Ch. 3 Important Accounting Topics
3.6 Contribution Margin and Break-Even
Learning Objectives
After finishing this section, students will be able to:
- Distinguish between fixed and variable cost.
- Calculate contribution margin.
- Calculate break-even point.
- Calculate how to make a profit.
If you are not controlling costs, you will not make a profit or even break-even. Knowing your costs help you manage your business. Managing your business helps board room meetings not be so tense!
Sales Price (or Billing Rate)
The price charged per unit of service (e.g., hourly rate, flat fee for a specific service).
Sales Volume
The quantity of services provided (e.g., number of billable hours, number of cases handled).
Contribution Margin
Contribution margin is the difference between the sales price and the variable cost per unit. This represents the amount of revenue available to cover fixed costs and generate profit.
Unit Contribution Margin = Unit Sales Price – Unit Variable Cost
Let’s look deeper into fixed and variable costs.
Fixed Cost
A fixed cost is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity. These are costs that remain constant regardless of the volume of work, such as rent, salaries of non-billable staff, insurance, and some technology costs.
Variable Costs
In addition to understanding fixed costs, it is critical to understand variable costs, the second fundamental cost classification. A variable cost is one that varies in direct proportion to the level of activity within the business. In a law firm, variable costs might include paralegal or associate time directly related to client matters, legal filing fees, travel expenses, and some software subscriptions.
Unlike fixed costs that remain fixed in total but change on a per-unit basis, variable costs remain the same per unit but change in total relative to the level of activity in the business.
Break-even Point
The break-even point is the dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs. In other words, no profit or loss occurs at break-even because Total Cost = Total Revenue.
As you can imagine, the concept of the break-even point applies to every business endeavor—manufacturing, retail, and service. Because of its universal applicability, it is a critical concept to managers, business owners, and accountants. When a company first starts out, it is important for the owners to know when their sales will be sufficient to cover all their fixed costs and begin to generate a profit for the business. Larger companies may look at the break-even point when investing in new machinery, plants, or equipment in order to predict how long it will take for their sales volume to cover new or additional fixed costs. Since the break-even point represents a point where the company is neither losing nor making money, managers need to make decisions that will help the company reach and exceed this point as quickly as possible. No business can operate for very long below break-even. Eventually the company will suffer losses so greatly that they are forced to close their doors.
Break-Even in Units = Total Fixed Cost / Contribution Margin per Unit
Break-Even in Revenue = Break-Even in Units * Billing Rate (or sales prices of product)
Since the break-even point represents a point where the company is neither losing nor making money, managers need to make decisions that will help the company reach and exceed this point as quickly as possible. No business can operate for very long below break-even. Eventually the company will suffer losses so greatly that they are forced to close their doors.
Example
Let’s say a lawyer’s fixed costs are $100,000 per year (rent, support staff salaries, etc.). Their variable costs are $100 per billable hour (paralegal time, travel expenses, etc.). Their billing rate is $300 per hour.
- Contribution Margin per hour: $300 (billing rate) – $100 (variable cost) = $200/hour
- Break-Even Point in Units: $100,000 (fixed costs) / $200 (contribution margin per hour) = 500 billable hours
- Break-Even Point in Revenue: 500 hours * $300 (billing rate) = $150,000
This means the lawyer needs to bill 500 hours to cover their fixed and variable costs. Any hours billed beyond that will contribute to profit.
Cost-Volume-Profit Analysis
CVP analysis, also known as break-even analysis, is a valuable tool for lawyers to understand financial implications of their practice and make information decisions about pricing, staffing, and overall profitability. By analyzing the relationship between costs, volume (of work), and profit, lawyers can determine the break-even point, assess the impact of changes in costs or volume on profits, and ultimately make strategic choices to optimize their firm’s financial performance.
The six items below can be determined by using CVP:
- Pricing Decisions: CVP analysis can help determine the appropriate billing rate to cover costs and achieve desired profitability. By understanding the relationship between costs and revenue, lawyers can make informed decisions about pricing strategies for different types of cases or services.
- Break-Even Analysis: Lawyers can use CVP analysis to calculate the number of billable hours or cases needed to cover all costs. This helps in setting realistic goals and understanding the minimum level of activity required to sustain the practice.
- Profit Planning: CVP analysis allows lawyers to project profits at different levels of activity. This enables them to set targets for revenue, expenses, and profitability and to develop strategies to achieve those targets.
- Cost Management: By identifying fixed and variable costs, CVP analysis helps lawyers understand where their resources are being allocated. This can lead to more efficient cost management, potentially identifying areas where costs can be reduced or optimized.
- Capacity Planning: CVP analysis can help determine the optimal number of lawyers and support staff needed to handle the workload while maintaining profitability. This can prevent overstaffing or understaffing, both of which can negatively impact the firm’s financial performance.
- Strategic Planning: CVP analysis provides valuable insights into the financial implications of various strategic decisions, such as expanding into new practice areas, hiring additional lawyers, or investing in new technologies.
5.4a Example
RJ is a manufacturer of blue LED lights. The business produces 3,000 LED lights per month, which are sold to independent retailers for $50, who then sell the LED lights to customers for $90. Variable costs are $20 per LED light and fixed costs are $70,000 per month.
Instructions:
- How much is the contribution margin per LED light?
- What is the company’s profit when 3,000 LED lights are sold?
- If the economy had a downturn, how many LED lights would need to be sold for the company to break even?
5.4a Practice
Unagi Enterprises teaches 30-minute self-defense classes to elementary-aged students. Each 30-minute class costs the student $25. The teacher is paid $10 per student attending the class. Unagi’s fixed costs are $20,000. The company wants to make $10,000 profit each month.
Instructions:
- How many classes need to be taught each month to break even and make the desired profit?
- If only 10 students can attend classes at a time, how many classes must be offered each month?
- Assuming each month has four weeks, how many hours a week will the studio be used?
- If the studio has ten teachers, how many sessions a week must each teacher teach?
- Based on your answer in #4 and assuming each class is at capacity, how much will each teacher earn a week?
- How much is the teacher earning an hour?
- Based on the calculations above, what would you change about this business?
Check Figures:
- Hours a week studio will be used, 25 hours
- Solution (Excel file will download)
5.4a Homework
ABC Computer makes and sells gaming computers. The selling price of each computer is $1,000. The variable cost for each computer is $400. Total fixed costs for ABC Computer are $90,000.
Instructions:
- What is the contribution margin per computer?
- How many computers must ABC Computer sell to reach the breakeven point?
- What is ABC Computer’s total profit when 200 computers are sold?
- How many computers must ABC Computer sell to yield a profit of $60,000?
- Due to the recent economic changes, the variable costs of each computer will increase to $600. Fixed costs will remain the same. With this change, how many computers will ABC Computer need to sell to reach the breakeven point?
- Using the changes in #5, how many computers must ABC Computer sell to yield a profit of $60,000?
Licensing and Attribution:
Content on this page is adapted from the following openly licensed resource(s):
Principles of Accounting, Volume 2: Managerial Accounting by Mitchell Franklin, Patty Graybeal, and Dixon Cooper licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License
is an unavoidable operating expense that does not change in total over the short term, even if a business experiences variation in its level of activity.
is one that varies in direct proportion to the level of activity within the business.
is the dollar amount (total sales dollars) or production level (total units produced) at which the company has recovered all variable and fixed costs.
