Using break-even analysis to make decisions
By the end of this unit you should understand:
o the meanings of break-even and contribution
o how to calculate break-even output
o how to draw and complete break-even charts
o how to read a break-even chart and illustrate profit or loss
o the impact of price and cost changes on break-even output and break-even charts
o the advantages and disadvantages of using break-even analysis.
What are break-even and contribution?
At the break-even level of output a business makes neither a loss nor a profit.
Contribution can be defined as the difference between sales revenue and variable costs of production.
Contribution is calculated through the use of the following formula:
Contribution = revenue - variable costs
The following information is needed for the calculation:
o the selling price of the product
o the variable cost of producing a single unit of the product
o the fixed costs associated with producing the product.
This information is used within the formula set out below:
Break-even output = fixed costs/selling price per unit - variable cost per unit
The break-even chart
Can be put a break-even chart on this slide, please and mark break-even point on it.
Break-even and changing variables
Break-even can deal with more complex circumstances including:
analysing the impact of changing costs and/or prices on the profitability of the business
deciding whether to accept an order for products at prices different from those normally charged.
The advantages of break-even analysis
• It is a simple technique allowing most entrepreneurs to use it without the need for expensive training.
• It is a technique that can be completed quickly, providing immediate results.
• Its use can be of value in supporting a business's application to a bank for a loan.
• By using break-even charts a business can forecast the effect of varying numbers of customers on its costs, revenues and profits.
The disadvantages of
It assumes that all products are sold.
It is a simplification of the real world. Businesses do not sell all their products at a single price.
Costs do not rise steadily as the technique suggests.
A break-even analysis will be only as accurate as the data on which it is based.
Which one of the following statements relating to break-even output is true?
a) It is the level of output at which sales revenue equals total costs.
b) It is the level of output at which variable costs equal sales revenue.
c) It is the level of output at which variable costs and total costs are equal.
d) It is the level of output at which profits are greatest.
Complete the following formula: Contribution - sales revenue = ...............
Is the following statement true or false? "Contribution always equals profits."
Complete the following formula:
Break-even output = fixed costs divided by ........................... per unit.
The selling price of Sally's hand knitted sweaters is £90. The variable cost of each one is £40. Her monthly fixed costs are £1000. Market research suggests that she will sell 16 sweaters per month. Should she start producing sweaters on the basis of this information?
o Sally discovers that her competitors sell hand knitted sweaters for £120. She thinks she could do the same. Does this alter the decision on whether or not to go ahead with the business?
o Is the following statement true or false? "At levels of output below break-even, the total revenue line will be below the total costs line, while at output greater than break-even, the total revenue line will always be above the total cost line."
o Is the following statement true or false? "A fall in variable costs per unit will always reduce break-even output."
o Does the total revenue line pivot or shift when there is a fall in prices?
o Is the following statement true or false? "The level of profit or loss on a break-even chart can be shown by the vertical distance between sales revenue and variable costs."