COST, REVENUE & BREAK EVEN ANALYSIS

IB BUSINESS & MANAGEMENTA COURSE COMPANION

(p232-249)

COSTS & REVENUE

• Once a business has worked out how to produce, it needs to think about how much to produce.

• This will depend on a number of factors, but in most cases production managers will focus on at least ensuring that they have covered their costs and not made a loss.

• The following simple formula can act as decision-making framework

PROFIT = TOTAL REVENUE – TOTAL COSTS.

Not for Profit Organizations

• Even if a business is a not-for profit organization it must still abide by the formula.

• Although it may not make profits it must as least cover it costs and so no make any losses.

Non-Governmental Organizations (NGOs)

• NGOs need to make enough money to not only cover their immediate costs, but also to ensure that they can reinvest for the future.

• Eg: Greenpeace will need enough money to pay lobbyists or buy boats for direct action such as monitoring whaling for scientific purposes by Japanese vessels.

REVENUE

• Revenue is fundamental to all production decisions. • It is the total money earned from selling the

product.• It also known as sales, sales revenue or turnover,

and it appears in the top line of a profit and loss account or part of cash in a cash flow statement.

• All these items refer to the “operational income” of a business – that is money earned from its business operations.

REVENUE

Non-Operational Activities• Sometimes a business can earn money from

non-operational activities, such as selling shares in a subsidiary or company assets generally.

• This form of revenue is classified as non operational income.

Total Revenue Formula

Total Revenue (TR) = Price (P) x Quantity (Q)

Example • If a car dealer were to sell 100 BMW 5 Series

Cars in 2011 for $200,000 each, there would be $20,000,000 in revenue. 100 x 200,000.

• Remember that revenue is very different to profit.

Profit MarginFast Food Outlet vs Fine Dining Restaurant

• With a fast food outlet there is a very low profit margin as the competition is very fierce and demand is relatively elastic – so the business cannot afford to put their prices too high.

• Prices will not be much more than their costs. • This means a fast food restaurant is dependent on a high

volume of sales (for standardized mass produced meals) to generate sufficient profit to operate.

• In contrast, the profit margin for a fine dining restaurant per customer will be significantly higher than the fast food chain’s average customer.

Different Types of Revenue

• Cash Sales: Money paid directly as cash.• Credit Sales: Money paid on credit using Visa or Mastercard,

AMEX or Diners Club. • Debit Card: Money transferred electronically from a bank

account.• Cheque: Money transferred from a bank account using a

hand-written note.• Loyalty Cards: Money transferred from a bank account into a

special store account.• Direct Debit: Money transferred from a bank account for

regular payments such as mortgage or cable TV monthly fee.• Annual Fee: Money paid once a year. Eg: subscriptions to a

tennis club or a car tax.

Which Revenue Source is Preferred?

• Some businesses prefer one form of payment to another.

• Eg: An internet company such as Amazon finds it much easier to accept credit card payments, but a local baker will obviously prefer cash.

COSTSFive Categories of Cost

There are five categories of costs that can overlap each other: Fixed Costs: Costs that do not change as output does. (eg:

cost of buying a factory) Variable Costs: Costs that do change as output does. (eg:

cost of buying stock) Semi-variable Costs: Costs that are made up of fixed and

variable components. (eg: basic line cost for renting phone + call costs)

Direct Costs: Costs that are directly related to output. Indirect Cost: (Overheads) Costs that are indirectly related to

output.

Fixed Costs - Examples

Example • A car dealer may have to pay for the rent of the

car showroom, even if there are no customers. • Businesses often refer to these must pay costs

as overheads as they appear as expenses in the profit & loss account, because they are indirect costs of production.

• Interest payments on loans could be another example of fixed costs.

Variable Costs

• Variable Costs – costs which do vary directly with production.

• Eg: If we are selling stock we will order or make less stock.

• Therefore our variable costs can change. • In the Profit & Loss Account, the stock we do

use appears as the cost of goods sold.

The Relationship Between Different Costs

Fixed = Indirect CostsVariable = Direct Costs

Semi-Variable – Partly Direct & Partly Indirect

How to we calculate total costs?

Total Costs (TC) =Fixed Costs (FC) +Variable Cost (VC)

TC = FC + VC

Semi-Variable Costs

• The semi-variable costs (also known as quasi-variable costs) are a combination of fixed and variable costs.

Example – Salary of a Car Salesperson• The salary of the car salesperson is typically

made up of two parts – a fixed element (the basic wage) and a variable element (the commission) which is dependent on the number of cars sold.

Semi-Variable Costs

Electricity Costs• Electricity bills are usually split into a fixed

element – the standing charge and a variable element – which is taken from the electricity meter and indicates how much has been used.

Costs – Classification ExerciseTRANSACTION WHAT TYPE OF COST?

Rent TelephoneElectricity Wages – Basic WagesWages – CommissionCosts of Good Sold (Inventory)

Contribution to Fixed Costs

• An important business tool is the contribution a product makes to the overall profitability of the business.

• When it knows this, a business can decide which product to focus on, so as to expand production, increase investment and ultimately improve sales.

• This is particularly useful for a business that has a range of products as the business will be able to judge whether one is outperforming another.

Contribution to Fixed Costs

• In the Boston Consulting Group (BCG) matrix, this can be a difference between a star, cash cow and dog product.

How do we calculate the total contribution for a company?

We use the following formula:

Total Contribution =Total Revenue – Total Variable Costs

The Contribution Per Unit

We can calculate the contribution per unit for the business by using the following formula:Contribution = price – variable costs (per unit)Example• We sell a luxury care for $200,000.• We sell 100 cars.• Our Total Variable Costs are $15,000,000• Insert into formula:$200,000 - (15,000,000) = $50,000 per car. 100

The Contribution Per Unit

Further Explanation of Car Example• Each car contributes $50,000 which can be

subtracted from fixed costs to generate the eventual profit for the business.

BREAK EVEN ANALYSIS

• Another important tool to help production decisions is break even analysis.

• This is especially relevant for a new businesses or for starting a new venture.

• The idea is to calculate the minimum product that would have to be sold for the business to break even – that is: just to cover the costs and no more than that.

• If a business manages to produce and sell more than the break even quantity it will make a profit.

How to calculate the break even output?

Profit = Total Revenue – Total Costs.

If Profit is O, break even is:

Total Costs = Total Revenue

Three Methods for calculating the Break Even Level of Output

We can calculate the break even level of output using the following three methods:

Creating a TableDrawing a Chart/GraphUsing a Formula

Semi Variable Costs & Break Even Analysis

• For break even analysis we do not consider semi-variable costs because this would make things must too complicated, so we must always divide costs into fixed or variable proportions.

Table Method for Break Even Analysis

Example Question • Business: A vendor selling face Rolex watches in the

Philippines.• A vendor has to pay a sum of $US1000 to secure

the right to sell his watches outside the tourists hotels on the beach. He paid this to the local enforcers (mafia)

• On average a tourist would pay $US 50 for a watch and the watches typically cost him US $25 from his supplier.

Table Method for Break Even Analysis

Example Question (continued)• Note that fixed costs (the fee for the right to sell watches) had

to be paid “up front” before he had sold any watches – the sum was a one-off payment, no matter how many watches were sold.

• Variable Costs are 0 if nothing has been sold.• Unsold watches can be returned to the supplier• The price stays the same throughout. Some tourists were good

at haggling and some were not, but the average price is $50.• If nothing has been bought, the total revenue for 0 is 0.• After this total revenue goes up by multiplying price & quantity.

BREAK EVEN ANALYSIS – VENDOR SELLING WATCHES EXAMPLE

QuantityOutput

COSTS ($ US) REVENUE ($ US) PROFIT(Loss) US

WatchesSold

FixedCost

Variable Cost

TotalCost

Price QuantityOutput

TotalRevenue

0 1000 0 1000 50 0

10 1000 250 1250 50 10 500 (750)

20 1000 50 20

30 1000 50 30

40 1000 50 40

50 1000 50 50

60 1000 50 60

70 1000 50 70

Watches Example – Analysis

• After completing the previous table, it is obvious that the watch seller breaks even by selling 40 watches.

• For every watch sold after this, the vendor will make a $25 profit.

The Formula Method for Break Even Analysis

Break Even Quantity = Fixed CostsContribution Per Unit.

Contribution = price – variable cost per unit.

Fixed Costs = $1000Contribution = $50 - $25 = $25. 1000/25 = 40 watches.

Graph Method For Break Even Analysis

• It is possible to transfer some of the information in the table to a graph.

• The vertical axis will have costs and revenue on it and the horizontal axis will have the quantity of watches sold.

• To this we can add fixed costs, which we can draw as a line parallel to the horizontal axis starting at $1000.

• The line is parallel to the horizontal axis because these costs do not change as more watches are sold – the costs are fixed.

Source: http://fast4cast.com/break-even-calculator.aspx

Tip:

Do not attempt to draw a break even graph, until you have calculated/determined the break even point using the formula.

How is profit & loss represented in the graph?

• The amount of profit or loss is given by the vertical distance between the total cost and total revenue lines.

• As the vendor sells more watches, his losses get smaller (the distance between total costs and total revenue gets less)

• After break even, the distance between total costs and total revenue increases, which means he makes more profit the more he sells.

• However, he must sell a minimum of 40 watches before making a profit at all.

The Margin of Safety

• If the watch vendor sells 60 watches, then he is said to have a margin of safety of 20 watches.

• The margin of safety is just the difference between actual sales and break even sales - it like a safety net.

• Note: It is the margin of safety output (quantity) we are interested in, not revenue, profits etc.

Graphs & Break Even AnalysisExamination Tip

• If you need to draw the graph in an examination, always do the calculation using the formula first.

• It helps centre the two axes so the scale will work out clearly.

• Always aim to try to place the break even quantity point-mid way on the horizontal axis.

Break Even Analysis - Exercise

• A school publishes a magazine.• 400 copies are printed.The costs are as follows: Fixed Costs: $600 Variable Costs: $2 per magazine.

The school will charge $4 for a copy of the magazine.Using the three different methods produce a table, graph and equation to show the break even quantity of magazines. Note: Do the equation first.