Break-even Analysis

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Break-even Analysis

• Shad Valley 2011

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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
  mealsyou are on track to break even!)

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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

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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) dont
  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).

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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.

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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.

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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
of Sales and Costs
20
10
1 2
Number of units produced and sold
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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
of Sales and Costs
20
10
1 2
Number of units produced and sold
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Break - Even Analysis(Cost/Volume/Profit
Analysis)
Total Revenue Line
Total Variable Cost
10
Contribution Margin per unit 2.50
7.50
Number of units produced and sold
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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..

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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

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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 0.5
  0
• Direct labour costs (counter help
  cook) 2.75 2.75
• Total variable cost per unit 8.99 6.40

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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 0.5
  0
• 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.

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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.

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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.

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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

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Break Even Chart
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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 _at_
  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

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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.

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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 ovens and facilities have the capacity
  to produce this volume each day?
• If you are closed on Christmas, New Years or any
  other dayyou will have to sell more on the other
  days on average.
• NOW - the big question.what is the market for
  your product in that locationwho would buy
  bagels? How frequently? What is their
  purchasing behaviour? Attitudes toward price?

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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