Break-Even Analysis This presentation provides an overview of the key points in this chapter. Note for tutors: If you wish to print out these slides, with notes, it is recommended that, for greater clarity you select the ‘pure black and white’ option on the PowerPoint print dialogue box.

Terminology Sales Revenue / Income – The amount of money a company takes from selling goods or services. Quantity sold x Sale price of each item Costs / Expenditure – The money that businesses spends while they trade. There are fixed, variable and total costs Profit (or loss). The amount of money a business makes (or loses) from carrying out their trade. Sales Revenue – Total Costs.

The basics of break-even analysis 1 Businesses must make a profit to survive To make a profit, income must be higher than expenditure (or costs) Income £50,000 Costs £40,000 Profit £10,000 Income £50,000 Costs £60,000 Loss £10,000 This first slide gives the basics, together with an example of a profit and a loss. Students should realise that no business can survive making a loss for any length of time (in the short term, they could perhaps borrow if overall prospects were good).

The basics of break-even analysis 2 There are two types of costs: Variable costs increase by a step every time an extra product is sold (eg cost of ice cream cornets in ice cream shop) Fixed costs have to be paid even if no products are sold (eg rent of ice cream shop) Students should understand that costs are incurred in every business. The student handbook gives the example of a pizza outlet that has to heat the building and pay business rates even if hardly anyone comes for a meal. Every person who buys a meal causes additional costs because of the ingredients in the food eaten.

Examples of costs These vary, depending upon the type of business. Typical costs include: Variable: materials, labour, energy Fixed: rent, business rates, interest on loans, insurance, staff costs (e.g. security) Each cost could be discussed briefly in turn, emphasising why they are either fixed or variable. The difference between labour (variable) and staff (fixed) will need some explanation. Examples such as temporary labour used to cover busy periods versus admin staff who have no direct connection with the level of activity could be used to illustrate the point.

The break-Even Point Variable costs + fixed costs = total costs When total costs = sales revenue, This is called the break-even point, eg total costs = £5,000 total sales revenue = £5,000 At this point the business isn’t making a profit or a loss – it is simply breaking even. The total amount of income received by a business should be greater than – or at least equal to – the total of the fixed and variable costs. The break-even point indicates when the two are the same.

Why calculate break-even? Tom can hire an ice-cream van for an afternoon at a summer fete. The van hire will be £100 and the cost of cornets, ice cream etc will 50p per ice cream. Tom thinks a sensible selling price will be £1.50. At this price, how many ice-creams must he sell to cover his costs? Calculating this will help Tom to decide if the idea is worthwhile. This slide provides a practical example to illustrate why break-even charts can be useful. Even at the start, students should appreciate that if the break-even point is high (eg 500 ice creams to break even) the project is far more risky than if the break-even point is low (eg 50 ice creams to break even).

Calculating Costs and Revenues Units/ Quantity Variable Cost (0.5) Fixed Cost (100) Total Cost VC+TC Sales Revenue (1.50) 50 100 150 200 250 300

Calculating Costs and Revenues Units/ Quantity Variable Cost (0.5) Fixed Cost (100) Total Cost VC+TC Sales Revenue (1.50) 100 50 25 125 75 150 175 225 200 300 250 375 450

Drawing a break-even chart 1 Students will have to be told that, in the time available, Tom thinks the highest number of ice-creams he could sell is 300. This has determined the horizontal line (axis) on the chart Tom therefore knows that at £1.50 each, his maximum sales revenue will be £450. This determines the vertical line (axis) on his chart.

Drawing a break-even chart 2 The first line drawn is for fixed costs. It is horizontal because the fixed cost figure (the van hire) is the same no matter how many ice creams are sold.

Drawing a break-even chart 3 Tom’s variable costs are 50p per ice cream. This cost line starts at the point where the fixed cost line meets the vertical axis. Since it starts at this point, it represents the total cost of the product for any given level of sales.

Drawing a break-even chart 4 Finally, Tom draws in his sales revenue line. It starts at zero since if there are no sales, there will be no income.

Identifying the break-even point Profit The point at which the revenue line crosses the total cost line is called the break-even point. This is found by drawing a line vertically downwards to the horizontal axis. The distance between the total cost line and the revenue line shows the loss which would be made at that level of sales. After the break-even point, the difference between the two lines represents profit. From the graph, students should be able to calculate that Tom will lose £100 if he sells no ice-cream, yet could make a maximum profit of £200. In addition, as 100 ice-creams is a reasonable number to sell, the venture is worthwhile. The situation would be different if it was a rainy day and his break-even point had been 200 ice-creams! Loss Break-even point

Using a formula to calculate the break-even point Fixed costs (Selling price per unit minus variable cost per unit) Students obviously need to be familiar with the appearance of the formula. The next stage is to practice using actual figures. Tutors may wish to ask students to apply Tom’s figures to the formula before showing the next slide. NB: Tom’s fixed costs were £100, his selling price per ice cream was £1.50 and his variable costs per ice cream were 50p. Also known as the Contribution as the amount left is what contributes to paying off the fixed costs.

Applying the formula = 100 Fixed costs (Selling price per unit minus variable cost per unit) Tom: £100 (£1.50 – £0.50) = 100 Students should note that using the formula is a quick method of calculating the break-even point, compared to drawing a chart. However, this calculation does not indicate how much profit or loss would be made for a particular level of sales. Contribution is £1.00 per unit

Why the Break Even point may change Changes in the break even point may happen if: Fixed Costs change Variable Costs change, or The selling price changes. If Fixed Costs go If Variable costs go If Selling price go up down The break even point will go

Increase in fixed costs. Original B.E.P = 100 If fixed costs go up to £120. The B.E.P= 120 £120 . (1.50-.50) The point at which the revenue line crosses the total cost line is called the break-even point. This is found by drawing a line vertically downwards to the horizontal axis. The distance between the total cost line and the revenue line shows the loss which would be made at that level of sales. After the break-even point, the difference between the two lines represents profit. From the graph, students should be able to calculate that Tom will lose £100 if he sells no ice-cream, yet could make a maximum profit of £200. In addition, as 100 ice-creams is a reasonable number to sell, the venture is worthwhile. The situation would be different if it was a rainy day and his break-even point had been 200 ice-creams! The reverse happens if fixed costs fall.

Increase in variable costs. Original B.E.P = 100 If variable costs go up to £0.60 The B.E.P= 112 £100 . (1.50-.60) The point at which the revenue line crosses the total cost line is called the break-even point. This is found by drawing a line vertically downwards to the horizontal axis. The distance between the total cost line and the revenue line shows the loss which would be made at that level of sales. After the break-even point, the difference between the two lines represents profit. From the graph, students should be able to calculate that Tom will lose £100 if he sells no ice-cream, yet could make a maximum profit of £200. In addition, as 100 ice-creams is a reasonable number to sell, the venture is worthwhile. The situation would be different if it was a rainy day and his break-even point had been 200 ice-creams! The reverse happens if variable cost falls.

Increase in Selling price. Original B.E.P = 100 If selling price goes up to £1.60 The B.E.P= 91 £100 . (1.60-.50) The point at which the revenue line crosses the total cost line is called the break-even point. This is found by drawing a line vertically downwards to the horizontal axis. The distance between the total cost line and the revenue line shows the loss which would be made at that level of sales. After the break-even point, the difference between the two lines represents profit. From the graph, students should be able to calculate that Tom will lose £100 if he sells no ice-cream, yet could make a maximum profit of £200. In addition, as 100 ice-creams is a reasonable number to sell, the venture is worthwhile. The situation would be different if it was a rainy day and his break-even point had been 200 ice-creams! The reverse happens if selling price falls.

Margin of Safety If a business knows a level at which it would like to sell / produce at it can work out its Margin of Safety. The Margin of Safety is the different between the BEP and the actual level of production / sales. E.g. If Tom aimed to sell 200 ice creams he would have a Margin of Safety of 100 as his BEP is 100 ice creams.

Margin of Safety – On the BE Graph. Profit Break-even point The point at which the revenue line crosses the total cost line is called the break-even point. This is found by drawing a line vertically downwards to the horizontal axis. The distance between the total cost line and the revenue line shows the loss which would be made at that level of sales. After the break-even point, the difference between the two lines represents profit. From the graph, students should be able to calculate that Tom will lose £100 if he sells no ice-cream, yet could make a maximum profit of £200. In addition, as 100 ice-creams is a reasonable number to sell, the venture is worthwhile. The situation would be different if it was a rainy day and his break-even point had been 200 ice-creams! Margin of Safety Loss

Target Profits A business can use the break even formula to calculate the quantity needed in order to achieve a target profit. Target profit (the profit a business wants to make) is calculated as follows: Fixed Costs + Target Profit = Number of units Contribution per unit

Benefits of Break Even Analysis Graph easier to understand. Helps in the decision making process. Shows level of profit / Costs at different output / sales levels. Can establish margin of safety.

Drawbacks of Break Even Analysis Can only be used in the short term. All costs potential change. If batch processing used cannot obtain exact BEP. Model only viable for one type of product / service at a set price. Assumption all output sold. Not always the case.

Contribution / Marginal Costing Once the contribution per unit has been calculated you can also calculate the total contribution at various levels of output or sales. Total Contribution = Contribution per unit x Total Number of sales / output. E.g. £1 x 200 ice creams = £200 total contribution

Contribution / Marginal Costing Once the total contribution and fixed costs are know you can work out the price at a particular output / sales level. Profit = Total Contribution - Fixed Costs If 200 ice creams sold, profit would be: £200 - £100 = £100 profit