Having a thorough knowledge of the expenses to operate a business is essential to develop strategies that will produce a profit. Expenses for businesses fall into two categories: fixed and variable.
Variable costs change with the level of production. Examples of variable costs are materials used to manufacture a product, labor needed for production, packing supplies and shipping cost to the customer. Fixed costs stay the same, regardless of the output volume.
Let's take a look at the annual fixed costs of the Hasty Hare Corporation, a manufacturer of sneakers for rabbits, as an example:
- Salaries of full-time supervisory employees - $137,000
- Rent on leases - $65,000
- Mortgage payments on plant and building - $52,000
- Loan payments on equipment - $43,000
- Depreciation of equipment and buildings - $23,000
- Property taxes - $32,000
- Advertising and marketing - $138,000
- Administrative salaries - $98,000
- Insurance - $28,000
Total fixed costs - $616,000
Average fixed cost is found by dividing total fixed costs by the output production volume.
The formula is: Total Fixed Costs/Output volume
Suppose Hasty Hare produces 10,200 pairs of sneakers in one year. The average fixed cost per pair is as follows:
Average fixed manufacturing cost per unit = $616,000/10,200 pairs = $60.39 per pair of sneakers
If a company increases its production volume, the average fixed cost per unit will decrease. This is known as achieving an economy of scale.
If Hasty Hare increases its annual output to 12,100 pairs, the average fixed costs of production becomes:
Average Fixed Cost per unit = $616,000/12,100 pairs = $50.91 per pair
Since total fixed costs are now spread over a higher production volume, the average fixed cost per unit has declined from $60.39 in the first calculation to $50.91 in the formula for higher volume.
Economies of scale can have an influence on management pricing policies and strategic planning.
Knowing the breakeven selling price for a product is important information for developing a pricing strategy and setting sales prices. This calculation determines the minimum selling price needed to cover total costs. The breakeven sales price is computed over a range of production volumes.
Let's look at breakeven sales prices for Hasty Hare. The company is selling its sneakers for a retail price of $100/pair.
The formula is: Breakeven Sales Price = (Total Fixed Cost/Production Volume) + Variable Cost per pair
With a variable cost of production of $29/pair, the breakeven sales price for different production volumes are as follows:
- For 10,200 pairs, AFC = $60.39
- At 12,100 pairs, AFC = $50.91
- 13,000 pairs, AFC = $47.38
- For 13,900 pairs, AFC = $44.32
The breakeven sales price is therefore:
- 10,200: $60.39 + $29.00 = $89.39
- 12,100: $50.91 + $29.00 = $79.91
- 13,000: $47.38 + $29.00 = $76.38
- 13,900: $44.32 + $29.00 = $73.32
Notice that as the production volume increases, the breakeven sales price goes down. This raises the question: Should management keep the price at $100 or lower the price in an attempt to sell more sneakers?
At a fixed sales price, the formula to calculate the breakeven sales volumes is as follows:
Breakeven Sales Volume = Total Fixed Costs/(Selling Price - Variable costs)
Breakeven Sales Volume = $616,000/($100 - $29) = 8,676 pairs of sneakers
Suppose Hasty Hare managers decide to lower the price $90 to increase sales. What happens to the breakeven sales volume?
Breakeven Sales Volume = $616,000/($90 - $29) = 10,098 pairs
Hasty Hare will have to increase sales by 16.3 percent ((10,098 - 8,676)/8,676) just to break even at the lower price.
While fixed costs remain constant in the short run, management is always trying to find ways to reduce fixed costs in the long term. As illustrated by these calculations, the amount of total fixed costs has a significant impact on pricing and marketing strategies.