The essential elements of break-even analysis relate to the assumed behavior of certain costs
within the cost structure. To use this model, the firm must place all its costs in two categories—
variable costs and fixed costs—and also determine the range of volume that may be sold over the
period. Let’s examine these components.
Variable Costs
Variable costs tend to vary as the output volume changes. Variable costs are incurred per each
unit of output. For example, direct materials are considered a variable cost because they vary
directly with the quantity of products produced. If I am producing 50 widgets and each one
requires $10.00 of material costs, then the variable cost of material is $10.00 per unit. Of course,
materials are not the only variable cost component of a product. Other common variable costs
include
• direct labor
• direct materials
• utility costs (associated with the production area)
• packaging
• freight-out (on products sold)
• freight-in (on materials)
• sales commissions
The above variable costs are additive to create a total variable cost per unit for each product
being sold. To illustrate, let’s create the variable cost per unit for one widget.
Direct labor $ 5.00/unit
Direct materials $10.00/unit
Packaging $ 1.00/unit
Utility cost $ 4.00/unit
Total variable cost = $20.00/unit
The following tabular and linear graphical relationships further illustrate the concept of variable
costs.
Variable Cost Relationship
Units Sold Variable Cost/Unit Total Variable Costs
(Units x Cost/Unit) $20.00 $ 0.00
1 $20.00 $ 20.00
5 $20.00 $ 100.00
10 $20.00 $ 200.00
20 $20.00 $ 400.00
50 $20.00 $1,000.00
Fixed Costs
In addition to variable costs, there are many costs encountered in business that are constant and
do not vary in total as the sales volume or the quantity of output changes over some range of
output. For example, administrative salaries are generally considered fixed because they are
normally the same month after month and do not normally fluctuate with volume. Other typical
examples of fixed costs are:
Depreciation $20,000 annual change
Amortization $ 3,000 annual change
Insurance premiums $ 8,000 annual expense
Property taxes $ 6,000 annual expense
Computer systems $ 5,000 annual lease cost
Overhead $10,000 supervisory costs
Lease costs $ 8,000 annual office lease
Total fixed costs $60,000 Total annual fixed
Fixed costs for a period are also additive. The total fixed cost for a given period (month, quarter,
or year) is unchanged regardless of the quantity of product output or sales. Note, however, over
some longer relevant range, say a decade, these fixed costs may become variable. Theoretically,
in the really long run there are no fixed costs, because with enough time every cost becomes
variable.
Using the previously developed unit variable cost ($20.00) and annual fixed cost ($60,000) the
following tabular and linear graphical relationships further illustrate the concept of variable
costs.
Variable Cost Relationship
Units Sold Fixed Cost Total Variable Cost
(units cost/unit)
$60,000 $ 0.00
1,000 $60,000 $ 20,000
5,000 $60,000 $ 100,000
10,000 $60,000 $ 200,000
20,000 $60,000 $ 400,000