CH 3 Break-Even Analysis and Pricing Strategies

Break-Even Point (BEP)

• The break-even point is where total revenue equals total costs, resulting in zero profit.

• It helps businesses determine the minimum sales volume needed to avoid losses.

Methods for Calculating BEP

1. Equation Method

   • Formula: Sales Revenue - Variable Costs - Fixed Costs = 0

   • Used to determine the sales volume required for break-even.

2. Contribution Margin per Unit Method

   • Contribution Margin per Unit = Selling Price per Unit - Variable Cost per Unit

   • BEP (in units) = Fixed Costs / Contribution Margin per Unit

3. Contribution Margin Ratio Method

   • Contribution Margin Ratio = Contribution Margin / Sales Revenue

   • BEP (in dollars) = Fixed Costs / Contribution Margin Ratio

Break-Even Calculation Example

• Given Data:

  • Selling Price per Bottle: $36

  • Variable Cost per Bottle: $24

  • Fixed Costs (Advertising): $60,000

• Break-Even Point:

  • Contribution Margin per Unit = $36 - $24 = $12

  • BEP (Units) = $60,000 / $12 = 5,000 units

  • BEP (Dollars) = 5,000 units * $36 = $180,000

Reaching a Desired Profit

• To achieve a target profit, modify the break-even formula:

  • (Fixed Costs + Target Profit) / Contribution Margin per Unit = Required Sales Volume

• Example: To achieve a $40,000 profit:

  • (60,000 + 40,000) / $12 = 8,333 units

  • Sales Revenue Needed: 8,333 * $36 = $300,000

Pricing Strategies

1. Cost-Plus Pricing:

   • Price is set at variable cost plus a percentage markup.

2. Prestige Pricing:

   • Prices are set higher due to branding or product exclusivity.

3. Target Costing:

   • Prices are set based on market conditions, and costs are controlled accordingly.

Effects of Pricing Changes on BEP

• Price Drop from $36 to $28:

  • Lower price means a lower contribution margin, increasing required sales volume.

  • New Contribution Margin per Unit: $28 - $24 = $4

  • BEP (Units) = $60,000 / $4 = 15,000 units

  • Sales Revenue Required = 15,000 * $28 = $420,000

Changes in Variable Costs

• If Variable Cost Drops to $12 per Bottle:

  • New Contribution Margin per Unit: $28 - $12 = $16

  • BEP (Units) = $60,000 / $16 = 3,750 units

  • Sales Revenue Required = 3,750 * $28 = $105,000

Changes in Fixed Costs

• If Fixed Costs Drop to $30,000:

  • BEP (Units) = $30,000 / $12 = 2,500 units

  • Sales Revenue Required = 2,500 * $36 = $90,000

CVP Graph Construction

1. Draw x-axis (Units) and y-axis (Dollars).

2. Plot the fixed cost line as a horizontal line.

3. Plot the total cost line as Fixed Costs + Variable Costs per Unit.

4. Plot the sales revenue line as Selling Price per Unit * Units Sold.

5. Intersection of total cost and sales revenue lines represents the BEP.

Margin of Safety

• Measures the cushion between budgeted sales and BEP.

• Formula: (Budgeted Sales - BEP Sales) / Budgeted Sales

• Example: If budgeted sales are 10,000 units and BEP is 5,000 units:

  • Margin of Safety = (10,000 - 5,000) / 10,000 = 50%

Flashcard Questions

1. What is the break-even point?

   • The point where total revenue equals total costs, resulting in zero profit.

2. What are the three methods for determining the break-even point?

   • Equation method, Contribution Margin per Unit method, and Contribution Margin Ratio method.

3. What is the formula for break-even point in units?

   • Fixed Costs / Contribution Margin per Unit

4. How do you calculate the contribution margin per unit?

   • Selling Price per Unit - Variable Cost per Unit

5. What is the formula for break-even point in dollars?

   • Fixed Costs / Contribution Margin Ratio

6. What happens to BEP if the selling price decreases?

   • BEP increases because the contribution margin per unit decreases.

7. What is Cost-Plus Pricing?

   • Pricing strategy where price is set as variable cost plus a markup percentage.

8. What is Target Costing?

   • Setting a price based on market conditions and controlling costs to ensure profitability.

9. What is the effect of reducing fixed costs on BEP?

   • BEP decreases because fewer units need to be sold to cover costs.

10. How is the margin of safety calculated?

    • (Budgeted Sales - BEP Sales) / Budgeted Sales

This study guide provides a structured approach to understanding break-even analysis, pricing strategies, and cost-volume-profit relationships.