Break-even Analysis

Shad Valley 2007

Break - Even Analysis
(Cost/Volume/Profit Analysis)

 This is a planning and control technique.

 PLANNING:
– make informed decisions about pricing your product or
service and the cost to produce it.
 CONTROL:
– compare your actual results with those that you have
forecast. (For example, your restaurant may require you to
sell 10,000 meals at $10.00 per meal = $100,000 in order to
break even annually. This works out to 192 meals a week or
28 per day. If on the first day of operation you sell 30
meals…you are on track to break even!)
Break - Even Analysis
(Cost/Volume/Profit Analysis)

 The break-even point can be found using the

following equation:

B.E. Point = Fixed Costs

Contribution Margin

= Fixed Costs
Selling price/unit - Variable Cost/unit
Cost Behaviour
 You can classify fixed and variable costs according to how they
change in response to changes in sales volume.
 Fixed Costs
– are costs that (within the relevant range) don’t change in response
to changes in sales volume.
– Examples include depreciation expense, rent, salaries and other
overhead costs.
 Variable Costs
– are costs that (within the relevant range) change in response to
changes in sales volume.
– Examples include direct materials and direct labour costs (wages
paid by hour).
 Relevant Range
 The relevant range is the range of output (units produced and
sold) that the cost and pricing assumptions can reasonably be
expected to hold. Total
Revenue
$ of
Total Costs
Sales
and
Costs Fixed
Costs

# of units produced and sold

Relevant Range
 Relevant Range
 If sales are expected to push the firm beyond its current
physical capacity, (beyond the relevant range) cost behaviour
assumptions must be revised. Total
Revenue
$ of Total Costs
Sales
and
Costs Fixed
Costs

# of units produced and sold

Relevant Range
 Break - Even Analysis
(Cost/Volume/Profit Analysis) Total Revenue
Line
$ of The slope of the
revenue line is
Sales determined by the
and price that you set
Costs for your product
or service.
Sales revenue
$20 when price per
unit is $10.00.
$10

1 2
Number of units produced and sold
 Break - Even Analysis
(Cost/Volume/Profit Analysis) Total Revenue
Line
$ of The slope of the
revenue line is
Sales determined by the
and price that you set
Costs for your product
or service.

$20
Sales revenue
$10 when price per
unit is $5.00.
1 2
Number of units produced and sold
 Break - Even Analysis
(Cost/Volume/Profit Analysis) Total Revenue
Line
$ of The slope of the
revenue line is Total Variable
Sales determined by the Cost
and price that you set
Costs for your product If variable cost
or service. per unit is less
than price per unit,
there is a positive
contribution
$10 margin.
Contribution Margin per unit = $2.50
$7.50
1 2
Number of units produced and sold
Contribution Margin
 For most small businesses, it is relatively easy to determine the
variable cost per unit.
 What you want to determine is how much it costs you in terms
of direct material and direct labour to produce your product or
service.
 Once you know the variable cost per unit, this becomes a good
guide to you in the pricing decision. Obviously, if you price your
product under your variable cost per unit, you will lose money
each time you sell one unit. The more you sell, the more money
you lose.
 Look at the following example…..
Contribution Margin Example
 You plan to start a bagel shop.
 The average customer will purchase a dozen bagels, some cream
cheese and a coke.
 You have determined that your variable costs to produce this ‘average
customer purchase’ as follows:

Variable Cost per unit

Coke and cup $0.85
12 Bagels cooked (materials and electricity) 2.99
Cream cheese and container 1.65
Straw/napkins/bag and other condiments 0.75
Direct labour costs (counter help & cook) 2.75
Total variable cost per unit $8.99
 Given your analysis you initially price coke at $2.00 and a dozen bagels
with cheese for $8.50 giving you a contribution margin of $1.51 per unit.
Total cost to the customer is $10.50 plus PST and GST or $12.08
Contribution Margin ….
 You now find out that the Great Canadian Bagel sells coke for
$1.75 and a dozen bagels with cheese for $6.50 for a total cost
to the customer of $9.49 (including Gst and Pst)…this is below
your estimated variable cost per unit!
 The Great Canadian Bagel is a franchise that benefits by the
fact that the franchisor has tremendous buying power (centrally
negotiates purchases and prices with suppliers for flour, cream
cheese and coke). This gives them a competitive advantage
over you...
Variable Cost per unit Great Canadian
Bagel
Coke and cup $0.85 $0.45
12 Bagels cooked (materials and electricity) 2.99 1.50
Cream cheese and container 1.65 1.20
Straw/napkins/bag and other condiments 0.75 0.50
Direct labour costs (counter help & cook) 2.75 2.75
Total variable cost per unit $8.99 $6.40
Contribution Margin ….
 Conclusion: if you are to compete with the Great Canadian
Bagel purely on price, you will fail.
Variable Cost per unit Great Canadian
Bagel
Coke and cup $0.85 $0.45
12 Bagels cooked (materials and electricity) 2.99 1.50
Cream cheese and container 1.65 1.20
Straw/napkins/bag and other condiments 0.75 0.50
Direct labour costs (counter help & cook) 2.75 2.75
Total variable cost per unit $8.99 $6.40

Selling Price to the Public per unit $10.50 $8.25

Contribution margin per unit $1.51 $1.85

Your variable cost per unit is higher than the Great Canadian Bagels variable cost per unit.

Your proposed selling price is 27% higher than your competition yet your proposed
contribution margin is 18% lower.
Contribution Margin Analysis
 Faced with this pricing and costing analysis, you have some
choices:
– forget about going into this business
– seek to negotiate arrangements where your direct operating costs
can be lowered
– devise a product or marketing strategy that would induce
consumers to purchase your products over the Great Canadian
Bagel product (higher quality product, perceived greater value that
justifies the higher price)
– seek to locate your business somewhere there is no direct
competition. (Nipigon, Marathon, Atikokan, Sioux Lookout)
 Of course, further analysis will be required (before proceeding)
to determine whether you could actually make a profit at the
business.
Contribution Margin
 The contribution margin is the amount of money that
is available from the sale of each unit to cover the
fixed costs of the firm.
 Once those fixed costs are covered, any further units
that are sold will result in profit….
Break Even Point
 Is the point where total revenue equals to total costs
 Variable and Fixed costs are summed to equal total costs.

Break even point in units = Annual Fixed Costs / contribution margin

 Break Even Chart
Total
Revenue
$ of TR = TC
Sales
Total Costs
and
Costs
Fixed Costs

# of units produced and sold

Break Even Point
in Units
Annual Fixed Costs of the Bagel
Business
 Let us assume for a moment that you have decided to locate your
proposed business in Nipigon where you are sure that there is no
competition, and it is unlikely competition would enter the market
after you arrive.
 You estimate that once established, you will face the following fixed
costs each year to run the business:

Annual building lease costs (12 months @ $2,000/month) $24,000

Office expenses (bank charges, accountant etc.) 8,000
Depreciation of equipment (ovens, microwave, etc.) 4,400
Gross Salary for the manager 34,000
Employer contribution to CPP/EI and employer health tax 9,520
Other fixed costs (advertising and promotion) 2,000
TOTAL ANNUAL FIXED COSTS $81,650
Break Even Point of the Bagel
Business
 The breakeven point, given your analysis to this point is:

Break-even point in #’s of meals annually = Annual Fixed Costs

Contribution Margin
= $81,650
$1.51
= 54,073 meals

This works out to 4,507 meals per month or 149 meals per day.
Break Even Point of the Bagel
Business
 Break-even point = 54,073 meals

This works out to 4,507 meals per month or 149 meals per day.

 This implies baking and selling 1,788 bagels per day with no
wastage.
– Do your oven’s and facilities have the capacity to produce this volume
each day?
– If you are closed on Christmas, New Year’s or any other day…you will
have to sell more on the other days on average.
– NOW - the big question….what is the market for your product in that
location…who would buy bagels? How frequently? What is their
purchasing behaviour? Attitudes toward price?
Break Even Point of the Bagel
Business
 Break-even point = 54,073 meals

 At an average price per sale of $10.50, that volume of meals

means annual sales revenue of:

Annual Sales Revenue = Price per meal times # of meals

= $10.50 * 54,073
= $567,766.50