AS Business Break Even Analysis “The level of output at which Total Costs = Total Revenue Neither a profit or a loss is made”

Know your Costs - Recap Fixed Costs Fixed Costs –These are costs that stay the same – regardless of the level of output! Rent Light & Heating Advertising Water Gas Salaries/Wages (office staff) Variable Costs – –These are costs that change – with changes in output! Stock Materials for making products Wages (what type of pay?)

Total Costs This is the total amount of money a firm spends on making goods or services This is the total amount of money a firm spends on making goods or services It is calculated by the following formulas: It is calculated by the following formulas: Total cost = fixed cost + variable cost

Step one – draw and label the axes of the graph Costs $ Output (thousands)

Step 2 – Draw fixed cost line Costs $ Output Fixed Costs (thousands)

Step 3 – Draw total costs Costs Output Fixed Costs (thousands) $ TOTAL Costs

Step 4 – add sales revenue line Costs £ Output Fixed Costs (thousands) TOTAL Costs Total Revenue

Step 5 - Analysing the chart Costs £ Output Fixed Costs (thousands) TOTAL Costs Total Revenue Break Even Point – Where Total Costs and Total Revenue are equal Making a Loss  Making a Profit

Calculating the Break even Break even output = Fixed Costs Selling Price – Variable Costs FC SP – VC (contribution) SP – VC (contribution) Football Clubs Sell Players – Very Cheaply

Classification of Costs...

Margin of Safety The amount by which the sales level exceeds the break even level of output It is an indication of how much sales could fall before making a loss So, if current production is 600 units and the BEP is 400 units Margin of Safety is 200 Units

TASK: Construct a BE Chart for the following showing the change in the BEP: Draw a “standard” Break Even chart indicating the BEP The company now buys some new machinery that will increase fixed costs but reduce variable costs Now draw the new Total Cost Line (TC1) and the Fixed Costs Line (FC1) to show the new BEP This shows the uses of BEP for a manager

Break Even – Evaluation Advantages They are easy to construct They are easy to construct Aids in Decision Making by managers – MoS, BEP, P/L – at different levels of output, varying costs or a change in selling price Aids in Decision Making by managers – MoS, BEP, P/L – at different levels of output, varying costs or a change in selling price Charts can be redrawn to give different scenarios and costs Charts can be redrawn to give different scenarios and costs Charts can be compared Charts can be compared The equation is precise The equation is precise REMEMBER – they are a PREDICTION – it hasn’t happened yet!

Break Even – Evaluation Disadvantages The Straight line for costs and revenues is unrealistic The Straight line for costs and revenues is unrealistic –Labour costs may increase towards maximum output (overtime or shift payments) –The Revenue line can be affected by price reductions to sell all of the units made –This could result in 2 BEP’s on one chart! Not all costs are easily classified into Fixed/Variable Not all costs are easily classified into Fixed/Variable It is assumed that all units made are sold It is assumed that all units made are sold It is unlikely that Fixed Costs won’t alter if producing at maximum capacity It is unlikely that Fixed Costs won’t alter if producing at maximum capacity COSTS ARE ONLY ACCURATE FOR A LIMITED AMOUNT OF TIME

Break Even – Evaluation They are easy to construct They are easy to construct Aids in Decision Making by managers – MoS, BEP, P/L – at different levels of output, varying costs or a change in selling price Aids in Decision Making by managers – MoS, BEP, P/L – at different levels of output, varying costs or a change in selling price Charts can be redrawn to give different scenarios and costs Charts can be redrawn to give different scenarios and costs Charts can be compared Charts can be compared The equation is precise The equation is precise REMEMBER – they are a PREDICTION – it hasn’t happened yet!

ABBEY RESTAURANT Profit = TR − TC Current menu: sales turnover = $12,000 variable cost = 5 × 600 = $3,000 overheads = $7,000 profit = 12,000 − 10,000 = $2,000 New menu: sales turnover = 14 × 600 × 1.2 = $10,080 variable cost = 4 × 720 = $2,880 overheads = $6,000 profit = 10,080 − 8,880 = $1,200

ABBEY RESTAURANT Calculate the break-even level of output of both options (show your workings). [6] Break-even = fixed costs ÷ unit contribution Current menu: break-even = 7,000 ÷ (20 − 5) = 467 customers New menu: break-even = 6,000 ÷ (14 − 4) = 600 customers

ABBEY RESTAURANT On the basis of your results to 1 and 2, would you advise Phil to adopt the new menu? Explain your answer. [10] On the basis of the results to the above questions, the answer is no. Relevant points include: Profit from new menu is $800 less than current situation. Profit from new menu is $800 less than current situation. Break-even output for new menu is 133 customers per month more than the current situation. Break-even output for new menu is 133 customers per month more than the current situation. As profits will fall and the target number of customers required to break-even will increase this suggests that the new menu is not a good idea. As profits will fall and the target number of customers required to break-even will increase this suggests that the new menu is not a good idea.

ABBEY RESTAURANT The problem for Phil is that the unit contribution from the new menu is much lower than from the existing menu; $10 compared to $15. The margin of safety for the current menu is 133 customers compared to 120 customers for the new menu. The margin of safety for the current menu is 133 customers compared to 120 customers for the new menu. However, if customer numbers for the current menu continue to fall, then there is a case for changing to the new, lower-priced menu. However, if customer numbers for the current menu continue to fall, then there is a case for changing to the new, lower-priced menu.

What other, non-financial, factors should Phil consider before taking the final decision? Explain their significance to Phil’s business. [9] If no change is made, will the number of customers continue to fall? If so, then the level of profit will continue to decrease. If no change is made, will the number of customers continue to fall? If so, then the level of profit will continue to decrease. Can Phil recruit a suitably qualified chef to continue with the current menu? Ifn not, then the quality of dishes may decline and cause customer dissatisfaction. Can Phil recruit a suitably qualified chef to continue with the current menu? Ifn not, then the quality of dishes may decline and cause customer dissatisfaction. If Phil cannot recruit a suitably skilled chef, then this would increase the pressure on the remaining chefs and Phil would need to train a new chef, increasing his costs. If Phil cannot recruit a suitably skilled chef, then this would increase the pressure on the remaining chefs and Phil would need to train a new chef, increasing his costs. Is Phil’s estimate of demand for the new menu accurate? The competition may already benefi t from customer brand loyalty. Is Phil’s estimate of demand for the new menu accurate? The competition may already benefi t from customer brand loyalty. How would the existing loyal customer base react to the proposed menu change? Phil may lose existing customers. How would the existing loyal customer base react to the proposed menu change? Phil may lose existing customers. What will be the impact of any change to the menu on existing chefs? As they are skilled, they may object to the new simpler dishes. What will be the impact of any change to the menu on existing chefs? As they are skilled, they may object to the new simpler dishes.

You will need to tell me about: What is your thought on the best option? Now tell me why you think this... APPLYING IT TO THE CASESTUDY... In this case, what is the managers objective? To increase profits Profit differences Contribution differences The impact of estimated demand Margin of Safety