Costing models - costing for planning
A common exercise in management accounting is to understand the interrelationship between selling prices and variable costs through ranges of sales or production volumes, the prime objective being to determine when the fixed costs of the business are covered by margin, which can often be likened to gross profit.
To carry out a detailed break-even analysis for planning purposes, breakeven charts may be produced and sensitivity analysis carried out. Spreadsheets are an obvious means of carrying out the sensitivity analysis.
Here is a very simple example:
Product selling price 10.0
Labour assembly cost per product 3.5
Components per product 4.5
Total variable costs 8.0
Total fixed costs of assembly area for one year 4,000
Selling or transfer price 10.0
Variable costs -8.0
Contribution or contribution margin 2.0
Total fixed costs 4,000.0
divided by contribution of gives 2,000 items 2.0
have to be made and sold to cover the
overheads or 2,000 items have to be made
and sold to break even.
Figure 9.1 is a spreadsheet solution of the above illustration. This goes on to show how the parameters may be varied to understand more of the situation being assessed.
FIGURE 9.1 Break-even chart
Break-even analysis and strategy Leaving the financial objective (to make money or make a return) out of the immediate thinking, an executive does not need numbers to devise strategies. An example could be that you work in retail and are aware that serving all types of customer is very difficult -do you go upmarket, go for the economy sector or try to satisfy all needs mid-market?
Break-even analysis A company is proposing to make a picnic product -a hamper - and, apart from sales being weather dependent, it is not sure whether to make the product for the mass market or to be sold by exclusive outlets.
The base data for expected price and costs is shown in Table 9.4.
TABLE 9.4 Base data
(a) With this base data, how many items need to be sold to break even?
(b) If selling price is not considered a problem (it will be sold in upmarket outlets), what price would be needed to guarantee a profit of 10,000 while selling only 4,000 items?
(c) If the product is to be sold in the mass market at 10.99, how many items need to be sold to break even?
(a) The break-even analysis is shown in Table 9.5.
- Number to break even with base data.
- Break-even number is the result of dividing the fixed costs by the contribution per item.
TABLE 9.5 Break-even analysis - three scenarios (a)
- Assuming no real extra costs to make the item a luxury item; selling it at a low volume of production - 4,000 items, but at a high price and also ensuring at least 10,000 profit (Table 9.6).
TABLE 9.6 Break-even analysis - three scenarios (b)
(b) The model is now effectively worked backwards. The guaranteed profit is in effect an extra fixed cost of 10,000. The required contribution can be calculated and a selling price of 17.75 arrived at.
(c) With a low selling price of 10.99 there is only 0.49 contribution per item, thus break even at 38,776 items (Table 9.7).
This is a simple example which illustrates the power of models to help with strategic decision making. What this may say is that being in the luxury market is safest, but there may be a limit to the market. The mass market requires huge volumes, but that is the mass market. Maybe being in the middle is most difficult?
TABLE 9.7 Break-even analysis - three scenarios (c)
Models can help reveal how strategies may work out in practice and are necessary when quantifying strategies. However, knowledge of the markets is essential and every nuance of customer behaviour may be difficult to capture and model. Strategies will at times be an act of faith.