Andre has asked you to evaluate his business, Andre’s Hair Styling. Andre has five barbers working for him. (Andre is not one of them.) Each barber is paid $9.90 per hour and works a 40-hour week and a 50-week year, regardless of the number of haircuts. Rent and other fixed expenses are $1,750 per month. Hair shampoo used on all clients is $0.40 per client. Assume that the only service performed is the giving of haircuts (including shampoo), the unit price of which is $12. Andre has asked you to find the following information.
1. Find the contribution margin per haircut. Assume that the barbers' compensation is a fixed cost. Show calculations to support your answer.
Contribution margin is the difference between the revenue and variable costs. In this case, barbers’ compensation has been declared as a fixed cost. Therefore, the only variable cost is the hair shampoo for the clients.
Revenue is $12 while the variable cost is $0.40
Contribution margin= $12-$0.40= $11.60.
2. Determine the annual break-even point, in number of haircuts. Support your answer with an appropriate explanation. Show calculations to support your answer.
Break-even point refers to the instance when the revenue is equal to the cost incurred to attain the revenue. It is a point of zero profits and zero losses.
The breakeven number of haircuts= Total annual fixed costs/contribution margin
Total annual fixed costs= total annual barbers’ compensation + total annual rent and other fixed costs
Total annual barbers’ compensation= 5(number of barbers)*$9.90(hourly rate)*40(working hours per week)*50(weeks) = $99,000
Total annual rent and other fixed costs=$1,750*12(months) = $21,000
Total annual fixed costs (annual operating expenses) = $99,000+$21,000=$120,000
Break-even number of haircuts= $120,000/$11.6 = 10,344.83(round off to the next whole number) = 10,345 haircuts
3. What will be the operating income if 20,000 haircuts are performed? Show calculations to support your answer.
Operating income= Gross revenue- Operating expenses.
Gross revenue= 20,000(haircuts)*$11.6(net earnings per haircut) = $232,000
Operating expenses as calculated in 2. Above is $120,000
Operating income=$232,000-$120,000= $112,000
4. Suppose Andre revises the compensation method. The barbers will receive $4 per hour plus $6 for each haircut. What is the new contribution margin per haircut? What is the annual break-even point (in number of haircuts)? Show calculations to support your answer.
Part of the barbers’ compensation has been declared as a variable cost ($6)
New contribution margin per haircut=Revenue per haircut ($12)-New variable cost per haircut.
New variable cost per haircut=$0.40(hair shampoo) + $6(payable to the barber per haircut) = $6.40
New contribution margin per haircut=$12-$6.40= $5.60
Annual break-even number of haircuts=New annual fixed costs/New contribution margin
New annual fixed costs=New annual barbers’ compensation+ total annual rent and other fixed costs ($21,000)
New annual barbers’ compensation=5(number of barbers)*$4(hourly rate*40(hours per week)*50(weeks per year) = $40,000
New annual fixed costs=$40,000(barbers’ compensation)+$21,000(rent)=$61,000
Annual number of break-even haircuts=$61,000(fixed costs)/$5.60(contribution margin) = 10892.86(rounded off to the nearest whole number) = 10,893 haircuts.
MEMO
To: Andre’s Hair Styling
From: Your Accountant (replace this with your name)
Date: 21/03/2018 (you may input your desired date)
Subject: Business evaluation analysis report
In response to your request for an analysis of your business; Andre’s Hair Styling, I am pleased to inform you that I have done an extensive evaluation of the costs and the incomes from your business. From the evaluation, I have come up with some useful suggestions on how you could apply the analysis to monitor your business operations. A comprehensive relationship of the costs is also included.
The contribution margin per haircut is the gross income from the haircut less the variable cost involved in the haircut service. The variable cost in this case is the hair shampoo used on each client while the gross income is listed cost of the haircut. Therefore, the contribution margin is $11.60 which is attained by subtracting the cost of shampoo ($0.40) from the gross income from the haircut ($12).
The annual break-even point, in the number of the haircuts, refers to the number of the haircuts per year that your business requires to give so that your annual gross income=annual operating expenses. Your annual operating expenses are given by annual barbers’ compensation+ annual rent. Each of the 5 barbers’ compensation being $9.90, the total annual compensation is $99000(5*9.90*40*50). The annual rent and fixed costs is $1250* 12 months which is equal to $21000. Therefore, the annual operating expenses are $120000($99000+$21000). Since the annual gross income is given by the number of haircuts* contribution margin of each haircut, we can find breakeven number of haircuts by dividing the annual gross income with the contribution margin to get 10345 haircuts ($120000/$11.60).
Your operating income if 20000 haircuts are performed will be attained by subtracting your annual operating expenses from your gross revenue from the 20000 haircuts. Your gross revenue from 20000 haircuts will be $232000 (20000*$11.60). Since the annual operating expenses are $120000, the operating income from 20000 haircuts is $112000 ($232000-$120000).
On revision of the compensation scheme, the variable costs increase while the fixed costs reduce. The variable costs increase since for every haircut, besides the shampoo cost ($0.40), the barber is also compensated $6. Therefore the new contribution margin is $5.60 ($12-$6.40: the new variable costs). Fixed costs on the other hand reduce since as opposed to the previous fixed compensation of $9.90, each barber’s fixed compensation is $4. Consequently, the breakeven number of haircuts changes to 10893 haircuts (annual operating expenses: $61000/ new contribution margin: $5.60).
From the above, variable costs are those costs incurred in giving each haircut such as shampoo and the new barber compensation per haircut. They affect the contribution margin from each haircut. Fixed costs, on the other hand, are those costs that are essential for the running of the business such as rent and other fixed expenses and the fixed barber compensation. They affect the operating expenses. It can therefore be concluded that the total variable cost is dependent on the number of haircuts given while fixed costs are an independent quantity; they do not change whether haircuts are given or not.
The information about the breakeven number of cuts will be useful to determine how much net income your business generates in each year. If using the previous compensation scheme, you’ll start making profits once 10345 haircuts are made as opposed to when using the new compensation scheme where 10893 haircuts need to be given for your business to start counting profits. Since variable costs are a dependent quantity on haircuts given, they are a clear and concise way of monitoring the productivity of the barbers; the more the variable costs, the higher the productivity and vice-versa.
All the best in your business.
Best,
(Your name)
