Target-Profit & Break-Even Analysis

Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology and holds certifications as a CIA, CISA, CFSA, and CPA, CA.

Total costs are compared to total revenue and are either lower (profit), higher (loss), or equal (break-even point). Learn to calculate this and identify target profit, as well as establish a margin of safety to accommodate unanticipated risks. Updated: 12/14/2021

Determining Profitability

Your son is saving for a new bike and decides to earn some extra money by mowing lawns in the neighborhood. He wants to know how many lawns he needs to mow in order to earn enough money to buy the bike. He must also figure out how much to charge each homeowner for this service, taking into account the cost of gas and his time to mow the lawn.

Businesses face similar decisions when trying to determine if a particular product is making money for the company, and how much of that product should be produced given the business's finite resources.

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  • 0:02 Determining Profitability
  • 0:36 Calculating the…
  • 4:21 Calculating Target Profit
  • 5:54 Margin of Safety
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Calculating the Break-Even Point

A business incurs a number of costs that are necessary for it to earn revenue, which is the same thing as income. For example, a business has to pay for electricity in order to operate, it needs to pay salaries to its employees, and it may need to pay rent.

Costs can be classified as either fixed or variable. Fixed costs are constant and don't fluctuate with the amount of activity. An example of a fixed cost would be the monthly rent a business pays for its office space. Variable costs, on the other hand, vary with the amount of activity. An example of a variable cost would be utility expenses, which vary with the amount of production. In the case of our lawn-mowing entrepreneur, the amount of gas in the lawnmower would be a variable cost since the more lawns he mows, the more gas he will use.

In order to manage costs, businesses need to calculate the break-even point. This is the point where total costs equal total revenue. At this point, the business isn't either making money (profit) or losing money (loss). It is essentially just bringing in enough money to cover its costs. The break-even point can be expressed in terms of units or sales.

The formula for calculating the break-even point in units is:

fixed costs / (selling price per unit - variable cost per unit)

For example, let's assume that the MJ Company incurs fixed costs of $450,000, has a variable cost for each unit of $25 and a selling price per unit of $40. The break-even point in units would be 30,000: $450,000 / ($40 - $25).

This means that the MJ Company must sell 30,000 units of its product in order to cover its costs. Remember, the MJ Company is not generating any profit at this production level, but if it were able to produce more than 30,000 units of this product it would generate a profit. This type of analysis can help a company determine if it's worthwhile to continue producing a product, or whether it would be better off ceasing production.

The break-even point can also be calculated in terms of sales dollars. The formula for calculating the break-even point in sales is:

fixed costs / contribution margin ratio

The contribution margin is the difference between the selling price of a product and its variable cost. The formula to calculate the contribution margin ratio is:

contribution margin / selling price of the product

Let's use the same data for the MJ Company, where the fixed costs are $450,000, the variable cost of each unit is $25, and the selling price per unit is $40. The contribution margin per unit is $15 ($40 - $25), so the contribution margin ratio would be 0.375: $15 / $40.

To turn that into a percentage, so you can use it in your break-even point formula, just multiply that by 100, which equals: 0.375 * 100 = 37.5%. Now we can determine that MJ Company's break-even point in sales is $1,200,000, which is equal to: $450,000 / 37.5%. This means that the company must generate sales of at least $1,200,000 in order to cover its costs. Any sales above $1,200,000 would result in the MJ Company earning a profit.

Calculating Target Profit

In addition to determining the minimum number of units that must be produced to cover costs, businesses also calculate profit targets, which are just goals for how much money a company hopes to make. These can be expressed in terms of number of units or sales dollars.

Let's assume that the MJ Company has a target profit of $600,000, fixed costs of $450,000, and a contribution margin per unit of $15. The formula for determining the sales (in units) to achieve this profit would be:

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