Breakeven Budgeting IB Syllabus 5.3 Text 5.2

Breakeven  A business can work out how what volume of sales it needs to achieve to cover its costs. This is known as the break even point.  One key to break even is to work out the contribution made from the sale of each unit.  The amount of money each unit sold contributes to pay for the fixed and indirect costs of the business.

Break Even Point  BEP (units) = TFC/(SPU-VCU) Total fixed costs Selling price per unit Variable costs per unit  BEP ($'s) = BEP (units) * SPU

Contribution margin  Contribution = selling price less variable cost per unit  E.g. a product sells for £15 and has variable costs per unit of £11. Each unit sale therefore makes a contribution of £4 towards the fixed costs of the business. If the business had fixed costs of £20,000, then it would need to sell 5,000 units (£4 x 5,000 = £20,000 contribution) in order to break even.

Example  An importer buys bottles of a particular type of French wine for £2 a bottle, stores them in a warehouse and then advertises them for sale over at £4 each. The fixed costs of running the business are £10,000 a month. Calculating contribution per bottle: Direct cost = £2 per bottle Variable cost = 50P per bottle Sales revenue = £4 per bottle Contribution = £1.50 (£4-£2.50)

Calculating Break Even Point  BEP (units) = TFC/(SPU-VCU) TFC: £ 10,000 SPU: £ 4 VCU: £ 2.50  BEP = £ 10,000/ £ 1.50 = 7000 units (rounded up from 6,667)  BEP ($'s) = BEP (units) * SPU  BEP = 7000 * £ 4 = £28000

Break even activity: Roy’s Soyburgers  The variable unit cost for making one soy-based burger is $.97.  The fixed cost of making burgers for 18 months will be a total of: $140,000. Remember, fixed costs cover things like your rent, your phone bill, and insurance coverage - these items tend not to vary in amount per month over the term of one year.  Your partner has forecast expected unit sales of 150,000 burgers in 18 months. The unit price you are projecting for the burger is: $1.99.This is your best estimate of what the average consumer will pay for your soy-burger. If you charge $1.99 for your burger, how many burgers will you have to sell before you make back your total cost: $140,000 + (150,000 burgers x 97 cents)?

Roy’s Soyburgers Breakeven  I don't know about you, but I am uncomfortable with a break-even volume of 137,000 units when expected unit sales are only 150,000 units. Wouldn't you be?  What if your colleague overestimated the demand? What if the economy slows down?  Sales forecasts for new products are notoriously inaccurate, and giving yourself less than a 10% margin for error seems risky. If your banker is willing to wait longer than 18 months to see a profit, no problem. But if you think that the banker will call your loan, you may want to consider a different pricing strategy.  Lucky for you, another MBA partner has been doing additional research and discovered that because Clevelanders are concerned with their health, they are willing to pay up to $2.79 for a gourmet burger of the top quality you propose.

 The variable unit cost for making one burger is $.97  The unit price you think you might sell the burger for is: $2.79.  The fixed cost of making burgers for 18 months will be a total of: $140,000.  If you charge $2.79 for your burger, how many burgers to breakeven? What is the break even point when the unit price is raised to $2.79?

Roy’s Soyburgers Breakeven  At a unit price of $2.79, our break- even volume on burgers sold drops to 76,900 units. You should be able to sell this many burgers in nine to eleven months if your forecasts are accurate to +/- 20%. This is going to make your banker happier!

Roy’s Soyburgers  What if your variable costs could be decreased to $.80? What are some things you could do to lower your variable costs?  What if you could get your fixed costs down to $100,000 over that same period of time? What are some things you could do to lower your fixed costs?

Breakeven analysis spreadsheet  Break-Even Analysis.xls Break-Even Analysis.xls

Safety margin  The margin of safety is the difference between the number of units of planned or actual sales and the number of units of sales at break even point.  If planned sales were thought to be 6,000 units, then the margin of safety would be 6,000 units – break even 5,000 units = 1,000 units. The business would be able to sell 1,000 less than planned before they were in danger of making a loss.

Drawing break-even charts 1. Label the vertical axis “sales and costs in dollars or pounds”. 2. Label the horizontal axis “sales/production (units)”. 3. On another piece of paper sketch the scales that you want to use given the data, then use this plan on the chart. 4. Plot any two points from the sales revenue data for the sales revenue line and then draw a straight line for sales revenue (assumes that the price per unit does not change) – if the information is not given for sales revenue, then work out two points, e.g. for 1000 units sold and 1500 units sold. The start of the line should be through the origin (where the axes meet). 5. Draw a horizontal line for total fixed costs starting at the point on the vertical axis at the level of costs. 6. At the same starting point it is possible to draw the total costs line. Total costs are fixed costs plus variable costs. Work out what the total costs are for say 1000 units and 1500 units. Then draw the straight line starting at the same point as the fixed costs started and then through the two plotted points. 7. Where the sales revenue crosses the total costs line is the break even point. Read off the units of sales to give the break even level of sales. 8. The gap between the total costs line and sales revenue line after the break even point represents the level of profit.

Break Even Analysis Costs/Revenue Output/Sales Initially a firm will incur fixed costs, these do not depend on output or sales. FC As output is generated, the firm will incur variable costs – these vary directly with the amount produced. VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC TC Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially. The lower the price, the less steep the total revenue curve. TR Q1 The break even point occurs where total revenue equals total costs – the firm, in this example, would have to sell Q1 to generate sufficient revenue to cover its costs.

Break Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 If the firm chose to set price higher than £2 (say £3) the TR curve would be steeper – they would not have to sell as many units to break even TR (p = £3) Q2

Break Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs. TR (p = £1) Q3

Break Even Analysis Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 Loss Profit

Margin of Safety Costs/Revenue Output/Sales FC VC TC TR (p = £2) Q1 Q2 Assume current sales at Q2. Margin of Safety Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made. TR (p = £3) Q3 A higher price would lower the break even point and the margin of safety would widen.

Break Even Analysis  A higher price or lower price does not mean that break even will never be reached!  The break even point depends on the number of sales needed to generate revenue to cover costs – the break even chart is NOT time related!

Break Even Analysis Importance of Price Elasticity of Demand: Higher prices might mean fewer sales to break even but those sales may take a longer time to achieve Lower prices might encourage more customers but higher volume will be needed to enable those lower prices to work

Break Even Analysis  Links of break even to pricing strategies and elasticity Penetration pricing – ‘high’ volume, ‘low’ price – more sales to break even Market Skimming – ‘high’ price ‘low’ volumes – fewer sales to break even Elasticity – what is likely to happen to sales when prices are increased or decreased?

Budgets  Estimates of the income and expenditure of a business or a part of a business over a time period Used extensively in planning Helps establish efficient use of resources Help monitor cash flow and identify departures from plans Maintains a focus and discipline for those involved

Budgets  Flexible Budgets budgets that take account of changing business conditions  Operating Budgets based on the daily operations of a business  Objectives Based Budgets Budgets driven by objectives set by the firm  Capital Budgets Plans of the relationship between capital spending and liquidity (cash) in the business

Budgets  Variance – the difference between planned values and actual values Positive variance  actual figures less than planned Negative variance  actual figures above planned