3.3 Break Even Analysis

Question 1

Graph method

Answer 1

Benefits:
Easy to construct and interpret
Provides useful guidelines to management
Comparisons can be made between different options
The equation produces a precise result
Can be used to decide on location and investment decisions

Negatives
Unrealistic assumption that cost and linear functions
Not all costs can be classified in fixed and variables
Unlikely assumption that all production is sold (no stocks)

Question 2

The formula method

Answer 2

Contribution (total)
The contribution to pay the costs of all the units sold
Total contribution > fixed costs = profits
Total contribution < fixed costs = loss

Contribution (per unit)
The selling price of the product (price) minus the direct cost per unit

Formula
Fixed costs / Contribution per unit
FC / (P - VC per unit)
Eg: direct labour cost/unit = 17$
       Direct material cost/unit = 18$
       Fixed costs = 200000$
       Current selling price 45$
       Maximum capacity = 3000 units
Break-even level of output: 200000/(45-(17+18)) = 20000 units

Question 3

Other uses

Answer 3

A marketing decision: Analyse the effect of an increase in the price. (Assuming demand is perfectly elastic/quantity sold does not fall) (affects total revenue)
An operation management decision: buying cheaper raw materials (affects total cost)

Question 4

Target Profit

Answer 4

Calculate the output to be produced to achieve the target profit.
Formula: Target level of output = (FC + target profit) / contribution per unit
Eg: Target profit = 25000$
FC = 200000$
Contribution per unit = 50$
Target level of output: (200000+25000)/50= 4500$
Break even level of output: 200000/50 = 4000$

Question 5

Target Revenue

Answer 5

Revenue that you need to break even
Formula: FC / 1 - (Direct cost / price)
Eg: FC= 60000$
Selling price= 30$
Direct cost/unit= 15$
Break even revenue: 60000 / 1 - (15/30) = 120000 (same)
Break even level of output: 60000/15 = 4000 units
Total Revenue: 30 x 4000 = 120000 (same)
Total cost: 60000 + 15 x 4000 = 120000 (same)

Question 6

Target Price

Answer 6

The price that has to be set in order to break even given a production level
Formula: FC / production level + direct cost
Eg: (firm wants) Break even level of output= 1000 units
FC= 6000$
Direct cost= 9$
Break even target price: 6000/1000+9= 15$
Break even level of output: 6000/(15-9)= 1000

Question 7

Info

Answer 7

1. Non current assets: fixed assets, they last more than 1 year
2. Leasing -> ownership remains to seller - long rent maintenance is an owner
3. Collateral: an asset which can be used or sold by the bank in the case of default
4. Bond: kind of a contract
5. Trade receivable: credit given to customers - invoice that customers pay at a later date
6. Debt factoring: financial service where a factor collects debts on behalf of others in return for a fee
7. Level of indebtedness: existing amount borrowed
8. Equity finance: permanent finance raised by companies through the sale of shares
9. Best combination is a little of both equity and debt bc a mix of both reduces the limitations
10. Can put only TC/FC/TR in graph method break even analysis
11. Total revenue= Price x quantity VC= vc per unit x quantity
12. Margin of safety= = current output- break even level of output