IB Business Management UNIT: 3.3 – Break-even Analysis Understand/practice break-even analysis & margin of safety

Fixed or Variable? Rent Wages Salaries Materials Insurance Commission Utilities

Breaking Even Business can be in one of the following financial situations: Loss: costs exceeds revenue Break-Even: costs equal revenue Profit: revenue exceeds costs

Breaking Even Break-even point exists where a business makes neither profit nor loss This occurs at the level of output where total costs equal total revenue Typically a goal of new firms

Contribution What is the purpose of calculating contribution? * Any product w/ a positive contribution will help pay some of the FC of the company. Contribution per unit = P – AVC This is just calculating margin

Ways to improve profit Increase Sales Revenue How do you do this? Decrease Variable Costs Decrease Fixed Costs Marketing (Promotions), New sales incentives, product life cycle extension strategies, Talk to suppliers, try to get supply costs down by getting different suppliers Better financial control, maybe looking at cost centers

Meaning of Break-Even Point Total Costs = Total Revenue when output reaches the break-even point Any sales above the break-even quantity will generate a profit Sales below the break-even level will yield a loss

Break-even Analysis A business can only survive in the long run if revenue > costs New firms especially want to determine the level of sales needed to generate a profit

Break-Even Analysis Two purposes for conducting a break-even analysis, which helps determine: If its financially worthwhile to produce a particular good or service (such as introducing a new product) Amount of profit that business is likely to earn if things go according to plan

Break-Even Analysis Example Jeans retailer has fixed costs of $3,500 per month Each pair of jeans sells for $30 $10 in variable costs per pair of jeans What is the break-even point?

Calculating Break-Even Point Method 1 Identify where total costs equal total revenue on a break-even chart The break-even point is the position where the total cost line intersects the total revenue line (TC=TR)

Calculating Break-Even Point Method 2 Using the TC = TR rule: TFC + TVC = Price x Quantity 3500 + 10(Q) = 30Q 3500 = 20Q 175 = Q (pairs of jeans)

Calculating Break-Even Point Method 3 Unit contribution is the difference between a product’s price and variable cost Contribution = Price – VC Break-Even Point = TFC / Unit Contribution $3500 $30-10 = 175 pairs

Break-Even Example Use the unit contribution method to calculate the break-even quantity for a firm that has the following financials: TFC = $200,000 AVC = $5 Price = $30 P - AVC = unit contribution Break-even = fixed costs unit contribution

Calculate this BEQ A high end kite maker has fixed costs of 25,500. She has a Variable Cost of $50 She is selling the kites for $75 Calculate the break-even quantity? Calculate the value of the total revenue at the break-even quantity. Calculate the value of total costs at the break-even quantity.

Margin of Safety Measures difference between firm’s current sales quantity & break-even point Positive margin means that firm is making a profit Always shown in units, not dollars! Safety margin = level of demand – breakeven qty. Already have orders.

Margin of Safety Example Demand for jeans is 280 pairs per month Break-even point is 175 pairs per month Safety margin is 105 units (280-175 = 105) This means the business can sell 105 fewer pairs of jeans before losing money.

MOS as a percentage of BEQ It is easier to compare the 2 numbers if it is written as a percentage. (BEQ/Level of demand) x 100 (105 ÷ 175) x 100 = 60%

Constructing a Break-even Chart Rules to follow when constructing BE chart: Draw/label TFC line Draw/label TC line. Q = 0; TC start at ??? Draw/label TR line. Q = 0; TR starts at ??? X-axis is labeled as “Output” or units Y-axis is labeled as “Costs, Revenues” $