Business managers use a bevy of financial metrics to analyze and track the performance of their companies. The goal is to manage a company's fixed and variable costs to produce a profit. To see how this is done, let's consider the case of The Hasty Rabbitt Corporation, which makes light-weight sneakers for rabbits.
Fixed costs are those expenses that do not vary with the volume of production and cannot be easily changed in the short term. These expenses must be paid at all times and all levels of production, even if sales are zero. The data below sets out the fixed costs for The Hasty Rabbitt Corporation:
- Rent for office building: $36,000
- Rent for warehouse and assembly buildings: $60,000
- Salaries for office personnel: $75,000
- Utilities for office and Plant: $48,000
- Insurance: $8,000
- Interest on loans: $7,000
- Salary for general manager: $80,000
- Licenses and permits: $4,000
- Telephone: $9,000
- Property taxes: $5,500
- Website and internet: $3,500
- Total fixed costs: $336,000
Variable costs change with the level of production and mostly consist of the raw materials and direct labor involved in manufacturing. Hasty Rabbitt has found a winning design for its sneaker and only has to sell one model, the Blazing Hare. Consumers see these sneakers as premium and are willing to pay $75 per pair.
The costs of production for each pair of Blazing Hare sneakers is as follows:
- Materials for upper, cushion and sole: $18
- Direct labor of manufacturing: $20
- Production supplies: $4
- Freight out: $3
- Total variable costs of production for each pair: $45
This means that the Hasty Rabbitt Corporation makes a gross profit of $30 ($75 - $45) for each pair of Blazing Hare sneakers that it sells. Now that the general manager has all the cost figures, how many pairs of sneakers does the company have to sell to make a profit? To get this answer, we turn to the breakeven analysis.
The formula to calculate the breakeven production level is as follows:
Fixed Costs/(Price - Variable Costs) = Breakeven Point in pairs of sneakers
$336,000/($75 - $45) = 11,200 pairs of Blazing Hare sneakers
Now the general manager knows the sales staff needs to sell 11,200 pairs to cover all of the company's fixed costs of $336,000 to break even. For any sales beyond this number, the Hasty Rabbitt Corporation will make a profit.
Suppose the sales staff is particularly aggressive, and they sell 13,000 pairs of sneakers. The company's profit-and-loss statement would look like this:
- Total sales-13,000 pairs X $75 = $975,000
- Less variable costs-13,000 pairs X $45 = $585,000
- Less fixed costs: $336,000
- Profit before taxes: $54,000
A breakeven analysis shows three ways that a company can improve profits: (1) increase sales, (2) lower the unit variable costs of production and (3) reduce the total fixed expenses.
Tracking and analyzing a company's fixed and variable costs is an important responsibility for the business owner. It is the design and control of these costs that determine whether a company makes a profit or not.