Abstract
Andrew’s Hair Styling is a hair salon offering only haircuts. This paper evaluates the company’s contribution margin, break-even point, and operating income under two distinct compensation structures. In the first case, barbers are paid only a fixed hourly wage. In the other case, barbers are paid a lower fixed hourly wage together with an incentive payment for each haircut. The business owner is interested in the effects of the revised compensation method on the aforementioned performance indicators.
The calculations indicate that, although the revised compensation structure will reduce annual fixed costs by 49%, it will also reduce net operating income at the 20,000 haircuts level by 54%. Based on this result and on further analysis, we recommend that the old compensation structure be kept in place as the revised structure unduly constricts the contribution margin (down 52%) and affects very negatively the profitability of the business.
All calculations are performed in Excel to preserve clarity and ease of use.
The owner of Andre’s Hair Styling, a small hair salon offering only haircuts, approached us with a request to evaluate his business. He was particularly interested what contribution margin and break-even point of his business. Andre needed two scenarios analyzed in which the guiding variable was the compensation method. Under the current method, barbers are paid $9.90 per hour. Under the new method, they will be paid $4 per hour plus $6 for each haircut.
The following table summarizes the information provided by the owner.
Current
Revised
5
5
Compensation/haircut
$ -
$ 6.00
Wage rate/hour
$ 9.90
$ 4.00
Work hours/week
40
40
Work weeks/year
50
50
Rent & other fixed/month
$ 1,750.00
$ 1,750.00
Shampoo/client
$ 0.40
$ 0.40
Price of service
$ 12.00
$ 12.00
First, we calculated the contribution margin per haircut by subtracting the variable cost per haircut from the price of a haircut. This is gives us a contribution margin of $11.60 with the current compensation structure, where the only variable expense is shampoo versus $5.60 under the revised compensation structure, where part of the barbers’ labor varies directly with the number of haircuts.
This means that $11.60 goes towards covering fixed costs in the former case and only $5.60 in the latter. Although profit sharing can be a good idea and can improve employee morale and productivity, it is important for an owner to keep an eye on the bottom line. However, in order to see what effect the change in compensation structure will have on profitability, first we have to consider the fixed costs.
Andre’s Hair Styling is paying $1,750 every month for rent and other fixed expenses. This is $21,000 annually. Under current conditions, barbers’ compensation is a fixed cost, which amounts to $9.90 per hour. There are 5 barbers working at the salon, including the owner. They put in 40 hours per week for 50 weeks annually. Multiplying these numbers gives us an annual fixed compensation expense of $99,000 for all 5 barbers. However, under the revised compensation method, barbers are paid only $4 per hour, which equals $40,000 per year for all 5 barbers. On top of this, they receive $6 for each haircut they perform. This $6 is subtracted from the contribution margin because it is a variable expense.
Now that we have calculated the annual fixed costs and the contribution margin, we can determine the break-even point in haircuts by dividing the latter into the former. In order to cover $120,000 of fixed costs and arrive at a zero profit, Andre’s Hair Styling has to deliver 10,345 haircuts. Under the revised compensation plan, this number changes slightly to 10,893
The results are summarized below.
Current
Revised
Fixed costs
$ 120,000.00
$ 61,000.00
Contribution margin/haircut
$ 11.60
$ 5.60
Break-even point (in haircuts)
10,345
10,893
Operating income @20,000 haircuts
$ 112,000.00
$ 51,000.00
As it appears from the calculations, although the break-even points in units are close in the two cases, the operating results at the suggested 20,000 haircuts level are dramatically different. This is due to the fact that as the number of haircuts delivered increases, the fixed costs remain the same and are spread over a larger base. Thus, although under the current setup fixed costs are twice as high as under the revised plan, the operating income is also almost double.
On the following graph we have plotted the operating result under both plans. The two plans deliver equal operating results at 9,833 haircuts. However, the result is negative $5,935. In positive territory, the current compensation method always dominates the revised plan.
In conclusion, we recommend keeping the current compensation structure as it delivers better results for the owner.
References
Accounting for Management. (2012, January 22). Contribution Margin and Basics of Cost Volume Profit (CVP) Analysis. Retrieved from http://www.accountingformanagement.com/cost_volume_profit_analysis.htm
Averkamp, H., CPA (2012, January 22). How Do You Calculate the Break-Even Point in Terms of Sales? AccountingCoach. Retrieved from http://blog.accountingcoach.com/break-even-point-2/
Averkamp, H., CPA (2012, January 22). Is Contribution Margin the Same as Operating Income? AccountingCoach. Retrieved from http://blog.accountingcoach.com/contribution-margin-operating-income/
CliffsNotes. (2012, January 22). Cost-Volume-Profit Analysis. Retrieved from http://www.cliffsnotes.com/study_guide/Cost-Volume-Profit-Analysis.topicArticleId-21248,articleId-21229.html
