1. 17 Costs and break-even
© Malcolm Surridge and Andrew Gillespie 2016

2. Cambridge International AS and A Level Business
Introduction
Costs are expenses that a business has to pay to engage in production.
Break-even is the level of output at which a business’s revenue is exactly equal to its total costs.
Profit (or loss) = total revenue – total costs.
Revenue = quantity sold x average selling price.
© Malcolm Surridge and Andrew Gillespie 2016

3. Types of costs Fixed costs Variable costs
Cambridge International AS and A Level Business
Types of costs
Fixed costs
Fixed costs do not change when a business alters its level of output
Variable costs
Variable costs alter directly with the level of a firms output
© Malcolm Surridge and Andrew Gillespie 2016

4. Types of costs Semi-variable costs Total costs
Cambridge International AS and A Level Business
Types of costs
Semi-variable costs
Both fixed and variable elements
Telephone usage (older) each call you make you pay a fee
Total costs
Total Costs = fixed costs + variable costs
Other categories of costs:
marginal costs
Is the extra cost resulting from producing one additional unit of output
© Malcolm Surridge and Andrew Gillespie 2016

5. Types of costs direct and indirect costs opportunity costs.
Cambridge International AS and A Level Business
Types of costs
direct and indirect costs
Direct costs can be related to the production of a particular product and vary directly with the level of output
Indirect costs are overheads that cannot be allocated to the production of a particular product and relate to the business as a whole
opportunity costs.
The value of the product that was given up.
© Malcolm Surridge and Andrew Gillespie 2016

6. Reasons to calculate costs accurately
Cambridge International AS and A Level Business
Reasons to calculate costs accurately
To determine future profits.
To make major decisions such as expansion of start-up.
Whether or not to accept a particular order from a customer.
To judge whether a reduction in waste is necessary.
© Malcolm Surridge and Andrew Gillespie 2016

7. Key cost calculations Average costs = total costs ÷ output
Cambridge International AS and A Level Business
Key cost calculations
Average costs = total costs ÷ output
Marginal costs are the extra costs resulting from producing an additional unit of output:
e.g. the cost of producing n units minus the cost of producing n-1 units.
Total costs = fixed costs + variable costs
© Malcolm Surridge and Andrew Gillespie 2016

8. 17.2 Costs and break-even
© Malcolm Surridge and Andrew Gillespie 2016

9. Uses of cost information
Cambridge International AS and A Level Business
Uses of cost information
Pricing decisions:
cost-plus pricing using average costs
contribution pricing using marginal costs
Page 182
Taking special order decisions.
If you have to retool your manufacturing that could cost extra (custom orders)
© Malcolm Surridge and Andrew Gillespie 2016

10. Uses of cost information
Cambridge International AS and A Level Business
Uses of cost information
Using costs to compare performance.
A large business will want to compare costs in different locations.
Figure out who is producing the most efficient and try to help the other outlets
Analysing why costs differ from forecasts
Variance analysis is the process of comparing forecast and actual data for revenues and costs and analysing the likely causes of any differences.
© Malcolm Surridge and Andrew Gillespie 2016

11. Uses of cost information
Cambridge International AS and A Level Business
Uses of cost information
Pricing decisions:
cost-plus pricing using average costs
contribution pricing using marginal costs
Page 182
Taking special order decisions.
If you have to retool your manufacturing that could cost extra (custom orders)
Budgets are financial plans setting out a business’s future revenues and expenditures
© Malcolm Surridge and Andrew Gillespie 2016

12. Cambridge International AS and A Level Business
Break-even analysis
Contribution is a vital part of calculating break-even output.
Contribution is the difference between sales revenue and the variable costs of production.
Formula: fixed costs ÷ contribution per unit
where contribution per unit is the selling price of one unit of output minus the variable cost of its production.
© Malcolm Surridge and Andrew Gillespie 2016

13. Monitoring Profit Targets
Budgets can be used to monitor how well costs are controlled but also to compare the different targets that were set.
If sales are good managers might raise prices
Might be able to reduce costs and negotiate larger discounts
Monitor labor costs make sure you are getting everything out of your employees

14. 17.3 Costs and break-even
© Malcolm Surridge and Andrew Gillespie 2016

15. Breakeven Analysis Defined
Breakeven analysis examines the short run relationship between changes in volume and changes in total sales revenue, expenses and net profit
Also known as C-V-P analysis (Cost Volume Profit Analysis)

16. Uses of Breakeven Analysis
C-V-P analysis is an important tool in terms of short-term planning and decision making
It looks at the relationship between costs, revenue, output levels and profit
Short run decisions where C-V-P is used include choice of sales mix, pricing policy etc.

17. How many units must be sold to breakeven?
How many units must be sold to achieve a target profit?
Should a special order be accepted?
How will profits be affected if we introduce a new product or service?

18. Key Terminology: Breakeven Analysis
Break even point-the point at which a company makes neither a profit or a loss.
Contribution per unit-the sales price minus the variable cost per unit. It measures the contribution made by each item of output to the fixed costs and profit of the organisation.

19. Key Terminology ctd.
Margin of safety-a measure in which the budgeted volume of sales is compared with the volume of sales required to break even
Marginal Cost – cost of producing one extra unit of output

20. *Contribution per unit
Breakeven Formula
Fixed Costs
*Contribution per unit
*Contribution per unit = Selling Price per unit – Variable Cost per unit

21. Breakeven Chart

22. Margin of Safety
The difference between budgeted or actual sales and the breakeven point
The margin of safety may be expressed in units or revenue terms
Shows the amount by which sales can drop before a loss will be incurred

23. Example 1 Using the following data, calculate the
breakeven point and margin of safety in units:
Selling Price = €50
Variable Cost = €40
Fixed Cost = €70,000
Budgeted Sales = 7,500 units

24. Example 1: Solution Contribution = €50 - €40 = €10 per unit
Breakeven point = €70,000/€10 = 7,000 units
Margin of safety = 7500 – 7000 = 500 units

25. Target Profits
What if a firm doesn’t just want to breakeven – it requires a target profit
Contribution per unit will need to cover profit as well as fixed costs
Required profit is treated as an addition to Fixed Costs

26. Example 2 Using the following data, calculate the level of
sales required to generate a profit of €10,000:
Selling Price = €35
Variable Cost = €20
Fixed Costs = €50,000

27. Example 2: Solution Contribution = €35 – €20 = €15
Level of sales required to generate profit of €10,000:
€50,000 + €10,000
€15
4000 units

28. Limitations of B/E analysis
Costs are either fixed or variable
Fixed and variable costs are clearly discernable over the whole range of output
Production = Sales
One product/constant sales mix
Selling price remains constant
Efficiency remains unchanged
Volume is the only factor affecting costs

29. Absorption and Marginal Costing Compared
Fixed costs included in Product Cost
FC not treated as period cost – closing/opening stock values
Under/over absorption of costs
Complies with Financial Accounting standards
Marginal
Fixed costs not included in Product Cost
FC treated as period cost
No under/over absorption of costs
Does not comply with Financial Accounting standards

30. Break-even charts Cambridge International AS and A Level Business
© Malcolm Surridge and Andrew Gillespie 2016

31. Changing variables and break-even
Cambridge International AS and A Level Business
Changing variables and break-even
Change in business environment
Effect on break-even chart
Rise in variable costs
Total cost line pivots upwards
Fall in variable costs
Total cost line pivots downwards
Rise in fixed costs
Fixed cost line and total cost line move upwards in a parallel shift
Fall in fixed costs
Fixed cost and total cost lines make parallel shift downwards
Rise in selling price
Revenue line pivots upwards
Fall in selling price
Revenue line pivots downwards
© Malcolm Surridge and Andrew Gillespie 2016

32. Uses and limitations of break-even analysis
Cambridge International AS and A Level Business
Uses and limitations of break-even analysis
Uses:
Limitations:
simple technique providing immediate results
it assumes all products are sold
it is a simplification of the real world
can support applications for loans
it is only as accurate as the data on which it is based
can be used for ‘what if?’ analyses.
costs do not rise steadily as the model suggests.
© Malcolm Surridge and Andrew Gillespie 2016