software application as an example.
If you can change the costs or sales, you can reduce your breakeven point. To do so, make some changes to the earlier formula:
Increasing the sale price to $45 per unit:Contribution margin per unit = $45 – $20Contribution margin per unit = $25Breakeven point in units = $1,000 ÷ $25Breakeven point in units = 40
Reducing the variable cost to $15 per unit:Contribution margin per unit = $40 – $15Contribution margin per unit = $25Breakeven point in units = $1,000 ÷ $25Breakeven point in units = 40
Reducing the fixed cost to $800 per unit:Contribution margin per unit = $40 – $20Contribution margin per unit = $20Breakeven point in units = $800 ÷ $20Breakeven point in units = 40
In each case, you lowered the breakeven point in units to 40 units instead of 50. The result? It takes less selling effort — and requires less financial risk.
Target net income: Setting the profit goal
Target net income is the profit goal you set. (I use net income and profit to mean the same thing.)
You compute target net income by plugging the figure into the breakeven formula — with one change. The profit changes from $0 to the target net income amount. Here’s the new formula:
Target net income = sales – variable costs – fixed costs
If you’re going to take that trip to the trade show, how much profit would make your trip worthwhile? How much profit could you produce if you decided not to go? Maybe that’s how you should answer the question. Assume your profit goal/target net income here is $2,000.
Using the original information for sales, variable costs, and fixed costs, you can compute the sales you need to reach target net income:
Target net income = sales – variable costs – fixed costs$2,000 = $40 × (units) – $20 × (units) – $1,000$3,000 = $20 × units)
150 = $3,000 ÷ $20
You’ll meet target net income by selling 150 units.
If you attend the trade show for three days, you need to average 50 sales per day to sell 150 units. If your booth is open for ten hours a day, you need to sell an average of five units per hour. Determine whether that’s reasonable. Is there enough interest in your product to reach that level of sales? That’s the real purpose of thinking through target net income.
Lower profits and margin of safety
The margin of safety is a cushion. If things don’t go as planned — if sales are lower than your budget — you need to know how low your total sales can go before you hit the breakeven point. The word margin, in this case, refers to the amount (in dollars or units) above the breakeven point.
Consider this example: You’re getting ready to book your tickets for the trade show. You computed a breakeven point of 50 units. To reach your target net income, you need to sell 150 units. Target net income uses your budgeted sales level. The difference between your budgeted level of sales (150 units) and your breakeven sales (50 units) is your margin of safety.
If actual sales were 30 units below your budget, your units sold would be 120 (150 – 30). You’re still way above your breakeven point of 50 units. The question always is if you don’t budget correctly, how far off can you be before your unit sales are below breakeven?
Contribution margin versus gross margin
Contribution margin represents the amount of money you have left after variable costs to cover fixed costs and keep for your profit. Gross margin explains how much of your sales proceeds are left after paying cost of sales.
Cost of sales is the direct costs of creating your product. (See the direct and indirect cost section of Chapter 2.) If you were manufacturing denim jeans, you would have material costs for the denim and thread (and maybe a zipper), as well as the labor costs to sew the jeans. Your gross margin per pair of jeans sold might look like this:
Gross margin = sale price – cost of sales (material and labor)
Gross margin = $60 – $25
Gross margin = $35
Contribution margin (sales less variable costs) is part of the target net income formula. Try to avoid confusing the gross margin with contribution margin. The terms look similar, and both are thrown around in accounting conversations. Contribution margin is sales less variable costs. Gross margin, on the other hand, is sales less cost of sales.
Using operating leverage
The degree of operating leverage is a formula that shows how well you’re using your fixed costs to generate a profit. The more profit you can generate from the same amount of fixed cost, the higher your degree of operating leverage.
Here’s the formula:
Degree of operating leverage = contribution margin ÷ profit
Profit = contribution margin – fixed costs
You already covered the component parts that make up this formula. To refresh your memory, see the section “Calculating the breakeven point” and the section “Contribution margin: Covering fixed costs.”
First, calculate the contribution margin. Use the number of units from the target net income discussion above:
Contribution margin = sales – variable costs
Contribution margin = $40 × (150 units) – $20 × (150 units)
Contribution margin = $20 × (150 units)
Contribution margin = $3,000
Use the degree of operating leverage formula to compute the degree of operating leverage:
Degree of operating leverage = contribution margin ÷ (contribution margin – fixed costs)
Degree of operating leverage = $3,000 ÷ ($3,000 – $1,000)
Degree of operating leverage = $3,000 ÷ $2,000
Degree of operating leverage = 1.5
Degree of operating leverage can also be defined as
