Cost Accounting For Dummies
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In cost accounting and management, cost-volume-profit analysis starts with the breakeven point. Breakeven answers this question: “What’s the amount I need to sell to cover all of my costs?” When you open the front door of your business on the first day of a new month, your first concern is likely to be how much you have to sell to at least cover all costs for that month. At a minimum, you don’t want to lose money.

It doesn’t matter whether you’re selling a few glasses of lemonade or manufacturing automobiles. Either way, the breakeven point has three simple elements:

  • It includes fixed costs and variable costs.

  • It includes sales, either units of product sold, or the total dollar amount of sales (revenue). The term volume refers to the level of sales.

  • It assumes profit of zero.

The reason for the name breakeven point is pretty obvious. It’s the point where you neither make nor lose money. It’s the point where you break even.

Examine the elements required to find the breakeven point: Fixed costs remain constant, regardless of the volume of products or services you provide. Variable costs increase or decrease proportionately with the amount of products you sell or services you deliver.

The total variable costs, of course, increase as you produce more products or provide more services, and vice versa if fewer items, products, or services are provided. Sales is the total dollar amount received for your product or service. Finally, profit represents sales less all of your costs.

Okay, if you want to split hairs, there’s an exception about fixed costs that is important in analyzing cost-volume-profit: relevant range. But in most cases, the level of activity stays within the relevant range for fixed costs.

What makes the breakeven point so important is that every sale above your breakeven point generates a profit. If your breakeven point is 100 units, you make a small profit when you sell the 101st unit. That’s good! After you know your breakeven point, you can plan the level of sales you need to generate a specific amount of profit.

What goes up can come down. If you sell only 99 units, you have a small loss. That’s not good! The fewer units you sell, the larger your loss.

Before you start selling a product, you need to know the fixed costs, the variable costs, and the sale price. You can use the cost and price information to determine how many units you need to sell to recover all of your costs — your breakeven point. The formula is

Profit ($0) = sales – variable costs – fixed costs

Failing to get a grip on profit, loss, and breakeven point can be funny, at least on TV. Saturday Night Live did a skit years ago about “The Change Bank.” Its only business was to make change, and its tag line was “We can meet all of your change needs.” The owner was asked: “How do you make money just making change?” “Volume!” says the owner.

The joke in the Change Bank skit is that regardless of how much business you do, there’s no profit in making change for people.

Consider the following breakeven scenario. You own a software company, and you’re thinking about buying a booth at a technology trade show. You hope to sell your product to trade-show visitors. Before deciding to attend, you benefit from a little breakeven analysis.

You might say to yourself, “I’m not getting on a plane unless I can at least cover all of my expenses. How many units do I need to sell to cover all expenses?”

That number is the unit sales needed to reach your goal. Say your application sells for $40 per unit, and you have variable costs of $20 per unit. Fixed costs amount to $1,000. Plug those numbers into the formula:

Profit ($0) = sales – variable costs – fixed costs
Profit ($0) = (units x $40) – (units x $20) – $1,000
Profit ($0) = units x ($40 – $20) – $1,000
Profit ($0) = units x $20 – $1,000

To finish this little piece of algebra, add $1,000 to both sides of the equation. Then divide both sides by 20: X = 50, or 50 units.

$1,000 = units x $20
$1,000 / $20 = units
50 = units

You need to sell 50 units at $40 per unit. If you don’t think you can sell at least 50 units of software, don’t get on the plane for the trade show.

About This Article

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About the book author:

Kenneth W. Boyd has 30 years of experience in accounting and financial services. He is a four-time Dummies book author, a blogger, and a video host on accounting and finance topics.

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