Break-even Analysis

Revenues, costs and profits Richard Repairs – your local garage repair service. Reminder for November and December trading. Looks OK. Yes? The more repair jobs he does, the higher his profits. Why? What would happen if he did fewer? Estimates for November and December November December A Number of Jobs 100 120 B Price charged per job £100 C Total revenue = A x B £10,000 £12,000 D Salaries £2,000 E Other fixed costs £1,000 F Total fixed costs = D + E £3,000 G Variable costs per job £50 H Total variable cost = A x G £5,000 £6,000 I Total costs = F + H £8,000 £9,000 J Profits = C - I

Revenues, costs and profits Looking back at November and December, it was a bad Christmas - perhaps too many people went away Did he make a profit or loss in November and December. Fill in Actual November December A Number of Jobs 80 60 B Price charged per job £100 C Total revenue = A x B D Salaries £2,000 E Other fixed costs £1,000 F Total fixed costs = D + E £3,000 G Variable costs per job £50 H Total variable cost = A x G I Total costs = F + H J Profits = C - I

Break-even New businesses may not make profits in the first few months or even first year after starting They will of course make estimates for revenues, costs and profits, based on market research In particular businesses will want to know how what sales are needed in order to break-even If Richard has 60 repair jobs he breaks even More than 60 jobs means he makes a profit Less than 60 jobs, he makes a loss Jobs Revenue Total Costs 40 £4,000 £5,000 50 £5,500 60 £6,000 70 £7,000 £6,500 80 £8,000

Calculating break-even He broke even in December Break-even output is the level of output where total revenue equals total costs This means the minimum sales needed to cover costs. Output less than break-even means a loss, higher output a profit How can we calculate the break-even point? Fixed costs are £3,000. 30 jobs at £100 means £3,000 revenue. Is this break-even? Need to cover variable costs as well. Each job brings in £100 in revenue, but adds £50 to costs So each extra job contributes £50 towards fixed costs. This is calculated as selling price – variable cost per unit So what might the formula be? Break-even output = Fixed costs Selling price per unit – variable cost per unit

Break-even charts

Examples Burger stall opens on Surbiton Crescent. Sells delicious burgers for £1.50. He has to pay £50 each day to Kingston Borough Council, and a further £50 for the cost of his stall. Each burger costs 50p in raw materials and cooking. How many does he have to make to break-even. Great new local boutique, Jenny’s Jeans, selling designer brand jeans for £40 each. A steal. The fixed costs of the shop are £1,500 per month, and each pair of jeans costs Jenny £15. How many jeans must she sell in a month to break-even? Draw approximate breakeven charts for above

Contribution The idea behind contribution is that each unit sold contributes to covering fixed costs If selling price is £2.00 and each unit (say a burger) has variable cost of £0.50, then each extra burger sold contributes £1.50 to paying fixed costs Contribution per unit is therefore selling price (per unit) minus variable cost per unit Total contribution measures how much all sales made have contributed towards paying fixed costs This is measured by number of units sold times contribution per unit For example 100 burgers sold means a total contribution of 100 x £1.50 = £150 This is the same as total revenues minus total variable costs, which would be 100 x £2.00 minus 100 x £0.50, which is £200 - £50 =£150

Margin of safety the amount by which current output exceeds break-even output

Usefulness of break-even First and most basic it enables a business to know what sales it needs to achieve to make a profit Can estimate profits or losses at different levels of output Gives margin of safety – how far sales are above break-even Can show what happens to profits and break-even if: Fixed costs change Variable costs change The business changes its price

Fixed costs increase (and nothing else changes) Break-even output = fixed costs selling price per unit – variable cost per unit = contribution per unit What happens if: Fixed costs increase (and nothing else changes) Then fixed costs ÷ contribution per unit will increase, so break-even output increases. Since contribution per unit is the same, a firm will have to sell more to cover the increased in fixed costs If fixed costs fall, then break-even output falls Variable cost per unit increases Then contribution per unit falls (selling price per unit minus variable cost per unit decreases), so break-even increases. Since the contribution from each unit sold decreases, a firm will need to sell more to cover fixed costs If the variable cost per unit decreases, then break-even output is lower because contribution per unit is higher so fewer units need to be sold to cover fixed costs Selling price is decreased Then contribution per unit decreases (selling price minus variable cost per unit decreases), so break-even output increases. Since the contribution from each unit sold decreases, a firm needs to sell more to cover fixed costs If the price is increased, then break-even will decrease (because contribution per unit increases so fewer units need to be sold to cover fixed costs)

Richard Repairs Fixed costs £3,000 per month Selling price £100 Break-even output = Fixed costs Selling price per unit – variable cost per unit = Contribution per unit Assume fixed costs increase from £3,000 to £4,000 per month. Break-even will increase to 80 jobs: £4,000 ÷ (£100 - £50) = £4,000 ÷ £50 = 80 jobs Say fixed costs do not change but variable costs increase to £60 per job. Break-even will increase from 60 to 75 jobs: £3,000 ÷ (£100 - £60) = £3,000 ÷ £40 = 75 jobs Say neither fixed costs or variable costs change, but Richard cuts the price to £80 (to get more business), then break-even rises from 60 to 100 jobs: £3,000 ÷ (£80 - £50) = £3,000 ÷ 30 = 100 jobs Richard Repairs Fixed costs £3,000 per month Selling price £100 Variable cost per unit £50 Breakeven is therefore: £3,000 ÷ (£100 - £50) = 60 jobs

Weaknesses