break even analysis
You, are the Chef and have requested that a new appetizer be placed on the menu. The general manager of your operation has tasted the appetizer and agrees it will be a winner but needs to know what it should be priced at, so he comes to you. He presents you with the following preliminary forecast for weekly sales at differing prices:
Table 1
VOLUME REVENUE
1,000 units $5.00
700 units $6.00
600 units $7.50
and asks you what you think the best selling price for the company would be. The problem now reveals itself and it is that although we can calculate the revenue we do not have any cost information. Arriving at a pricing strategy is impossible. So we must start by investigating the concepts of fixed, variable and total costs and then combine the cost information with the price projections to determine unit contribution and total contribution.
We will begin by discussing the graph below:: Graph 1
TERMINOLOGY
Fixed Cost: Fixed costs are costs that do not vary with the output quantity. Fixed cost is the dotted line on the graph. Notice that the total cost curve (red line) does not begin at zero because of this fixed cost component, represented by the distance 0Z (referred to from this point on as $0Z), of total cost. An example of fixed cost would be the rent or lease expense on the property and building that continues to be paid even when you shut down each year for one month.
Variable Cost: This is the portion or component of the total cost that will vary and increase with output, sales or production of the new appetizer. Variable cost assignment is not an clear cut issue and there are a number of accepted methods to use. In this case variable unit-costs would-could include the food cost, labor cost, utility cost, facility maintenance cost etc. Variable cost could be effected by a quantity purchase agreement that would create the condition where costs would be increasing at a decreasing rate as you increase sales. It could also be impacted by the phenomena of the learning experience that has the effect of decreasing labor costs over time due familiarity of the process (no more training or learning to do). But for this tutorial we will assume that the total cost is linear as show in Graph 1 above.
The following equation will put together in numbers what we have discussed so far:: Equation 1
In the above equation. k is the constant unit-variable cost of producing one more new appetizer and in fact it is the slope of the red colored total cost line or curve in Graph 1. Not rocket science as you can see. The Total Cost to make the new dish is equal to:: the Fixed Costs of [next page]