Suppose a Manufacturer produces a product at a cost of $18.00 in materials per unit and $4.00 labour, paid on a piece-rate basis. The product is sold for $40.00 per unit by a sales agent who is paid a 5% commission on all her sales. The product is produced in a modest facility rented for $6,000 per year, and the Manufacturer spends $15,000 per year advertising the product. There is also a $4,000 annual royalty fee paid to the inventor of the product for the right to use his idea. a) What are the variable costs per unit of producing and selling this product? Variable costs are those which vary in direct proportion to the total number of units produced and sold. They are incurred for every unit produced and sold, and they are not incurred if the unit is not produced and sold. b) What are the fixed costs per year of producing and selling this product? Fixed costs do not change over a range of sales levels. They must be paid (at least for a while) even if nothing is produced or sold at all! They do not increase when sales increase (up to a certain point) and when they do increase, they increase in big “chunks,” which are not in direct proportion to sales. c) What is the unit contribution on sales of this product? Unit contribution is the amount which each unit sold “contributes,” first to paying fixed costs, and second to generating profit. It is calculated by subtracting all Variable Costs only from Selling Price. $40.00 Selling Price per unit $24.00 Total Variable Costs per unit $16.00 Unit contribution d) What is the annual breakeven volume for this product in units? In dollars? This question is equivalent to “What is the minimum number of unit contributions necessary to cover the fixed costs?” To determine that, simply divide Total Fixed Costs by Unit Contribution. $25,000 Fixed Costs to cover = 1,562.5 units must be sold to Breakeven $16.00 Unit Contribution from each unit Since the Fixed Costs are in dollars, and Unit Contribution is in dollars per unit, the result of this calculation is a figure for units. This can easily be converted to breakeven dollar sales by multiplying by the price, in this case $40 per unit, to get $62,500 dollars sales must be reached to breakeven. Suppose now that the manufacturer is considering increasing annual spending on advertising to $17,500? e) What percentage increase does this cause in total fixed costs per year? f) How would this change affect the annual breakeven volume in units and dollars? What is the percentage increase in the breakeven numbers above breakeven with the standard advertising spending? The new advertising budget would represent a $2,500 increase in that cost, which would create a 10% increase in Total Fixed Costs. This would increase the breakeven points to 1719 units, and $68,750 respectively, which is exactly 10% above the previous breakeven points without the increased advertising. This should be obvious from the above formula for breakeven. Alternatively, suppose the manufacturer is considering reducing the selling price of the product by 10% instead of increasing the annual advertising budget. g) How would this change affect the annual breakeven volume in units and dollars? What is the percentage increase above breakeven with standard pricing and advertising spending? This change affects both Selling Price, and the Sales Commission part of Total Variable Costs per unit, and thus Unit Contribution is affected as well. Note that because the Materials and Labour Variable Costs do not change when the price does, the New Unit contribution goes down by almost 24%, (1 – $12.20 / $16.00) despite the fact that the price cut was only 10%!
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