Chapter – 31
Break Even
Definitions
1. break-even when a business generates just enough revenue to cover its total
costs.
2. break-even chart a graph containing the total cost and total revenue lines,
illustrating the break-even output.
3. break-even output the output a business needs to produce so that its total
revenue and total costs are the same.
4. break-even point the point at which total revenue and total costs are the
same.
5. contribution the amount of money left over after variable costs have been
subtracted from revenue. The money contributes towards fixed costs and
profit.
6. margin of safety the range of output between the break-even level and the
current level of output, over which a profit is made.
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.
CONTRIBUTION PER UNIT AND TOTAL CONTRIBUTION
A business might calculate the contribution on the sale of a single unit, or the sale
of a larger quantity, such as a whole year's output.
Unit contribution: In the previous example the unit contribution was calculated. It
was the contribution on the sale of one unit, a single car. The formula for
calculating the unit contribution is:
Contribution per unit = Selling price - Variable cost = £990 - £890
= £100
Total contribution: When more than one unit is sold the total contribution can be
calculated. For example, a clothing company receives an order for 1000 pairs of
trousers. The variable costs are £7.50 a pair and they will be sold for £9.00 a pair.
The total contribution made by the order is:
Total contribution = Total revenue - Total variable cost = (£9.00 × 1000) - (£7.50 x
1000) = £9000 - £7500
= £1500
The £1500 in this example will contribute to the clothing company's fixed costs
and profit. The total contribution can also be calculated by multiplying the unit
contribution by the number of units sold.
Total contribution = Unit contribution x Number of units sold = (£9.00 £7.50) ×
1000
= £1.50 x 1000
= £1500
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.
Break-even output = Fixed costs/Contribution
BREAK-EVEN CHART
The use of graphs 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.
The value of total cost over a range of output.
The value of total revenue over a range of output.
Break-even charts can show the level of fixed costs over a range of output.
The level of output needed to break-even.
The profit at a particular level of output.
At levels of output below the break-even output, losses are made.
At levels of output above the break-even output, a profit is made.
The relationship between fixed costs and variable costs as output rises.
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.
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 new
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.
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.
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.