Costing and Break-even Analysis Types of Costs Fixed Costs – costs that will remain the same whatever the level of output produced or sold. Variable Costs – vary in direct proportion to output, as output increases variable costs increase. Semi –variable Costs – made up of two cost components, fixed and variable. Fixed costs – include rent, mortgage etc. Do not vary with output Variable costs include raw materials. Semi variable costs include electricity (proportion will increase with business activity, i.e. lighting required every day however if orders increase more electricity will be used as the machinery will be operating more.

Costing and Break-even Analysis Break-even analysis All businesses need to know at what level of sales they will begin to make a profit. Break-even analysis allows calculation of the level of output or sales where firms start to make profits and amounts of losses or profits made at different levels of sales. New businesses, expansion etc.

Graphical method of break-even analysis Graphical method of break-even analysis. Using the example seen on the NGFL handout CD Racks for All Wooden CD racks are sold for £10

Break-even Chart 6000 5000 4000 Costs / revenue 3000 2000 1000 FC Costs / revenue FC Fixed costs Rent £2000 per year Salaries £8600 per year Rates £1000 per year Bank interest £50 per month Care needs to be taken to make sure the correct time period is calculated in this instance it is monthly costs. 2000/12 =166.67 8600/12 = 716.67 1000/12 = 83.33 Interest = 50 Total fixed costs per month £1016.67 0 100 200 300 400 500 600 Output/Sales

Break-even Chart 6000 5000 4000 Costs / revenue 3000 VC 2000 1000 FC Costs / revenue VC FC Adding the Variable cost line To be as accurate as possible 2 points need to be identified on the chart to draw the line. In this instance the first point is 0 for if there is no output there are no variable costs, each unit produced is multiplied by the total variable cost. The variable cost for the CD rack is Wood £2.20 Glue £0.60 Packaging £1.20 Labour £2.00 Total variable cost £6.00 Variable cost is calculated – unit multiplied by total variable cost. 2nd point is In this instance 300 x £6.00 = £1800.00 0 100 200 300 400 500 600 Output/Sales

Break-even Chart 6000 TC 5000 4000 Costs and revenue 3000 VC 2000 1000 TC Costs and revenue VC FC Total Cost Line At every level of output the firms costs are a mixture of fixed and variable costs, the 2 added together make the total cost. The TC line will begin a the point of fixed cost as no variable costs have been incurred at this stage. Mark this as the first point of the line, the second point will be the fixed and variable cost, in this instances it is £1016 and £1800 = £2816 (FC + VC) 0 100 200 300 400 500 600 Output/Sales

Break-even Chart R 6000 TC 5000 4000 Costs / revenue 3000 VC 2000 1000 TC Costs / revenue VC Point of Break-even FC The Revenue Line The final line to add is the revenue received from sales this is calculated by multiplying the number of sales by selling price (Sales x Selling Price) Again we need to points to draw an approximately accurate line. The first point will be 0 as there are no sales. The second point will be 300 times £10 (as the racks are sold for £10) =£3000. The point where the Revenue line intersects the Total cost line is the point of break- even. 0 100 200 300 400 500 600 Output/Sales

Break-even Chart R 6000 TC 5000 4000 Costs / revenue 3000 VC 2000 1000 TC Costs / revenue VC Point of Break-even Break-even revenue FC Once the point is determined draw a line to the vertical axis and this will give you the break-even revenue and draw a line to the horizontal axis and this will give you the break-even number of sales or output. Break-even output 0 100 200 300 400 500 600 Output/Sales

Revenue and Break-even 6000 5000 4000 3000 2000 1000 TC Costs / revenue Profit at sales of 510 units VC Point of Break-even Loss at sales of 150 units FC Calculating Profit and Loss using the Break-even chart. In this instance break-even is approx 280. To find the profit or loss you must measure the difference between the Revenue line and the Total Cost line at the given level of output. In the exam an output figure is given. In this instance the figure is 510, the estimated profit is £900 (Revenue – Total Cost (R-TC)). Calculate the Loss when the output is at 150. 0 100 200 300 400 500 600 Output/Sales

Break-even Analysis Margin of Safety The difference between output and level of break-even output level. A high margin of safety is desirable as even if output falls profits can be made. However if there is a low margin of safety then if output falls then this could lead to losses being made. Action needs to be taken to increase output through increased orders, reducing costs hence reducing break-even point and increasing margin of safety. Capacity Firms want to produce at maximum capacity, to return maximum profits, maximise investment and ensure margin of safety is at its highest. However this has negative affects as quality will be jeopardised, costs will be increased through maintenance and there will be little place for accommodating further orders that could be valuable to the firm.

Break-even Analysis Contribution Not all of the revenue received from selling an item can be profit, as the item produced or sold has money spent on variable costs. The difference between the revenue or selling price of an item and the direct cost of producing the item is known as contribution. This is the amount each item sold contributes toward paying the other costs of the business i.e. fixed costs. Once fixed costs are covered , then the contribution earned on each item sold becomes profit. This has an impact on firms accepting orders and investment can be based on contribution. What-if analysis This analysis merely asks questions based on item selling price, profit if sales increased by number of units, or margin of safety if fixed costs increased. The nature of beak-even graphs make them suitable for what-is analysis. However this is more suitable with the use of spreadsheet software. What-if analysis results in redrawing lines on the breakeven to show changes in costs, revenues and new break-even point and new levels of profit and losses at different levels of output. Advantages Easy visual means of analysing firms financial position at different levels of output Profit and loss can be seen at a glance – good for non-financial specialists Helpful for making decisions in ‘what-if’ situations As part of a business plan – can be helpful in gaining finance Can identify the margin of safety – aids planning Limitations Often regarded as too simplistic – some assumptions are unrealistic It assumes all output is sold Assumes that conditions remain unchanged – wages, prices, technology Relies on data being accurate Assumes that total revenue and cost curves are always linear Allocating fixed costs in a multi product firm can be problematic Fixed costs are often stepped – this makes the break-even analysis difficult