Costing
Costing
For an entrepreneur to know the cost of a product or service is of utmost importance since the cost plays an important role in pricing the product or service for resale. One would under normal circumstances never price a product under its cost.
Cost however is not that easy to determine since there are different types of cost. The first kind of cost is the direct cost. If you purchase a box of items for R 100 for 10, one can say that the direct cost is R 10 per item. But if you had to take a taxi to the shop and you had to pay R 10 in total for this, one needs to add this indirect cost to the cost of the item and in this case it will work out at R 1 per item, which will bring your total cost to R 110 or R 11 per item. If you then had a salesperson that you will be paying R 2 per item (this is also a direct cost since each expenditure is directly related to the sale of an item) then your total cost will be R 13 per item.
If you sell each item for R 17 each, how many items will you have to sell to break even?
One can tabulate it as follows:
EXAMPLE to calculate your breakeven selling volume
Items sold XXX 1____ 2_____ 3
Cost price R10 R20 R 30
Commission
(variable cost) R 2 R 4 R 6
Transport
(fixed cost) R10 R10 R 10
TOTAL R 22 R 34 R 46
Sales R 17 R 34 R 51
Profit/loss - R5 R 0 R 5
Here is a rough drawing of the relationship.
Sales
Profit region
Breakeven point Total cost
Variable cost
51
46
34
22
17
10 Fixed cost
Loss region
Formula to calculate breakeven point:
Breakeven Point = fixed costs / contribution margin.
Breakeven point definition and explanation:
The breakeven point is the point at which a business breaks even (incurs neither a profit nor a loss)
The breakeven point is the minimum amount of sales required to make a profit.
Where there is a linear relationship between variables (Total Cost, Sales, Variable cost) the break-even point in terms of Unit Sales (x) can be directly computed. We know that the break even point is where Total Revenue (TR) equals Total Costs (TC) :
TR = TC
Total Revenue is the Price multiplied by the volume sold (P x x), which is unknown.(the break even volume). Where that is equal to TC is our volume breakeven point.
P x x = TC
Total Cost (TC) for a given volume (number of products produced or sold) is made up of two elements – Total Fixed Cost plus Variable cost times the volume. TFC + V x x
Therefore to find the value of x, we now have
P x x = TFC + V x x
P x x - V x x = TFC
(P-V) x x = TFC
Therefore x, the breakeven is
x = TFC
P - V
where:
TFC is Total Fixed Costs,
P is Unit Sale Price, and
V is Unit Variable Cost.
The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs. The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:
Summary
The break-even point for a product is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). A break-even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product.
You need to be able to explain Break-even – this means that you need to:
a. Know the break-even graph. You might have a graph and be asked to identify the points
b. Know how to calculate contribution margin (CM) and its importance. Remember
CM = Sales Price – Variable Cost
c. Know how to calculate the contribution margin ratio. The formula is CM Ratio = Contribution Margin / Sales Price.
d. Know how calculate break-even in units. The formula to calculate breakeven in units is: BE in units = FC / Contribution Margin.
e. Know how to calculate units needed to achieve target profit. The formula is Target Profit in Units = (Fixed Costs + Target Profit) / Contribution Margin.
Another example
If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by:
Total fixed costs / (selling price - average variable costs).
Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold.
This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs.
Therefore, Profit = (selling price*quantity)-(average variable costs*quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product.
An example:
Assume we are selling a product for R2 each.
Assume that the variable cost associated with producing and selling the product is 60 cents.
Assume that the total fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is R1000.
In this example, the firm would have to sell (1000/(2.00 - 0.60) = 715) 715 units to break even.
Break Even =TFC / (SP − VC)
where TFC is Total Fixed Cost, SP is Selling Price (per unit) and VC is Variable Cost (per unit).
EXAMPLE to calculate your breakeven selling price
Given the formula to calculate breakeven selling price:
BE selling price = profit +[(variable cost per unit x Quantity produced) + Total Fixed Cost]/Quantity Produced
Variable costs are items such as: direct labor and direct materials
Fixed costs are expenses such: marketing/advertising and indirect labour (salaries)
So, say you make 100 items.
Some cost figures are:
MATERIALS
100 blank cd's = R 400 (price for all)
100 CD Cases = R 300
100 cd labels = R 200
Ink cartridge = R200
or 1100/100 = R11,00 per unit
LABOR
how much would you pay yourself? Well, we'll say it's free.
OVERHEAD
you pay the rent, utilities so it's free
FIXED COST
R 1000 for marketing and advertising (surveys and ads and whatever else to start off)
ok, let's do the calculation:
BE selling price = (R0 + 1100 + 1000)/100
That equates to R 21,00 per unit given sales of 100 units.
Now, what do u want your profit TO BE????
Say you wish to make R 5000 off 100 cd's, then:
Selling price = (5000 + 1100 +1000)/100 = R 71,00 per cd.
Charl Heydenrych
18 September 2008
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