44 per hour: A price increase of 20%, to $48 per hour:

BE = {0 - [($44 - $40) x 1,000]} / ($44 - $16) BE = {0 - [($48 - $40) x 1,000]} / ($48 - $16)
= - ($4,000) / $28 = - ($8,000) / $32
= -143 hours = -250 hours
 Effect of Before-Change Contribution Margin on Breakeven Sales Level
Price Change Sam's BE Janitech's BE
(CM○ = $12, or 30%) (CM○ = $24, or 60%)
20% ↓ 2,000 500
10% ↓ 500 200 *
10% ↑ -250 * -143
20% ↑ -400 -250

• JaniTech’s management would probably shy away from the 10% price increase that Sam
favored.
• If the resulting sales decrease was any greater than only 14.3% of sales, their gross profits
would decrease. On the other hand, JaniTech’s management might show interest in the 10%
price decrease. If it resulted in a sales increase to any degree greater than a modest 20% of
their base sales, their gross profits would increase.
• The difference in price-change decision is due to the differences in contribution margins
between two companies.

• Low contribution margins, like those of Sam’s, even a small price increase increases the
contribution margin by a relatively large proportion.
• With low contribution margins, price increases tend to be more attractive.

• With high contribution margins, such as those of JaniTech’s, every additional unit of sales
brings in a large chunk of contribution.
• With high contribution margins, price decreases tend to be more attractive.
 CHANGE-IN-PROFIT FORMULA

• Breakeven analysis in a price-modification decision involves evaluating the breakeven's

critical sales level for the prospective price change against the expected actual sales
response to the price change.

• Keep in mind that the expected sales response---like the breakeven sales level --- is a
change from the base sales level.

• If a manager calculates that the breakeven sales level for a prospective price decrease is
100 units (an increase over base sales of 100 units) and expects the sales change resulting
from that price decrease to be 120 units (an increase over base sales of 120 units), then the
manager could conclude that going ahead with the price decrease will increase the gross
profits associated with the product.
• A manager who is evaluating a prospective price change will want to know more than just
whether or not expected sales change would surpass the critical sales level.

• The manager might be interested to know how a particular expected sales change, resulting
from the prospective price change, would change the product's gross dollar profits.

• This can be calculated by subtracting the breakeven sales level (in units) from the expected
sales change (in units) and multiplying the difference by the contribution margin.

Change in profit = (Expected unit sales change - BE unit sales) X CM

Example: The manager who calculated the 100-unit breakeven for the price decrease might
want to know how much the estimated 120-unit actual sales change would affect profits. If the
product’s contribution margin after the price decrease is $14, the manager could use the
change-in-profit formula, as follows:

Change in profit = (expected unit sales change - BE unit sales) x CM

= (120 units - 100 units) x $14
= 20 units x $14
Change in profit = $280