# Understanding, Allocating, and Controlling Overhead Costs

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4 Firm XYZ Calculation of Contribution Margin Department A Department B Department C Total Price/unit Units 18, , , , Sales 127, , , , Variable Expense 60, , , , Variable Expense to Sales Variable Expense per Unit Contribution Margin 66, , , , Firm XYZ Overhead Cost Allocation Department A Department B Department C Total Contribution Margin 66, , , , Variable Cost Basis Allocated Overhead 43, , , , Net Profit 22, , , , Sales Basis Allocated Overhead 50, , , , Net Profit 15, , , , Equal Basis Allocated Overhead 51, , , , Net Profit 14, , , , / 4

5 ferred to as contribution to common overhead. Examining the contribution margin for each department or product provides the manager with a simple picture of the sources of overall profitability. Departments or products with negative contribution margins should be discontinued or reorganized since they are not even covering their direct expenses. The following example illustrates the calculation of contribution margins. Break-even Analysis Knowing your fixed costs (both fixed overhead costs and other fixed costs) and contribution margin can also be used to determine the break-even point. Breakeven analysis determines the level of sales that will yield the firm neither profits nor losses, i.e. total revenue = total costs. By applying the contribution concept and break-even analysis, the manager can get an idea of the sales level needed to be profitable. Break-even analysis can also be used to determine the sales level needed to reach a profit objective, determine a sales price, or evaluate a change in fixed costs. Once you know your fixed costs and contribution margin, the break-even point can be calculated in either units or sales dollars. Break Even Point (units ) = Fixed Cost Price/unit - Variable Cost/unit or Fixed Cost Contribution Margin per unit Break Even Point (sales dollars) = Fixed Cost Contribution Margin Percentage For our example-firm XYZ, Department C: Break-even Point (units) = 79, = 62,416 units This indicates that approximately 6,800 additional units of sales must be generated for department C to meet direct expenses and recover the fixed costs which the manager feels should be allocated to this department. For the firm XYZ as a whole: Break-even Point (Dollars) = 155, = \$359,700 The sales revenue break-even point indicates that total sales could decrease to \$359,700 (a drop of around \$41,000) before the firm begins to lose money. The sales necessary for firm XYZ to make a profit of \$50,000 can also be easily calculated: Break-even Point with Profit Goal = Fixed Costs + Desired Profit CM% = 155, , = \$461,879 Break-even analysis can also be used to evaluate changes in the production process. Suppose the manager of firm XYZ is considering purchasing a new machine for department C. Interest and depreciation on the new machine will add \$25,000/year to the overhead costs. On the other hand the machine will save \$.25/ unit in labor costs. The new break-even point will be: 79, , = 68,597 units The manager must then assess whether this sales volume can be realistically obtained, before considering the addition of the equipment. A final use of break-even analysis is in determining the minimum sales price (assuming that sales volume is constant) which must be charged in order for the firm to meet all of its expenses. Break-even Fixed costs sales price = Anticipated volume or For Department A + Variable Cost/unit Fixed costs/unit + variable cost/unit = 43, ,186 = \$ / 5

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