Learn how to break your costs into fixed and variable components, and then use the cost-volume-profit equation to help you determine your break-even point and other sensitivity analysis.
- Have you ever wondered how many customers must come into a McDonald's store every hour of every day, every day of every year for the company to break even? For the company to make no money, but lose no money? - How would you even begin to figure that out? - That brings up to the topic of Cost Volume Profit Analysis, or CVP Analysis. With CVP Analysis we can answer those questions. We can compute how many customers must come into a restaurant, how many fans must attend a baseball game, how many tickets must be sold at a charitable event, for the restaurant, or the team, or the charity to break even.
- [Kay] Now step one in this process is that cost must be analyzed and partitioned into costs that vary with the level of activity and costs that are fixed. - Examples for a restaurant of fixed cost are the rent on the building, the cost of the furniture and fixtures, the cost of the salaries of the management. Costs that would vary would include food costs, and the costs of hourly workers, these costs would vary based on the number of customers and the number of hours the business is open. Once you've split your costs into two piles, and keep in mind that parts of some costs can be placed in both piles, like a sales person who's paid both a fixed salary and a variable commission.
But once costs have been split into the two piles, we're ready to do some relatively simple computations that will lead us to some very powerful conclusions. - Let's consider this example. We're going to hold a charity event to raise money for a worthwhile cause. We'll rent a room at the local convention center, a fixed cost, we'll advertise the event, another fixed cost, and we'll book a caterer who will provide the food. The caterer will charge based on the number of tickets sold, that makes this a variable cost.
- [Jim] Our plan is to sell the tickets for $100 each. The room rental will be $7,000, and the advertising for the event will be $5,000. The caterer is going to charge us $20 per ticket sold, as she will provide a meal for every person. - [Kay] Now we'll introduce what's called the CVP equation. Selling price times the number of tickets sold, minus the variable costs times the number of tickets sold, minus our fixed cost equals our profit. - [Jim] By using a little algebra, we can reorganize the equation so that it reads as follows: selling price minus variable costs per ticket, times the number of tickets sold, less fixed costs equals the profit.
- Let's stop for just a minute because we've now isolated a very important concept in managerial accounting. It's called the contribution margin. The contribution margin is selling price less variable costs. This amount, the contribution margin, is used to cover or contribute to our fixed costs, and once fixed costs are covered, that amount becomes our profit. - So let's go back to our example, the charity event. Let's just fill in the CVP equation with what we know. Our selling price is $100 and our variable costs are $20, resulting in a contribution margin of $80 per ticket.
That means every ticket buyer is contributing $80 towards the covering of our fixed costs of $12,000. - Now a little math and we are able to solve for the number of tickets we need to sell to break even. In this example, we will need to sell 150 tickets before we make any money towards our charitable costs. In other words, we have to sell 150 tickets just to break even. - Now the beauty of this simple analysis is that we can now start asking some interesting questions. Did I book a big enough room for the event? Did I book a room that's too big? - [Kay] And I can also start tinkering with my variables.
What if I raise the ticket price to $180? How many tickets would I need to sell to break even then? - [Jim] Turns out that running the numbers will tell you that you'll need to then sell just 75 tickets to break even. - Now you can use this CVP equation to do all sorts of sensitivity analysis. We can change the profit from zero to some sort of target and then run the numbers again. - [Jim] For example, if I wanted to raise at least $10,000 for this charitable event and the ticket price was still at $100, I could do the computations and see that I would need to sell 275 tickets to generate this amount of profit, $10,000.
- What if I booked a banquet room at a lower cost? What if I could be more efficient with my advertising and lower those costs? What if I asked the caterer for a less expensive meal? All these decisions will affect my break even point, and my profit. - But the last thing you would want to do is to get to the charity banquet and find out you didn't sell enough tickets to even break even. You can do these sorts of calculations beforehand to determine if this idea is worth going forward. - [Kay] The secret, break your costs into fixed and variable components, and then use the CVP equation to help you determine your break even point.
Skill Level Beginner
Q: Why can't I earn a Certificate of Completion for this course?
A: We publish a new tutorial or tutorials for this course on a regular basis. We are unable to offer a Certificate of Completion because it is an ever-evolving course that is not designed to be completed. Check back often for new movies.