Using break-even analysis to make decisions

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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

Calculating break-even

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

break-even analysis

 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.

Quick questions

 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.