Break Even Analysis

…determines the point at which a business neither makes a profit or loss. …all costs are covered by a particular volume of output

Expected selling price £150 Indirect costs (Fixed costs) Direct costs (variable costs) Direct materials Direct labour Direct expenses £50 £30 £20 £100 Factory rent £50,000 p.a (per annum) Mp3 Player Expected selling price £150 a) Contribution per unit = Selling price - Variable costs £50 = £150 - £100 b) Break Even Point is calculated by: c) at BEP: Total Costs = Total Revenue (1,000 units x VC £100)+ FC £50,000 = 1,000 units x SP £150 £150,000 = £150,000 £50,000 £50 = 1,000 units

Break Even Chart Takes considerable time to work out the BEP using this method. 225,000 Total Revenue (TR) 200,000 Total Costs (TC) Cost, Revenue (£) 175,000 150,000 Variable costs (VC) 125,000 100,000 75,000 50,000 Fixed costs (FC) 25,000 250 500 750 1000 1250 1500 Volume or Output (units)

Uses of Break Even Analysis Break even analysis is particular useful when making decisions regarding the launch of new products or services, or diversification into new markets. When launching a new product it is important to know the level of output and sales needed to break even. This can be calculated by dividing fixed costs by contribution per unit.

Margin of Safety From the break even quantity we can calculate the excess of sales over break even. This is known as the margin of safety. The formula is: actual output minus break even output. The higher the margin of safety is, the greater the profits. In fact, think of it in terms of once break even has been reached, each unit contribution now adds to the firm’s profits. If we multiply the margin of safety by contribution per unit we get the level of profits. Profit = margin of safety X contribution per unit We can vary the formula to calculate the level of output needed to achieve a target level of profits. What we do here is to add the profit target to fixed costs and the simply work out the number of unit contributions needed to achieve this level of profit. Thus, the formula is: Fixed costs + profit target Contribution per unit

Summary At the break even level of output and sales (note only when the output is sold does it contribute to sales revenue), is when the firm is neither making a profit nor a loss. It is when sales revenue covers costs, but no more than that. Logically, if output and sales are below the break even level then the firm is making a loss, whereas if output and sales are above the break even level then it is making a profit. The higher the level of output and sales above break even, the greater the profit.