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A second tool for management decisionmaking that has grown out of cost/volume/profit analysis is breakeven analysis.
Once you know what your variable costs are, as well as your overall fixed costs for the business, you can determine your breakeven point: the volume of sales needed to at least cover all your costs. You can also compute the new breakeven point that you'd need to meet if you decided to increase your fixed costs (for example, if you undertook a major expansion project or bought some new office equipment).
Your breakeven point can be determined by using the following formulas:
- Sales Price per Unit — Variable Costs per Unit = Contribution Margin per Unit.
- Contribution Margin per Unit divided by Sales Price per Unit = Contribution Margin Ratio.
- Breakeven Sales Volume = Fixed Costs divided by Contribution Margin Ratio.
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Assume that the financial statements for Lillian's Bakery reveal that the bakery's fixed costs are $49,000, and its variable costs per unit of production (loaf of raisin coffee cake) are $.30.
Further assume that its sales revenue is $1.00 per loaf. From this information, it can be determined that, after the $.30 per loaf variable costs are covered, each loaf sold can contribute $.70 toward covering fixed costs.
Dividing fixed costs by the contribution to those costs per unit of sales tells Lillian's Bakery at what level of sales it will break even. In this case: $49,000/$.70 = 70,000 loaves.
As sales exceed 70,000 loaves, Lillian's Bakery earns a profit. Sales of less than 70,000 loaves produce a loss.
Lillian's Bakery can see that a 10,000 loaf increase in sales over the breakeven point to 80,000 loaves will produce a $7,000 profit, and a 30,000 loaf increase to 100,000 will produce a $21,000 profit. On the other hand, a decline in sales of 10,000 loaves from breakeven to 60,000 loaves will produce a loss of $7,000, and a 30,000 decrease from the 70,000 breakeven point produces a $21,000 loss. |
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In the example above, a 25 percent increase in sales from 80,000 loaves to 100,000 loaves would produce an increase in profits from $7,000 to $21,000. Similarly, a small drop in sales below breakeven would produce a substantial increase in loss. How is this explained? There is obviously more involved than simply trying to determine the breakeven point. In the next section, we'll show that the concept of operating leverage explains why the mix of fixed and variable costs can have a large effect on your profit levels, as your sales volume increases and decreases.
Here's a handy interactive calculator that'll do a breakeven computation for you.
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