This analysis is part of my answer to Essay Questions in IBM 6015 – Marketing Management (Prof. Roland Gau) Take Home Exam 2
In our class discussion we talked about pricing strategies and the break-even points. We also talked about starting a simple business selling Bubble Milk Tea. Use those concepts to present a break-even analysis for starting a simple business that sells a single, simple food item of your choice that could be set up next to our Bubble Milk Tea stand.
a) Describe what “break-even” means, why it is important, and explain how it can be calculated (both conceptually, and mathematically).
Break-even means the point when total cost equals to total revenue. The break-even analysis aims to indicate a specific volume where break-even is achieved. It is used altogether with the pricing model of target-return pricing which the target return rate decides the price. This model is often used for public utility companies, such as water and gas, who are usually under rate-of-return regulation[1]. In this model, volume ultimately decides whether target return can be met or not. With the aid of break-even analysis, we identify a threshold where the venture will break even.
Break-even analysis is important because it considers 2 things: fixed cost (cost that does not change with volume) and variable cost (cost that changes with volume). Hence, we can observe the different effects of changing in fixed and variable costs. For instance, startup entrepreneurs may follow the analysis to decide if they invest in brand-new asset (i.e., high fixed cost) or purchase from second-hand instead. Mature company uses this analysis to estimate the effect of cost-down strategy. Furthermore, break-even analysis shows the volume where company can make its ends met by selling this product. On one hand, a project must justify for itself with a breaking-even volume that is aligned with market potential and feasible to the company’s capacity. Failing to break-even results loss per production, and requires additional investment from the company to support the project. On the other hand, company can estimate the volume when it starts to make a profit.
However, break-even analysis does not take price elasticity (i.e., demand affected by price) and the price of competitor into account which affect focal company’s pricing strategy. An illustration of break-even calculation is presented below.
Step 1: Calculate the unit cost at capacity (i.e., volume)
unit cost=variable cost+(fixed cost)/volume
Step 2: Set a target return rate and calculate the target return price accordingly
target return price =unit cost +(target return rate ×investment)/volume
Step 3: Calculate break-even volume, where price covers just variable cost and fixed cost per unit
break even volume=fixed cost/(price-variable cost)
It’s important to note that variable cost can be step rather than linear. In such case, calculation must be based on the applicable variable cost at each volume scale.
b) What would you set your price at for this food item? Defend that price point.
Food item: deep fried donut
List price: NT$35 each, or three for NT$100
Price after 4:30pm: NT$30 each
Pricing objective
To maximize current profit and sell the venture to investors within the grace period (3 years) of startup loan, I set a target return rate of 10% that is higher than average Taiwan stock market (TAIEX) annual return[2] of 8.6%. I deem this return be attractive for investors.
Determining demand
Given the low-cost and high-frequency nature of donut, consumers are less price sensitive in this item. I also consider donut as a good complement with bubble milk tea in terms of taste and price, and is not readily available in this area; moreover, donut is an ideal snack for office workers and cram school students (major consumers in this area) because it does not produce strong smell. In addition, there is no proximate competitor or substitute. The alternative of packed donuts sold at Fami Mart are less fresh, allowing deep fried donut a competitive edge in this area. To ease the calculation, I assume there’s no competitor entry.
The venture opens on weekdays, from 12pm to 6pm. I estimate the market potential by the number of pedestrians separately for rainy and non-rainy days[3], arrive to 24,240 pedestrians per year who would pass by the venture during its hours.
| Number of days in a year × weekday portion of the year (71.4%) | Pedestrians count per day during 12pm – 6pm | Total pedestrians count | |
| Rainy day | 118 | 60 | 7,080 |
| Non-rainy day | 143 | 120 | 17,160 |
| Total | 261 | 24,240 |
Out of the 24,240 pedestrians, I roughly estimate 3% of them would end up purchasing 1 donut per person, which makes a demand of 727 donuts per year. I round it to 800 when estimating cost.
Estimating cost (detail is provided in the next section)
| Fixed cost | Variable cost at volumes | Level of production | Total cost (investment) | Unit cost |
| NT$20,905 | NT$3.38@600pcs
NT$3.30@900pcs |
800 | NT$23,609 | NT$29.51 |
I refer to the most famous deep-fried donut[4] within a 20-minute-walking radius for ceiling price (NT$35). The floor price (NT$30) reflects my unit cost. Within this range, I adopt target-return pricing method, of which I set target return rate at 10%. The target-return price is NT$32.46
target return price =29.51 +(10% ×23,609)/800=32.46
To include a quantity discount that encourages larger volume purchase, I make the final list price at NT$35 each, or three for NT$100. Last but not least, I also consider for yield pricing to clear inventory due to product perishability. Hence, the price after 4:30pm is NT$30 covering just the unit cost.
c) Conduct a break-even analysis. Estimate the number of units sold required to break even, and discuss how feasible this is as a successful business venture. Be sure to list out your assumptions, organized in a smart way (perhaps with some tables to list out your fixed and variable costs), and defend all of the choices that you make.
General assumptions
- Sole proprietorship, where owner is compensated by equity rather than wage; labor and health insurances do not apply for owner who is on his own risk
- Owner also serves as the accountant for this venture, thus does not accrue accountant fee
- Owner is qualified to Young Entrepreneurs Loan[5], a startup financing product whose interest is fully subsidized by the Department of Economic Development, Taipei City Government
- Under such a loan, there is no interest expense against owner, but a one-time fee (0.5% of the loan). The grace period is up to three years without collateral. Owner borrows the most amount possible (NT$2,000,000) and keeps the rest in cash for operation
- Storage, refrigerator, water, and electricity are supported by the NCTU office
- Long-lived assets purchased from second-hand market cost 40% of price for new products
Fixed cost estimation
| cost of capital (100% loan, 0.5% one-time fee) (link) | NT$10,000 |
| movable stand, sign board, product display, pricing sign, and light bulb (link) | NT$2,000 |
| health examination required for food vendor (link) | NT$1,100 |
| extension cord –new | NT$1,000 |
| uniform –new | NT$1,000 |
| work surface for handling dough (link) | NT$332 |
| big umbrella covering the stand (link) | NT$311 |
| spoon and utensil for oil pan (link) | NT$310 |
| towel –new (link) | NT$300 |
| clip (link) | NT$212 |
| fermenting box (link) | NT$180 |
| oil pan and shelf (link) | NT$80 |
| donut makers (link) | NT$40 |
| buckets | NT$40 |
| Total fixed cost | NT$20,905 |
Variable cost estimation
| unit cost at production level | Oil $650 per 600 donuts |
Flour
$70 per 60 donuts |
Sugar
$44 per 50 donuts |
Plastic bag $150 per 900 donuts | Total
per donut |
| less than 100 | NT$6.50 | NT$1.40 | NT$0.88 | NT$1.50 | NT$10.28 |
| less than 300 | NT$2.17 | NT$1.17 | NT$0.88 | NT$0.50 | NT$4.71 |
| less than 600 | NT$1.08 | NT$1.17 | NT$0.88 | NT$0.25 | NT$3.38 |
| less than 900 | NT$1.08 | NT$1.17 | NT$0.88 | NT$0.17 | NT$3.30 |
Based on the market sizing in previous section, I estimate a demand of 727 donuts per year. The applicable variable cost is NT$3.38 which I input for break-even analysis.
The number of units sold required to break even under current pricing is 3,809 pieces, as the calculation below shows.
break even volume=20,905/(35-3.38)=3,809
Consider my estimated demand of donut is only 727 per year, this break-even volume requires more than 5 years to achieve. This length of time is longer than my plan to sell this venture within the grace period of loan (which is 3 years in this case). Thus far, I do not consider it a successful business venture yet. But several modifications can be made.
- increase sale: use the stand during morning to sell breakfast and increase revenue
- decrease cost: use own money instead of loan to reduce cost of capital
- use the excess of cash I borrow from the government to invest in affiliates
To conclude, this venture was limited to an unfavorable location where parking is inconvenient, making it accessible mainly for pedestrian consumers. However, the pedestrians in this area are mostly office staffs and cram school students, whose distribution concentrates during the weekdays but not on weekends. This external environment largely restricts feasibility for this vendor. Despite enjoying free water and electricity supply from the NCTU office as a favorable internal environmental factor, the venture takes too long time to break-even. Besides, other investors may not have the privilege to access NCTU resources, further increase the cost and require additional investment. In brief, this venture is currently unfeasible.
[1] Newbery, David. (1998). Rate-of-return regulation versus price regulation for public utilities. The New Palgrave Dictionary of Economics and the Law: 3.
[2] https://tw.stock.yahoo.com/news/%E9%87%91%E8%9E%8D-%E5%8F%B0%E8%82%A1%E8%BF%9115%E5%B9%B4%E5%B9%B3%E5%9D%87%E5%B9%B4%E5%8C%96%E5%A0%B1%E9%85%AC%E7%8E%878-6-%E8%82%A1%E5%82%B5%E7%9B%B8%E8%BC%94%E6%9B%B4%E7%A9%A9%E5%81%A5-072805829.html
[3] Historic weather data was retrieved from https://www.ntpc.gov.tw/ch/home.jsp?id=f165f60bfe5a0a96
[4] https://goo.gl/maps/ZQdymqeYsnKo8Fed8
[5] http://www.easyloan.taipei/?md=index&cl=y_financing&at=yf_loan