IB Business and Management 5.3 Breakeven analysis

Quick test: Give 2 other names for Revenue (2) Give 2 examples of fixed costs (2) Give 2 examples of variable costs (2) What is the formula for Revenue? (1) A firm has fixed costs of £2000 per month. Variable costs of £3 per unit and selling price of £5. In July they sell 1,200 units How much revenue does the firm make? (1) What are the firms total costs? (1) How much profit does the firm make in July? (1) Total marks = 10

Profit = Total Revenue – Total Costs What Is Breakeven? If a firm is breaking even it means that the business is neither making a profit or a loss. Breakeven is the output at which a firm’s total revenue is equal to its total costs. Profit = Total Revenue – Total Costs Questions Do you understand what Revenue and Costs are? What is Revenue? How is is calculated? What are costs? When a business is breaking even the profit figure will be 0, can anyone tell me what Total Revenue and Total Costs need to be to get a profit figure of ?

Why might a firm use breakeven analysis? New firms need to estimate how much they must produce before they make a profit This may help them to decide if their business idea is viable May be required as part of a business plan Existing firms may wish to know: Profit/Loss at any level of output The output needed to produce a certain level of profit

Assumptions of simple break-even analysis 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 in direct proportion to output

Finding The Breakeven Point The Breakeven point can be found in 2 ways Graphical Method Contribution method

Break Even Charts Costs/Revenue TR TC VC FC Output/Sales The break even point occurs where total revenue equals total costs. The firm will have to produce and sell this number of units to breakeven Total revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially. Initially a firm will incur fixed costs, these do not depend on output or sales. The lower the price, the less steep the total revenue curve. As output is generated, the firm will incur variable costs – these vary directly with the amount produced. VC The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC Breakeven Revenue FC Breakeven Output Output/Sales

Example A small Photo frame manufacturer has the following costs: Rent £5,000 per year Business Rates £2,000 per year Raw Materials £1.25 per unit Utilities £3,000 per year Packaging £1 per unit Salaries £10,000 per year The firm sells the photo frames for £4.50 to retailers How many photo frames does the firm need to produce in a year in order to break-even?

Step 1: Creating a Table Output Fixed Cost Variable Cost Total Cost Total Revenue 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

Example A small Photo frame manufacturer has the following costs: Rent £5,000 per year Business Rates £2,000 per year Raw Materials £1.25 per unit Utilities £3,000 per year Packaging £1 per unit Salaries £10,000 The firm sells the photo frames for £4.50 to retailers How many photo frames does the firm need to produce in a year in order to break-even?

Step 2:Adding Fixed Costs Output Fixed Cost Variable Cost Total Cost Total Revenue 20,000 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

Example A small Photo frame manufacturer has the following costs: Rent £5,000 per year Business Rates £2,000 per year Raw Materials £1.25 per unit Utilities £3,000 per year Packaging £1 per unit Salaries £10,000 The firm sells the photo frames for £4.50 to retailers How many photo frames does the firm need to produce in a year in order to break-even?

Step 3:Adding Variable Costs Output Fixed Cost Variable Cost Total Cost Total Revenue 20,000 1000 2,250 2000 4,500 3000 6,750 4000 9,000 5000 11,250 6000 13,500 7000 15,750 8000 18,000 9000 20,250 10000 22,500

Example A small Photo frame manufacturer has the following costs: Rent £5,000 per year Business Rates £2,000 per year Raw Materials £1.25 per unit Utilities £3,000 per year Packaging £1 per unit Salaries £10,000 The firm sells the photo frames for £4.50 to retailers How many photo frames does the firm need to produce in a year in order to break-even?

Step 4:Adding Total Costs Output Fixed Cost Variable Cost Total Cost Total Revenue 20,000 1000 2,250 22,250 2000 4,500 24,500 3000 6,750 26,750 4000 9,000 29,000 5000 11,250 31,250 6000 13,500 33,500 7000 15,750 35,750 8000 18,000 38,000 9000 20,250 40,250 10000 22,500 42,500

Example A small Photo frame manufacturer has the following costs: Rent £5,000 per year Business Rates £2,000 per year Raw Materials £1.25 per unit Utilities £3,000 per year Packaging £1 per unit Salaries £10,000 The firm sells the photo frames for £4.50 to retailers How many photo frames does the firm need to produce in a year in order to break-even?

Step 5:Adding Total Revenues Output Fixed Cost Variable Cost Total Cost Total Revenue 20,000 1000 2,250 22,250 4,500 2000 24,500 9,000 3000 6,750 26,750 13,500 4000 29,000 18,000 5000 11,250 31,250 22,500 6000 33,500 27,000 7000 15,750 35,750 31,500 8000 38,000 36,000 9000 20,250 40,250 40,500 10000 42,500 45,000

Plotting the Graph Draw a set of Axis X axis= output (0-10,000) Y axis= £ Cost/Revenue (0-50,000) Plot the line for Total Costs Plot the line for Total Revenues

Breakeven Chart TR Costs/Revenue £ TC BEP Output

Answer Breakeven output is approx 8,900 Breakeven Revenue = £40,000

Margin Of Safety Margin of safety is the quantity sold which is greater than the breakeven level of output. = Actual Output – Breakeven output E.g. If a company has a BEP of 260 units and actually make and sell 310 units they have a margin of safety of 50

Break Even Charts – What they show Costs/Revenue TR TC Profit Loss Margin of safety Breakeven Output D2 D1 Output/Sales

Contribution Contribution is the amount each unit pays towards fixed costs once variable costs have been covered. Contribution = Selling price – Variable cost per item

Using Contribution to calculate the Breakeven Point To calculate the breakeven point in terms of output the following formula can be used Breakeven Output = Fixed Costs Contribution per Unit How can we work out the Breakeven Revenue? Multiply the Breakeven output by the Selling Price

Questions Work out the Breakeven Output and Breakeven Revenue for the following situations (Remember to show working out) Fixed Cost £3,000; Variable Cost £4.25 Selling Price £8 Fixed Cost £89,000; Selling Price £99.99 Variable cost £67.31 Fixed Costs £1,000; Selling Price £1.75 Variable cost 93p

Answers £3,000/£3.75 = 800 units £6,400 £89,000/£32.68 = 2724 units £272,372.76 £1000/£0.93 = 1220 £2,135

Contribution and the Margin of Safety A business breaks even once they have sold enough units to cover their fixed costs: Hence BEP = Fixed Costs Contribution per unit Any units sold above the break even output all of the contribution will be profit. The number of units a business sells above the breakeven point is called the margin of safety Therefore Profit = Margin of Safety x Contribution per Unit

Changes in Variable Costs Costs/Revenue TC1 TR TC TC2 If Variable Costs go up the line will become steeper. What will happen to the Break Even Point? If Variable Costs go down the line will become less steep. What will happen to the Break Even Point? The level of variable costs affects the gradient of the Total Costs line. BEP2 BEP BEP1 Output/Sales

Changes in Fixed Costs Costs/Revenue TC1 TR TC TC2 If fixed costs go up, the Total Costs line will shift upwards If fixed costs go down, the Total Costs line will shift downwards The fixed cost line affects where the Total Cost line starts BEP2 BEP BEP1 Output/Sales

Changes in Selling Price TR1 Costs/Revenue TR TR2 TC A decrease in the selling price will make the TR line less steep A change in Selling price will affect the gradient of the Total Revenue line An increase in the selling price will make the TR line steeper BEP1 BEP BEP2 Output/Sales

Example – Advertising costs increase TC2 Costs/Revenue TR TC An increase in Advertising causes an upwards shift of the Total Cost line. This results in an increase of the breakeven output from BE1 to BE2 BE1 BE2 Output/Sales

Questions Explain what will happen to the Breakeven output in the following situations. Illustrate with a diagram. The cost of raw materials increases The company moves to premises with cheaper rent The company decreases the selling price to compete with a new competitor The electricity supplier increases their prices

Limitations of Breakeven Analysis Information used may be unreliable as it is based on forecasts and predictions Assumes SP stays the same regardless of output Fixed Costs may not stay the same Ignores factors such as economies of scale Assumes that all output is sold Only suitable for analysis of single products Only considers quantitive factors

Breakeven Table Output Fixed Cost Variable Cost Total Cost Total Revenue Profit 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000