Break-Even Analysis What is it? By John Birchall

What is it? - 1 In business we have TWO types of COSTS = FIXED and VARIABLE We measure costs in the Long run and short run - what does this mean? When making a product or service we incur DIRECT and INDIRECT costs- what are these? We need to know how much PROFIT each unit of output gives us = CONTRIBUTION

How might we use this information? Comparing profits over a period of time giving advice on how profitability can be improved noting other non- financial factors that might influence performance of business Judging balance between fixed and variable costs assessing one firms costs against another is the level of profit sustainable forecast v outcome and variance awareness

What is it? - 2 Finds minimum output and sales needed to cover costs even at 0 output you incur FIXED COSTS Price equals revenue, so total sales x price = Total Revenue We want to know how much money we make from each unit of sale = CONTRIBUTION. Price per unit - direct costs

What is it? - 3 This is the contribution that each unit of sale makes towards covering FIXED COSTS i.e. those that DO NOT vary with output. Or once the Fixed Costs have been covered how much PROFIT each unit of sales makes. Let’s take a simple example

What is it? - 4 We sell a product for 8 euros and its has Direct Costs of 6 euros. The contribution per unit will = Euro 2. A product with a price of 7 euros and direct costs of 3 euros will make a contribution of 4 euros per unit sold. The TOTAL CONTRIBUTION = contribution per unit x number of units. 200x 4euros = 800 euros

Assumptions we make The selling price remains the same,regardless of the number of units sold Fixed Costs remain the same,regardless of the number of units of output Variable Costs vary directly in proportion to output Formula = Fixed Costs (euro)/Contribution per unit (euro)

What is it? - 5 A product with a price of 9 euros and direct costs of of 4 euros will contribute 5 euros for EVERY unit sold. At 5 euros per unit the company would need to sell 400 units in order to pay FIXED COSTS of 2000 euros and so BREAK EVEN e2000/e9 - e4 = e5 = 400 units

Costs and Contributions - 1 Firms have to buy FIXED ASSETS and these have to paid for. As production begins so Variable Costs take begin. Added together they make Total Costs. It is unlikely that low levels of sales will produce a profit

Costs and Contributions - 2 As sales INCREASE so Fixed Costs become less of a burden. The AVERAGE COST falls. For example, if output is 100, the Fixed Costs =E10000/100= 100 per unit BUT if sales expand to 2000 the Average Costs fall to just 5 per unit. So high levels of output and sales are good

Costs and Contributions - 3 In our example(see diagram) the break even point is 2000, at which level the sales revenue and costs are But is it good business to just break even? No, you need a margin of safety. This is the difference between the ACTUAL output and the break even output. Actual = 3000 and break even = 2000, then 1000 = margin of safety

Costs and Contributions - 4 Contribution - Strengths and Weaknesses Strengths - managers have an overview, even in multi-product companies, fixed costs are allocated and no room for discussion, pricing can use contribution as part of decision on its level Weaknesses - pricing using contribution take no account of market conditions

Costs and Contributions - 5 Weaknesses continued - some costs cannot easily be classified as either fixed or variable In the long run fixed costs change and the original contribution is no longer relevant But it does give us a guide as to where sales need to be in order to cover costs and begin to make a profit

Break Even - its uses - 1 Whether to start trading whether to make and introduce a new product the likely profit points ( or losses) resulting from sales forecasts analysing the impact of changing variables ( costs and price changes) on the profitability of the business

Break Even - its uses- 2 Deciding whether to accept an order for products at prices different from those normally charged. Let’s look at what changes might arise and what we would have to do.

Changes in Variable - 1

Changes in Variables - 2

Special Order Decisions Do you accept a new order? Likely to accept even if price lower than usual if- price exceeds variable costs of production the business has sufficient spare capacity to meet the order The products will NOT be re-sold, so undercutting the firm’s normal selling price (price discrimination) other benefits could come e.g new markets

Uses of break even analysis Different levels of profit at varying levels of output discover at which level of output you start to make profits new entrants can decide if worthwhile quick and easy to do Conduct ‘what if’ surveys say what if the selling price changed, or the variable costs altered or the fixed costs changed

Disadvantages of break even Information may not be reliable Sales and output and unlikely to be exactly the same the analysis is STATIC - new calculation and diagram need for each change Do fixed costs remain the same across all output range? Do selling prices remain fixed and the same for each customer? Do variable costs remain static(economies of scale)