Join Jim Stice for an in-depth discussion in this video Calculate a company's breakeven point, part of Running a Profitable Business: Calculating Breakeven.
- [Voiceover] Again, let's review. Our CVP equation looks like this: Selling price times the number of Units less the Variable costs per unit times the number of Units less our Fixed costs equals Profit. Now remember that our Selling price less our Variable costs equals our Contribution Margin. So another way to frame the CVP equation is to say this: our Contribution Margin times our number of Units less our Fixed Costs equals our Profits. In many cases as a manager, you'll want to know how many units need to be sold to break even.
The Breakeven Point is defined as the volume of activity at which total revenues equals total costs, or in other words, where profit is zero. The breakeven point may also be thought of as the volume of activity at which the contribution margin exactly equals the fixed costs. Although the goal of business planning is to make a profit, not just a breakeven, knowing the breakeven point can be useful in assessing the risk of selling a new product, setting sales goals and commission rates, deciding on marketing and advertising strategies and making other similar operating decisions.
Because the breakeven point is, by definition, that activity level at which no profit or loss is earned, the basic CVP equation can be modified to calculate the breakeven point as follows. All that you need to do to compute the breakeven point is simply set income equal to zero and then solve for the unknown, such as the number of units to be sold or the total revenues to be achieved. Note that we will use X to represent the unknown element. Now, when computing a breakeven point, it is easy to just take the CVP equation one step further, like this.
Here, our Contribution Margin is exactly equal to our Fixed costs. So, let's go back to the data for our landscaping example. We know that our contribution margin is $72 per job and we know that our fixed costs are $44,496. Substituting these numbers into our equations looks like this: $72 times the number of jobs, X, equals $44,496. Solving for X results in 618.
618 is the number of jobs needed to cover all our costs. In other words, to make no profit on this landscaping crew, they need to complete 618 jobs. Now we can start to ask questions, like, "Is 618 jobs feasible? "Can I reduce the fixed costs, "thereby reducing my breakeven point? "Can I increase the price I charged per job, "thereby increasing my contribution margin, "and as a result, decreasing my breakeven point?" Let's take a look at just the first question.
Is 618 jobs feasible? We'll think about the other questions in a later module. Let's assume that our crew can complete four jobs in a day, great. If the business is located in a climate that cooperates and I can work year-round, then I have, assuming 50-workweeks in a year and a five-day workweek, 250 working days. Assuming I can fill each day with four jobs, then I will more than cover the 618 jobs required to break even.
My potential in this situation is a thousand jobs. Suppose I can only fill the schedule with three jobs per day, I will still more than break even as three jobs per day times 250 days is 750 jobs, which exceeds my breakeven point. But if I think I can only compete for two jobs a day, then I will face a problem as two jobs a day times 250 days is only 500 jobs. Far below my breakeven point. Now you can start to see the power of CVP analysis.
If I think realistically that I can only keep this crew busy with an average of two jobs per day, then I should reevaluate whether or not I should have this crew. Now let's tinker some more. I'm from Utah. You might only get nine months of weather that allows for landscaping work. Let's call that 38 weeks. Now I have to get 618 jobs into 38 weeks. Remember, my fixed costs are fixed, regardless of whether the crew is working or not. I still have to pay for the equipment even if there's snow on the ground.
So, 38 weeks with a five-day workweek means 190 days. If I can get four jobs in each and every day, then my capacity is 760 jobs. I would exceed my breakeven point. But if I can only get three jobs each day, then that is only 570 jobs and I don't break even. The beauty of this analysis is that I can do this analysis before I invest the money in my fixed cost. If I study the market and I'm able to get a good handle on the costs, I can get a decent estimate as to the profitability before I spend any money.
That's as opposed to spending the money to buy the truck and the equipment and hiring the supervisor and then finding out there's no money for you to make in this market. Hopefully you're starting to appreciate the power of CVP analysis. In the next section, we will illustrate using a company we are all familiar with how contribution margin and CVP analysis come into play when making business decisions. We're gonna talk about McDonald's.
Want to learn more? Learn about three types of accounting—financial, managerial, and income tax—in their Accounting Fundamentals course.
- Breaking down fixed and variable costs
- Pricing a service to cover costs
- Identifying high contribution margins
- Calculating a company's breakeven point
- Conducting breakeven analysis with breakeven equations
- Computing target net income
- Exploring sensitivity analysis