So far, Charlie is happy with the results we have shown him, but he's a bit worried about any potential errors he may have made in figuring out what his costs are. The information he gave us is derived from notes in a little black book he carries around in his shirt pocket. He tries to keep accurate records about his purchases and consumption of materials. However, when he gets involved in what he's doing his interest in craftsmanship gets in the way of careful recordkeeping. Consequently, he wants to know "What if?"

1. "What if my estimate of material costs is off. Hardwoods like oak, maple and cherry get pretty expensive, and that $50 material cost is probably an average. It's about right for oak. Maple is a little less expensive, but cherry is a lot more. I typically buy the best quality I can find. If I do buy somewhat lower quality material, the added waste and scrap more than eat up any savings I gained on the purchase price. I figure cherry probably costs me a good $25 per chair more than the oak. Suppose $75 is a more realistic price. What's that going to do for my breakeven point?"
    
2. "What if my estimate for my own labor is too high. I don't have another job, so I am not foregoing any income by working here in the shop. In nice weather I can putter around the yard and enjoy my garden, so I probably put in less time here in the shop in the summer than in the winter. What would happen if I only charge, say, $45 per chair for my time?"
    
3. "I know I could reduce my sales price and make the same amount of money if I quit paying the dealer that commission. I am essentially paying  a price to have the dealer take orders for me. What sales price would give me the same breakeven point at 4 units?"
    

Evaluate each of these scenarios independently. Go back to your spreadsheet, make the respective changes and see what happens? For each scenario, what advice would you give to Charlie? What lesson[s] can you derive from each of these changes in our assumptions?

1. What happens if raw material costs increase to $75/unit?
   As is evident from the table below, the breakeven point rises to almost 5 units.

   

    

   Answer 
    

2. What happens if he cuts his labor to $45/unit?
   Now the breakeven point drops to about 3 units per month.

   

   Answer
    

3. What selling price would Charlie have to charge in order to have the same 4-unit breakeven point if he stops selling through the dealer and thus eliminates the commission? Is the dollar sales for the breakeven point the same as it was originally? Why or why not?  Answer
   Since the commission is a variable cost, eliminating the commission and reducing the sales price by the same amount have a compensating impact on the unit breakeven point. However, the dollar sales required to break even will decline because each unit sells for $32.50 less than before.

   

This sort of analysis is called sensitivity analysis, and it is designed to determine how sensitive a particular situation is to changes in one or more parameters. Where there is high sensitivity, a relatively small error in estimation one or more data elements can have a significant impact on the outcome. Charlie's situation is not very sensitive. He has a high contribution margin [40% of sales], so even a $25 increase in material costs still leaves him with a comfortable contribution margin. Nonetheless, our analysis does reveal that a large reduction in fixed costs would reduce his break even point to a single unit per month. If Charlie is really worried about having to produce an average of 4 chairs per month, he might consider moving back to the basement of his house. Note that this concern could derive from two sources. (1) As a retiree, he might not want to work as much as necessary to make 4 or 5 chairs per month. (2) Even if he's willing to work that hard, he has to have demand for the product in order to sell what he makes. There is nothing to be gained in building for inventory in this situation. Therefore, some sense of his energy level and the potential market would be very helpful.

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Copyright © 2004 Gerald M. Myers. All rights reserved. This site has been developed as aid to instructors and students in managerial accounting. The scenarios contained herein are not intended to reflect effective or ineffective handling of managerial situations. Any resemblance to existing organizations is purely coincidental.

Last modified: August 03, 2005