Development and Use of the Generalized

Breakeven Formula
Illustration:

A toy company has been selling 12,000 units per year of a particular
educational toy at $30 per unit. The company's variable cost for
manufacturing this product is $10 per unit, so the product's unit contribution
margin is $20 ($30-10$). If a manager is considering spending an
additonal $45,000 to advertise the toy, he could use the breakeven formula to
evaluate the ability of the existing $30 price to support this expenditure:

Selling Price/u $ 30 Breakeven (BE) = ΔFixed Costs/Contibution Margin

- Variable Cost/u 10 = $45,000/$20
Contribution Margin/u $ 20 = 2,250 units
• The application of the breakeven formula tells us that the critical sales level
for the incremental advertising fixed cost is 2,250 units.

• Additional advertising would have to lead to sales of 2,250 units over what
would otherwise have been sold to support the ability of the existing price to
handle the additional advertising.

• The number of units that would otherwise have been sold will be referred to
as the level of base sales (BS).

• The critical sales level of a breakeven analysis is always the number of

units sold over and above the base sales level.

• For breakeven analysis on an existing product, the sales level in the

previous period can be used as an estimate of base sales.
• In the educational toy example, the base sales level could be estimated at
12,000.
• If sales had been at that level during the previous years, it is reasonable to
estimate that sales would continue to be at 12,000 units during the upcoming
year if the additional advertising expenditure were not made.
• Thus, at the price of $30, the total sales level of the toy would have to
surpass14,250 units (12,000 + 2,250) for the additional advertising to
increase the company’s profits.
• For a breakeven analysis on a new project, such as in the use of the
breakeven formula to evaluate an initial price, the number of units that would
be sold if the project is not undertaken would be zero.
 Generalized Breakeven Formula

• The breakeven formula is useful for evaluating a tentative initial price as

well as for evaluating the ability of an existing price to support a change in
fixed costs. Breakeven formula involves determining the number of
“chunks”of contribution dollars that balance the incremental fixed costs.

• The breakeven formula is well-known and has long been widely used as a
business decision-making tool.

• However, to adapt breakeven analysis to the modification of existing

prices, the breakeven formula is inadequate.
Effects of Price Modification on Profit From Base Sales

• To consider why the breakeven formula is inadequate for a price-change

decision, consider the situation in which the manager of the toy company
mentioned above is considering a price modification.

• He is evaluating whether or not to decrease the educational toy's price from

$30 to $25 per unit and focus the additional $45,000 advertising
expenditure on communicating this price decrease to consumers.

• The use of the breakeven formula here would suggest that the breakeven
sales level for this prospective price decrease would be $45,000/($25-$10),
which equals 3,000 units.
• The problem with this breakeven level, however, is that it fails to take into
account that it is not just the new unit sales generated by the price decrease
that will determine the profitability of this price change.
• Modifying an existing price affects all of the product’s sales.

• Thus, if the price of the toy is decreased by $5 per unit, then the sales of the
toy that would have occurred even if the price had not decreased-the base
sales-will have a contribution margin that is $5 lower.
• To be appropriate for decisions concerning the modification of existing prices,
a breakeven calculation must take into account changes in profit from base
sales.
Taking Changes in Profit from Base Sales Into Account

• For a price change breakeven calculation to take into account the effect of the
price change on profit from base sales, it is necessary to calculate the change in
total contribution dollars that results from changing the price on these base sales.

• When this change in total contribution dollars is an increase, then it needs to be

subtracted from the incremental fixed costs.
• Those “new” contribution dollars from base sales would reduce the amount that
would need to be covered in order to break even.

• When this change in contribution dollars is a decrease, then it needs to be added

to the incremental fixed costs.
• The contribution dollars lost on base sales would increase the amount that would
need to be covered in order to break even.
• Computing the change in total contribution dollars due to the effect of the
price change on profit from base sales involves identifying the change in
contribution margin (∆CM).

• The contribution margin that would result from the price change taking place
will be referred to as the new contribution margin.

• ΔCM = CM - CMo
• The change in contribution margin is the change in contribution dollars per unit,
the change in total contribution dollars due to the effect of the price change on
base sales can be arrived at by multiplying this per-unit quantity by the number of
units comprising the base sales level. It can be obtained by multipying ∆CM by
BS.

• To take this change in total contribution dollars into account in a breakeven

calculation, it needs to be subtracted from the incremental fixed cost.

• When it is a positive change - an increase in contribution dollars --- subtracting it

reduces the amount that needs to be covered in order to break even.
• When it is a negative change - a decrease in contribution dollars - subtracting it
adds to the amount that needs to be covered. Thus, the formula for taking base
sales into account in a break-even calculation is as follows:

ΔFC - (ΔCM x BS)

BE = --------------------------
CM

• This will be referred to as the generalized breakeven (GBE) formula.

• To illustrate the use of the GBE formula, let’s return to the educational toy
example.

• The breakeven formula indicated that the incremental fixed costs associated
with the $5 per unit price decrease could be covered by 3,000 units of
additional sales. However, this did not take into account that the $5 price
decrease would also apply to existing sales, which would have the effect of
increasing the number of additional units that must be sold to break even.
 ΔFC - (ΔCM x BS)
BE = --------------------------
CM
• So using the GBE formula to take this effect into account:

$45,000 - {[($25-10) - ($30-$10)] x 12,000}

BE = ----------------------------------------------------------
$15
$45,000 - [($15 - $20) x 12,000)]
= -------------------------------------------
$15
$45,000 - (-$5 x 12,000)
= -----------------------------
$15
$45,000 - (-$60,000) $45,000 + $60,000 $105,000
= --------------------------- = ------------------------- = ------------- = 7,000 units
$15 $15 $15
• 7,000 units indicates the correct breakeven sales level for the price change.
• For a $5 decrease in the toy’s price to increase the company’s gross profits,
the additional annual sales resulting from that price decrease would have to
exceed not 3,000 units, but rather 7,000 units.
• The GBE formula is very useful for the task of modifying existing prices to
achieve greater profitability.

• Note that when the pricing task is to set an initial price, the GBE formula can
still be used. In that case, the product in question is not yet being sold, so
there are no base sales. This makes BS equal to zero, which makes the
entire ΔCM x BS equal to zero. Thus the GBE formula becomes the
breakeven formula.
• The GBE formula is called “generalized” because it is useful in a wider range
of pricing situations than the breakeven formula that is usually used.

• The GBE formula is simply the usual breakeven formula written in a more
complete form.
Example:
• A manufacturer has been selling 50,000 units per year of a certain product.
The price of this product is $20 and the variable costs associated with the
product are $12 per unit. The manufacturer is considering decreasing the
price of his product to $17 so as to increase sales. If he goes ahead with this
price change, the manager will purchase new production machinery at a cost
of $75,000, to accommodate the increased sales.
(a) The manager intends to evaluate the prospective price change by computing
the breakeven sales level.
(b) Compute for the breakeven sales level if they proceed to purchase the new
production machinery while keeping the product’s price at $20.