Fixed Cost In Break-Even Analysis Refers To The Cost That Procurement – How to Calculate a Supplier’s Break-Even Point

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Procurement – How to Calculate a Supplier’s Break-Even Point

It is often said that in a negotiation, knowledge is power. One vital piece of information that will give you great knowledge is an understanding of your supplier’s break-even point. This is because once your supplier is operating at a level that is above their break-even point, any new business will only attract marginal cost and so is very profitable for the supplier.

Before you are ready to analyse a supplier’s break-even point, there are a couple of concepts you need to understand; those of fixed costs and variable costs.

Fixed costs, as the name implies, are costs that don’t vary with the volume of activity. For example, in a manufacturing company that makes widgets, the rent on premises will remain the same irrespective of how many widgets are produced. Similarly, in a service company, such as a travel agent, the cost of the manager remains the same no matter how many holidays are sold.

Variable costs on the other hand do change with the volume of output. In making widgets, material costs will vary in proportion to the number of widgets produced.

Semi-variable costs are a combination of variable and fixed. An example of a semi-variable cost is that for a supervisor. His costs would normally be treated as a fixed cost but if production levels are high then overtime may be needed and this would provide the variable cost element.

Total costs are obviously the sum of all three.

Now you know these cost types, you are in a position to understand an important concept in analysing a supplier’s costs – the break-even analysis. You draw a break-even point chart by first plotting the fixed costs. As this doesn’t vary with output, it’s a horizontal line. Variable costs have a gradient that is determined by the cost per unit of output. Adding these two costs together gives you the total cost.

If you now draw the sales line, the point at which the total cost line and sales line cross is the break-even point. In other words, it’s the output level at which sales value equals total costs. At output below this level, the supplier loses money. Above it, the supplier makes profit.

This can be very useful information to have in a negotiation. For example, if the supplier is currently operating above its break-even point then further sales will have a big impact on bottom line profits. To be specific, if the supplier’s variable costs are 30% of sales value then for every £1 of business they get above their break-even 70p is additional profit. You can negotiate with a supplier to share this… still giving them a profit but also giving you a discount.

A true win-win!

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