Expected Rate of Return
What is the Expected Rate of Return?
Companies often need to identify how much sales in dollars or how many sales in units they need to reach, in order to start making a profit. From this, finance and economics scholars have created an equation to identify the breakeven point for business. The breakeven point is a popular finance concept used to determine the number of units a business must sell in order to break even. In other words, the breakeven formula will help business owners understand how many units they need to sell in order to not make a profit and not incur a loss. Further, the formula can be manipulated to incorporate a baseline profit into the equation. Finally, with just a few more changes, a company can identify the dollar amount of sales needed to break even.
The breakeven formula is a pretty straightforward formula, which is:
- Units = Fixed Costs/ (Sales – Variable Costs).
The solution to the equation gives a business owner the number of units needed to break even. As previously stated, the formula may also be manipulated to incorporate a baseline profit for the company. In this situation, the formula would be as follows:
- Units = (Fixed Costs + Profit) / (Sales – Variable Costs).
By incorporating profit into the formula, a business owner is able to identify a target profit and then determine the number of units that needs to be sold in order to achieve their objectives. However, business owners tend to understand dollar figures as compared to unit sales. Further, most businesses sell more than one type of product. From this, identifying the dollar sales needed, instead of units, requires one simple additional step.
- Unit * Sales price = Dollar Sales Needed.
This step may be applied to either formula to determine the dollar sales needed to achieve either the breakeven point or the breakeven point plus a baseline profit.
Why Is Expected Rate of Return Important?
Understanding the breakeven point is important for numerous reasons. First, understanding the breakeven point helps when creating a cash budget for a business. When a business owner creates a cash budget, the first step is to identify revenues for the month. To calculate the revenues for the month, business owners multiply the units expected to be sold by the average sales price of the product. From this, revenues for the month are established. At this point, a business owner does not understand if the sales projections were in them a prophet. However, if a business owner creates a breakeven point analysis, then, the person will be able to identify whether the project’s sales will earn a profit, breakeven or produce a loss for the month. By approaching cash budgeting, with a breakeven point analysis already completed, then understanding the various components of the cash budget will be made easier. A second reason that the breakeven analysis is important is because identifying a sales price that will cover fixed cost and variable costs is a difficult process. In this situation, a business owner can construct a simple Excel spreadsheet. In the spreadsheet, changing the sales price will allow the business owner to identify the number of units needed to break even any specific sales price. This will result in the owner better understanding how sales price impacts units sold and profits. Finally, a business owner can use the same structure to manipulate fixed and variable cost as well. Again, by manipulating either the fixed costs or the variable cost, the business owner will have a better understanding of the impact that changing cost has on the number of units that needs be sold to breakeven.
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Who Needs to know the Expected Rate of Return Formula?
The breakeven point should be understood by finance students, accounting professionals, and business owners. Finance students need to understand the breakeven analysis because the concept is covered in numerous classes such as accounting, corporate finance, managerial accounting, financial accounting, and economics. By mastering this concept early in your degree, students find the noted classes easier to understand and they usually achieve better grades. Accounting professionals need to understand the breakeven point because of the numerous applications for the formula. For example, accounting professionals are often asked by small business owners, “At what point will my company breakeven”? By mastering the breakeven point analysis, accountants will typically have this answer already calculated and be able to present their findings when confronted with the question. Finally, small business owners need to understand this formula for a multitude of reasons. To illustrate, small business owners usually create a business plan an annual basis. Part of the business plan is to identify the breakeven point. Through mastery of the formula, small business owners will be able to quickly complete the section of the business plan. From this, more time may be spent analyzing competition or creating a SWOT analysis for the company.
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Step by Step - Expected Rate of Return Explained:
Expected Rate of Return Terminology:
Before an in-depth review of the breakeven point is conducted, examination of terminology used when dealing with the breakeven point is needed.
- Fixed Costs - The fixed costs our cost that do not change on a monthly or annual basis.
- Variable cost - the variable cost are only incurred by a company when the unit is sold.
- Sales price - this is the price one unit is sold for.
- Contribution margin - the contribution margin is the dollar amount that may be applied to reducing fixed cost.
- Contribution margin ratio - the contribution margin ratio measures the incremental income produced by an additional dollar of sales.
- Margin of safety - the margin of safety is the difference between the expectations a business owner has for sales and a breakeven dollar amount for sales.
- Profit equation - the profit equation helps business owners identify profits using sales price, variable costs, and fixed costs
Expected Rate of Return - Step by Step:
Solving the breakeven point is pretty straightforward once all variables are found. For the numerator, FC is the fixed cost. And the denominator, SP is sales price and VC is variable cost. To solve the equation, start with the denominator. Subtract sales price from variable costs. This answer is also considered to be the contribution margin. Finally, divide the fixed cost by the contribution margin. The answer is the number of units that needs to be sold in order to breakeven.
Break Even Point With Base Profit - Step by Step:
As the picture above shows, incorporating a baseline profit is as simple as adding the anticipated profit to the fixed cost. From this, just solved the equation by dividing the fixed cost plus profit by the contribution margin. This again will give you the number of units sold to achieve the baseline profit.
Concluding Thoughts on Expected Rate of Return:
Small businesses face a multitude of challenges from changing customer case, increased competition, and controlling costs. Considering this, small business owners have a difficult time identifying the breakeven point, in units, that they need to achieve to start making a profit. Because of this issue, economists and financial scholars have created a formula to help small business owners identify the breakeven point. The breakeven point is a formula used by small business owners to determine the number of units needed to avoid a loss but not make a profit. This formula consists of three variables, which are fixed cost, sales price, and variable costs. The breakeven formula may be manipulated to incorporate a baseline profit or change to determine the sales volume needed to achieve breakeven. The importance of understanding this formula cannot be understated. Small business owners need to understand the breakeven point formula for strategic purposes, students must understand this formula due to the number of classes the cover the concept, and accounting professionals should master the formula to help clients with creating business plans and other strategic weapons.