Break Even Analysis

Break Even Analysis

1. Use of break-even analysis

   • to find out how much profit a given level of sales will generate (Contribution x units produced) - fixed costs= profit
   • to find out how many units must be sold to generate a target profit (target profit + fixed costs) / contribution per unit
   • important to remember that any change in fixed costs, variable costs or selling price per unit will result in a new break-even point.
   • the business can decide whether it is able to produce and sell this number of units
   • useful when making decisions regarding the launch of new products
   • when launching a new product it is important to know the level of output and sales needed to break even

2. Limitations of a break-even analysis

   • dont take into account possible changes in cost over the time period
   • dont allow for changes in the selling price
   • analysis only as good as the quality of information
   • dont allow for changes in market conditions in the time period

3. Contribution to Fixed Costs

   • important business concept
   • must never be confused with profit
   • the contribution of a product refers to how much it contributes to the fixed costs and profit of the business once all of the variable costs have been covered
   • can be calculated either per unit of output or in terms of the total contribution of units produced
   • calculating the cost of a product, both direct labour and direct materials are often easy to identify and allocate
   • Contribution per unit
     • selling price of a product less variable cost
     • P- AVC
   • Total contribution
     • total revenue from sales of a product less total variable cost of producing it

4. the effects of change in price or cost on the break-even quantity, profit and margin of safety, using graphical and quantitative methods

   • benefits and limitations of breakeven analysis
     • if a business is able to calculate the break even quantity that must be sold to cover all costs, it will be easier to make important production and marketing decisions
     • No profit or loss is made
   • Break-even point of production
     • the level of output at which total costs equal total revenue
   • Breakeven= Fixed Costs / unit contribution
   • Unit contribution= Price - AVC

5. Margin of safety

   • the margin of safety is a useful indication of how much sales could fall without the firm falling in to loss
   • if a firm is producing below the break-even point, it is in trouble. This is sometimes expressed as a negative margin of safety.

6. Aiding other decisions:

   • A marketing decision
     • the impact of a price increase.
     • This raises the total revenue line at each quantity sold.
     • The assumption made in this example is that maximum sales will still be made.
     • with a higher price level this may well be unlikely
   • Operations management decision
     • the purchase of new equipment with lower variable costs
     • this will lower the total cost line at each level of quantity, and fixed costs remain unchanged

7. Advantages of break-even Analysis

   • charts are relatively easy to construct and interpret
   • it provides useful guidelines to management on break-even points, safety margins and profit/loss levels at different rates of output
   • comparisons can be made between different options by constructing new charts to show changed circumstances
   • equation produces a precise break-even result
   • break-even analysis can be used to assist managers when taking important decisions (location, new equipment)
   • Disadvantages of Break-even Analysis
     • assumption that all costs and revenues are represented by straight lines
     • not all costs can be conveniently classified into fixed and variable costs. The introduction of semi-variable costs will make the technique more complicated
     • there is no allowance made for stock levels on the break-even chart. It is assumed that all units produced are sold. This is unlikely to always be the case in practice.
     • It is also unlikely that fixed costs will remain unchanged at different output levels up to a maximum capacity.