12: Using break-even analysis to make decisions

Question 1

Breaking-even

Answer 1

When a business is just earning enough sales revenue to pay for all its costs. Its not yet making a profit but it is not recording a loss either.

Question 2

Contribution

Answer 2

this is the difference between sales revenue and variable costs of production.

Question 3

Contribution per unit

Answer 3

this is the difference between the selling price of one unit and the variable cost of producing one unit.

Question 4

Total contribution

Answer 4

contribution per unit x no. of units sold.

Question 5

Some important points to remember about contribution per unit:

Answer 5

• It can be increased by raising the selling price.
• It can be increased by reducing variable costs per unit.
• It is not the same as profit per unit as fixed costs are not subtracted.
• An increase in contribution per unit raises the potential profit that a business can make.

Question 6

Break-even level of output

Answer 6

This is the level of output or the number of customers that earns enough revenue to cover total costs of production.

BE = Fixed costs / contribution per unit

Question 7

Some important points to remember about break even:

Answer 7

• A REDUCTION in contribution per unit with RAISE the break-even level of output.
• If output does not increase then profits of the business will FALL.
• Gives an indicator to the entrepreneur and the banks of the likely number of customers needed before the business can start to cover all of its costs.
• If this output level seems unreasonably high, then the entrepreneur may have to reconsider the original plan and look at ways to either reduce fixed costs or raise contribution per unit of output.

Question 8

Margin of safety

Answer 8

This is the amount by which the existing level of output is greater than the break-even point.

Question 9

Strengths of break-even analysis:

Answer 9

• Relatively simple concept and the formula can be understood and used by most entrepreneurs.
• The info it provides can be vital when taking a decision whether to go ahead with a business proposal.
• It is widely used to support applications from entrepreneurs for loans.
• It can be quickly adapted to allow for many ‘what if’ situations to be considered and compared. This reinforces the usefulness of the technique for decision making.

Question 10

Weaknesses of break-even analysis:

Answer 10

• It assumes all output produced is sold - there is not scope for keeping stocks with break-even analysis.
• It over simplifies business situations. E.g. assumed ‘average’ customer revenue and ‘average’ variable cost when in reality there will be considerable variations.
• Many firms sell more than one product.
• A break-even chard does not show what will definitely happen - it is a planning aid to help business managers consider the impact of various possible decisions.