Break-Even Analysis: Understanding Costs & Profits PDF

**Break Even** **CONTRIBUTION** Craig Eckert sells second-hand cars. His last sale was£990 for a Golf GTI. He bought the Golf at a car auction for £890. The difference between what he paid for the car and the price he sold it for is £100 (£990- £890). This difference is called the contribution. It...

**Break Even** **CONTRIBUTION** Craig Eckert sells second-hand cars. His last sale was£990 for a Golf GTI. He bought the Golf at a car auction for £890. The difference between what he paid for the car and the price he sold it for is £100 (£990- £890). This difference is called the contribution. It is not profit because Craig has fixed costs to pay such as rent, insurance and administration expenses. Contribution is the difference between selling price and variable costs. In this case the selling price was £990 and the variable cost was £890. The £100 will contribute to the total fixed costs of the business and the profit. **BREAK-EVEN POINT** Businesses, particularly those that are just starting up, often like to know how much they need to produce and sell to break-even. If a business has information about fixed costs and variable costs and knows what price it is going to charge, it can calculate how many units it needs to sell to cover all of its costs. The point where total costs(fixed costs + variable costs) are exactly the same as total revenue is called the break-even point. The level of output a business needs to produce so that total costs are exactly the same as total revenue is called the break-even output. It makes neither a profit nor a loss. For many businesses the break-even point is highly significant. It shows the level of output where all costs have been covered and that all future sales will generate a profit for the business. **CALCULATING BREAK-EVEN USING CONTRIBUTION** It is possible to calculate the break-even output if a firm knows the value of its fixed costs, variable costs and the price it will charge. The simplest way to calculate the break-even output is to use contribution. The following formula can be used. Fixed costs Break-even output = Contribution **BREAK-EVEN CHART** The use of graph\'s is often helpful in break-even analysis. It is possible to identify the break-even point and break-even output by plotting the total cost and total revenue equations on a graph. This graph is called a break-even chart. Figure 1 shows the break-even chart for Jack Cadwallader\'s business. Output is measured on the horizontal axis and revenue, costs and profit are measured on the vertical axis. What does the break-even chart show?.The value of total cost over a range of output. For example, when Jack produces 1500 benches total costs are £120,000. The value of total revenue over a range of output. For example, when Jack produces1500 benches total revenue is £150,000. Break-even charts can show the level of fixed costs over a range of output. For example, the fixed costs for Jack\'s business are £60,000. The level of output needed to break-even. The break-even point is where total costs equal total revenue of £100,000. This is when 1000 benches are produced. So the break-even output is 1000 benches. The profit at a particular level of output. If Jack produces 1500 benches, profit is shown by the vertical gap between the total cost and total revenue equations. It is £30,000. At levels of output below the break-even output, losses are made. This is because total costs exceed total revenue. At an output of 500, a£30,000 loss is made. At levels of output above the break-even output, a profit is made. This profit gets larger as output rises. At an output of 1500 a profit of£30,000 is made. MARGIN OF SAFETY What if a business is producing more than the break-even output? It might be useful to know by how much sales could fall before a loss is made. This is called the margin of safety. It refers to the range of output over which a profit can be made. The margin of safety can be identified on the break-even chart by measuring the distance between the break-even level of output and the current(profitable) level of output. For example, Figure 2 shows the break-even chart for Jack Cadwallader. If Jack produces1200 benches the margin of safety is 200 benches. This means that output can fall by 200 before a loss is made. If Jack sells 1200 benches the chart\'shows that total revenue is £120,000, total cost is £108,000 and profit is £12,000. Businesses prefer to operate with a large margin of safety. This means that if sales drop they still might make some profit. With a small margin of safety there is a risk that the business is more likely to make losses if sales fall. USING BREAK-EVEN ANALYSIS Break-even analysis is used in business as a tool to make decisions about the future. It helps answer \'what if\' questions. For instance, what would happen in each of these situations. If the price went up, what would happen to the break- even point? If the business introduced a new product line, how many would:the rew product have to sell to at least break-even? If the business is just starting up, what has to be the level of output to prevent a loss being incurred? What will happen to the break-even point if costs are forecast to rise? Would the break-even point be lower if components were bought in from outside suppliers rather than being made in-house? Break-even analysis is also found in business plans. Banks often ask for business plans when deciding whether or not to give a loan. So break-even analysis can be vital in gaining finance, especially when starting up a business. LIMITATIONS OF BREAK-EVEN ANALYSIS Break-even analysis does have some limitations. It is often regarded as too simplistic and some of its assumptions are unrealistic. Output and stocks: It assumes that all output is sold, so that output equals sales, and no stocks are held. Many businesses hold stocks of finished goods to cope with changes in demand. There are also times when firms cannot sell what they produce and choose to accumulate stocks of their output to avoid making staff redundant. Unchanging conditions: The break-even chart is drawn for a given set of conditions. It cannot cope with a sudden increase in wages and prices or changes in technology. Accuracy of data: The effectiveness of break-even analysis depends on the quality and accuracy of the data used to construct cost and revenue functions. If the data is poor and inaccurate, the conclusions drawn on the basis of the data may be incorrect. For example, if fixed costs are underestimated, the level of output required to break- even will be higher than suggested by the break-even chart. Non-linear relationships: It is assumed that the total revenue and total cost lines are linear (a straight line). This may not always be the case. For example, a business may have to offer discounts on large orders, so total revenues fall at high outputs. In this case the total revenue line would rise and then fall, and be curved. A business can lower costs by buying in bulk. So costs may fall at high outputs and the costs function will be curved. Multi-product businesses: Many businesses produce more than one single product. It is likely that each product will have different variable costs and different prices. The problem is how to allocate the fixed costs of the multi-product business to each individual product. There are a number of ways, but none is perfect. Therefore, if the fixed costs incurred by each product are inaccurate, break-even analysis is less useful. Stepped fixed costs: Some fixed costs are stepped. For example, in order to increase output a manufacturer may need to acquire more capacity. This may result in rent increases and thus fixed costs will rise sharply. Under these circumstances it is difficult to use break-even analysis.