One of the risks of running a business, both from an operational
and well as financial standpoint, is the potential failure to sell enough product or service to earn business
costs. On the other hand, certain types of cost tend to increase marginal profitability once certain sales
levels are achieved.
Costs fall into variable or fixed categories and impact survivability
and profitability in different ways. Variable costs, such as wages, cost of raw stock, and utility bills
tend to increase in direct proportion to to the increase in sales level. On the other hand, certain operating
expenses such as the depreciation on buildings and equipment, and rents and leases, are fixed, and remain
the same over a substantial sales range.
As a result, fixed expenses tend to increase the percentage
of profitability once they are paid, while the variable expense of wages, for example, accompany every
unit of product sold. On the other hand, fixed costs have to be paid or incurred regardless of production
levels. As such, while fixed costs tend to increase profitability, they also increase the risk of the
survivability of the business. Variable cost, on the other hand, are incurred proportionately to the units
sold, and are paid when sales are made. Fixed costs, on the contrary, have to be accumulated from the
sales of many units and are not paid until enough units are sold to pay them.
As a result of this business phenomenon, company decision
makers have to decide, where possible, on the levels of fixed and variable costs in their business profile
and they use an accounting process called breakeven analysis to do this.
The issue is: how many units of sales or dollars of sales
volume will one have to make in business to pay all fixed and variable costs? The formula for units of
sales is :
Breakeven = fixed cost/( unit sales price - unit variable
If a company had fixed costs of $100,000 and sold its product
for $50 with variable costs of $18 per unit, the company would break even at a unit sales level of:
$100,000/($50-$18) = 3125 units.
We know this because if we sold 3125 units at $50 our gross
sales volume would be $156,500, from which we would deduct,$56,250 in variable expense such as wages,
leaving $100,000 to cover the fixed cost.
If on the other hand management was able to partially automate
its production department by replacing a worker costing $20,000, with a machine, shifting the variable
cost to fixed cost and reducing variable cost to $12 per unit, breakeven would then be:
Breakeven = $120,000/($50-$12) =3158 units
Note the breakeven would now be higher because higher
fixed costs would would have to be accumulated. Further note, however, that on every unit above 3158
units, the profit will be $38 on each unit instead of the $32 in the prior scenario. Thus we see
how fixed cost increases profitability and risk, and how breakeven analysis is an essential financial
tool for business managers.