Introduction to business

Lecture 2: Starting a company

contribution margin, break-even analysis
(MFD, Ch.1.)

Mojca Marc

Todays lecture
2 analytical tools to help you make decisions:

1) Contribution margin analysis

2) Break-even analysis

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 A big order!
In early November, Malea gets an offer from Winter Explorers
specialty-clothing store who want to order 150 units for the
Christmas season and pay 100 per jacket. Malea can make 50
jackets per month (after school, weekends) and she already
started to produce the 50 jackets for the hotel.

She needs to find somebody to work with Francesca.

Francesca plans to work for a department store for 2,000 a
month.
Francesca needs to make 150 jackets in two months. If she is
not productive enough, Malea may end up losing money.

Cost of materials no problem, the store will bill only for the fabric
and zippers that shell use, the surplus can be returned.

A big order!
When Malea was alone, all the costs were variable (20 per
jacket). If the price was higher than 20 (the cost per jacket),
Malea made profit with each jacket.

If Francesca joins: her salary (2,000 per month) will be a fixed

cost for Malea regardless of how many jackets Francesca
makes.

Malea worries that Francesca will not be productive enough and

she will end up losing money. Malea has 200 orders in total
(50 for the hotel and 150 for the clothing store), Francesca
needs to make 150 jackets in two months.

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 Contribution margin
Lets prepare a scenario analysis for Malea:

(1) Good productivity (2) Outstanding productivity

Francesca makes 120 jackets Francesca makes 150 jackets

Revenues
- Materials
- Francescas salary

= Profit

How to calculate contribution margin?

1. You divide costs into fixed and variable.
2. Then, you can calculate it in three different ways:

Total contribution
= Revenues Variable Costs = TR-VC
margin (CM)

Contribution margin
per unit (CMunit) = Price per unit Variable Costs per unit = P-VCunit

Contribution margin CM CMunit

= =
ratio (%) Revenues Price per unit

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How to calculate contribution margin?
Lets calculate the contribution margin in all three ways for
Malea! We will assume she will sell 150 jackets by Christmas
at a price of 100 and variable cost of 20 per jacket.

Total Per unit Ratio

Revenues
Variable costs
Contribution margin

How to use contribution margin

If Malea sells additional 10 jackets, how much will profit
increase (once FC are covered)?

Increase in profit = Increase in sales (units) CM unit

Increase in profit =.

If Malea increases sales by 2,000, how much will profit

increase (once FC are covered)?

Increase in profit = Increase in sales () CM ratio

Increase in profit = ..

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 What can you tell from contribution
margin?
1) Total CM indicates how much the company generates
before having to pay for fixed costs.

2) Per unit CM indicates how much money a company makes

each time it sells a unit this money is used first to pay
fixed costs and, once they are paid, it becomes profit.

3) If per unit CM is positive (P>VCunit) selling a unit is attractive

in the short term. In the long term, price must be higher than
total cost per unit (not just variable cost per unit).

4) When a company has multiple products, the CM per unit

(and CM ratio) is different for each productthis is used to
evaluate how attractive each product is.

Exercise 12 two products

The Cookie Factory Ltd. sells two types of cookies: vanilla stars and chocolate
deluxe stars. The table shows monthly sales and costs for the company:
Vanilla Stars Chocolate Stars Total
Sales 250,000 150,000 400,000
Cost of material 160,000 30,000 190,000
Fixed costs 40,000

Calculate the contribution margin of each product (total and ratio). Prepare an
analysis of contribution margin based on the template below.
Which of the two products is more attractive for the company?
How much is the profit of the company?
If sales increase by 100,000, how much would you expect profit to increase?
What are your assumptions?

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 Exercise 12 - solution
Vanilla stars % Chocolate stars % Total %

Sales 250,000 100% 150,000 100% 400,000 100%

minus VC

Contribution margin

minus FC

Profit

Break-even analysis
But what if Francesca does not perform as well as Malea
hopes? Lets analyze two other scenarios:

(1) Low productivity (2) Average productivity

Francesca makes 40 jackets Francesca makes 80 jackets

Revenues
- Materials
- Francescas salary

= Profit

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 Break-even analysis
How many jackets must MFD produce and sell in 2 months so
that Malea can pay for Francescas salary?

Cost of material 20

Each jacket has 80

contribution margin

How to calculate the break-even point?

Break-even is the number of units that need to be sold to have
zero profit. At this level of activity the total revenues equal
total costs.

If Malea sells more than 50 jackets, she will have profit. If she
sells less than 50 jackets, she will have a loss.

How to calculate break-even point?

1) With contribution margin
2) Equation: TC=TR
3) Graphical method

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 How to calculate the break-even point?
1) With contribution margin

Break-even point Fixed costs = Fixed costs

=
(in units sold) CMunit P-VCunit

Break-even point = Fixed costs = Fixed costs

(in sold) CM ratio(%) (P-VCunit)/P

Break-even point = Francescas salary =

(in units sold) CM per unit
Break-even point = Francescas salary =
(in sold) CM ratio

How to calculate the break-even point?

2) Equation: TR=TC

TR=TC
TR=FC+VC
QP=FC+QVCunit
(QP)-(QVCunit)=FC
Q (P-VCunit)=FC

Q= Fixed costs = Fixed costs

(P-VCunit) CMunit

Assumptions: one product, proportional VC (constant VCunit)

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 How to calculate break-even point?
3. Graphical method: break-even where TR=TCzero profit

8000

7000 TR

6000 Profit
TC
5000

Revenues
4000 FC Fixed costs
Total costs
3000
Loss

2000

1000
Loss Profit
0
0 10 20 30 40 50 60 70 80
Number of jackets produced/sold
This is the
break-even
point

Changes in break-even point

Which is better for a company: a lower or a higher break-even
point?

How can a company decrease the break-even point?

- Lower fixed costs (FC line shifts downward)

- Lower VCunit (TC line rotates downward it has a flatter slope)
- Higher price (TR line rotates upward it has a steeper slope)

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 How to use break-even for decisons?
1) Gives a minimum sales target that need to be exceeded
to generate profit.
Malea needs to sell at least 50 jackets per two-month period to break-even, she
will have profit if she sells more than 50 jackets within the next two-months.

2) You can compare the break-even amount with the size of

demand in the market.
Is there enough demand for fleece jackets, so that she can sell at least 50 of them
every two-months?

3) You can compare the break-even amount with the

production capacity of the company.
Can she produce at least 50 jackets every two-months?

For which type of decisions can you use

break-even analysis?
Marketing decisions:
1) Launching a new product
2) Modifying the sales prices
3) Changing the product mix

Operational/financial decisions:
1) Investing in a new production line
2) Building a new plant
3) Outsourcing the production of a specific item.

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 Example: Break-even analysis for MFD
Francesca suggested 2 alternative compensation models for
her salary. What is the break-even for each of the proposals?

Alternative 1: Alternative 2:
Fixed costs Fixed costs
Fixed salary 3,200 Fixed salary 2,400
Variable costs Variable costs
Variable salary 10 per jacket Variable salary 20 per jacket
Cost of material 20 per jacket Cost of material 20 per jacket

Example: Break-even analysis for MFD

Solution:

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Exercise 14 changes in BE
Suppose the variable costs for MFD increase or decrease by 5
per unit (to 25 or 15 per unit). How would that affect the
break-even point? Plot the relevant graph. (MFD, Ch. 1 12)

Exercise 15 changes in BE
Suppose Francesca demands a fixed salary of 5,000 for the
eight week period remaining until Christmas. How does it
impact the break-even point? Plot the relevant graph. (MFD,
Ch. 1 13)

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Exercise 16 changes in BE
Suppose Francesca agrees to a fixed salary of 4,000 for two
months, but Malea is thinking about changing the price of a
jacket. How would an increase or decrease in the price by
10 affect the break-even point? Plot the relevant graph.

Key points
1) How to calculate contribution margin in three ways (total,
per unit, ratio).
2) How to use contribution margin: expected increase in profits
3) How to calculate break-even (units, sold, graphical).
4) How break-even changes if P, VCunit, or FC change.

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 Homework

1. Suppose Francesca would be willing to work for Malea if she

is paid 40 per unit instead of a fixed salary. What is the total
contribution margin for 150 units? The contribution margin
per unit? The contribution margin ratio? (MFD, Ch.1-Q.8)
2. If Francesca is able to deliver the 150 jackets, what is the
profit under the two alternatives Francesca proposed?
(MFD, Ch.1-Q.14)
3. Until next Thursday: read chapter 2 in MFD till page 45.

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