Three (3) Components of the Break-even Point Formula

The three components needed to determine a company's break-even point in units are FIXED COSTS, VARIABLE COST PER UNIT, and SELLING PRICE PER UNIT. Below discusses each component.

COMPONENT 1   -  FIXED COSTS

Fixed Costs are costs or expenses that do not fluctuate with the production or sale of one "additional" unit. In other words, fixed costs are costs that do not increase when a company makes or sells one additional product. If The Cigar Company sold a box of cigars to you, what costs or expenses would not increase for them? The Company's advertising, office rent, leasing expense, telephone expense, utilities expenses, bank charges, interest expenses, printing of cheques, depreciations, and salaries would not increase and therefore would be considered fixed costs. Moreover, these expenses would not increase when The Cigar Company produces or sells one additional product (box of cigars). In other words, these costs are relatively fixed or constant over a one year period. Usually, but not in all cases, fixed costs will be a business's operating expenses (marketing and administration expenses) shown on the income statement. If you can not decide whether a cost or expense is a fixed cost, ask yourself the following question.

If I sell or produce one additional product (your Product) will the cost of the item in question, increase? Let's look at a few examples, while assuming you are the owner of The Cigar Company.

• 1. If I sell one additional box of cigars will rent expense increase? No!!! A business does not have to rent another office every time it sells a product. If it did, we wouldn't see too many businesses in existence. Rent is always a fixed cost.
  2. If I sell one additional box of cigars will telephone expense increase? No!!! Telephone costs are generally always considered a fixed cost.
  3. If I sell one additional box of cigars, will salaries increase? No, but there is one exception. If the worker is paid a commission for every product he/she sells, then the commission can be considered a variable cost, and not a fixed cost. Some business owners, however, will consider commissions paid to workers as a fixed cost. Their reasoning is that commissions will be a fixed cost over a long period (I.E. over a one year period). Also, since a business will forecast sales for the upcoming year, for example, they will have a rough idea of what will be paid out in commission and therefore such costs are treated as fixed. For businesses paying commissions, we recommend they be considered a variable cost and NOT a fixed cost.
  4. If I sell one additional box of cigars will advertising increase? No!!! Advertising is always considered a fixed cost over the break-even period. The break-even period could be one week, one month, six months, but most break-evens are calculated over a one year period.
  5. If I sell one additional box of cigars will office supplies expense increase? No!!! Office supplies expense is generally always a fixed cost because for each cigar box you sell, you do not have to buy more office supplies. As a company sells many products (not just one) however, they will need to purchase additional office supplies. Therefore, office supplies are always considered fixed over a break-even period.

In summary, a company's marketing & administrative expenses (operating expenses on the income statement), in most cases, will be its fixed costs. Let's now define variable costs.

COMPONENT 2  -  VARIABLE COSTS PER UNIT

Variable costs are costs or expenses that do fluctuate with the production or the sale of one "additional" unit. Variable costs may include purchases of raw materials, purchases of products for retail sales, shipping charges of raw materials/products, direct labor costs, sales force commissions on a per sale basis, and other costs that a company may incur when selling or producing one additional product or unit.

Variable Costs must be calculated on a per unit (product) basis. For example, The Cigar Company buys the cigars and sells them to its customers (the company does not produce of manufacture the cigars, rather they are purchased from a manufacturer or a wholesaler, finished and ready for resale).  Therefore, The Cigar Company's only variable cost per unit would be the cost to buy one box of cigars plus the cost of shipping each box of cigars. Recall in our example, the variable cost per cigar box is $20.00. This $20.00 includes the cost to purchase one box of cigars and the average shipping cost for each box of cigars. Moreover, the cost per box of cigars might be $18.00, while the shipping cost per box of cigars might be $2.00. Therefore, the total variable cost for each box of cigars would be $20.00 ($18.00 + $2.00).

If you sell two or more products having different per unit variable costs, then you will have to use the weighted average product cost approach to determine your break-even point. For example, lets assume The Cigar Company sells two brand-name boxes of cigars; the Cuban Cigar and the "infamous" American Cigar. A box of Cuban Cigars cost $20.00 while a box of American Cigars cost $15.00 to buy and have shipped. What is the company's single variable cost per unit? A single variable cost per unit can not be established since the company has two variable costs ($20.00 and $15.00). Therefore, the company will have to calculate a Weighted Average Product Cost that consists of one value. We will examine how to determine a weighted average product cost when we discuss how to determine a break-even point for a company selling multiple products.

In summary, variable costs on a per unit basis for a retailer or service provider will always include the cost, on average, to purchase one product (cigar box) plus the cost, on average, to ship one product (cigar box). The variable costs on a per unit basis for a manufacturer might include the cost, on average, to purchase raw materials to make one unit, the average cost to ship the raw materials, average direct labor costs to produce one finished product, and any shipping costs incurred when selling the product to wholesalers, retailers or service providers. In a nutshell, variable costs per unit are the costs incurred to produce or sell one unit/ product. Now lets examine the third component of the break-even formula; namely, the selling price per unit.

COMPONENT 3   -  SELLING PRICE PER UNIT

The selling price per unit is the third component needed for the break-even calculation. The selling price per unit is the price at which a company sells each of its products or services. A company selling only one product will have only one selling price and this price will be used in the break-even formula. A company selling two or more products, however, will have a selling price for each product. Businesses selling multiple products will be required to calculate a weighted average selling price before a break-even point can be determined. For example let's assume your company sells two types of computers - a low quality computer and a high quality computer. The low end computer sells for $1,200 and the high end sells for $3,000. What is the company's single selling price? A single selling price can not be established since the company has two selling prices ($1,200 and $3,000). Therefore, the company will have to calculate a Weighted Average Selling Price that reduces the two selling prices down to one selling price. Determining a weighted average selling price for multiple products will be discussed later.

In summary, the selling price used to determine a company's break-even point is simply the price at which the company plans to sell each product. If a company sells more than one product, it will have to calculate a weighted average selling price.