3.3 Break-Even Analysis

Question 1

What is a “break-even” analysis?

Answer 1

A tool that businesses can use to determine how many sales are needed to cover all their costs.

Question 2

What is a “break-even point”?

Answer 2

“the level of output that generates sufficient revenue to cover total costs without any profit left.”

Question 3

What is the contribution method to calculating the “break-even point (BEP)”?

Answer 3

BEP = Fixed Costs / Contribution per unit

Question 4

How would you calculate the ““contribution per unit”?

Answer 4

Selling price - average variable cost
“How much a product contributes to covering the fixed costs of a business.”

Question 5

How would you calculate the “total contributions”?

Answer 5

(Price - average variable cost) x Q
“How much the whole product line (all the products/services produced by the business) contributes to covering the fixed costs.”

Question 6

How would you calculate the “margin of safety” (MOS)?

Answer 6

Current level of output - Break-even point
“The difference between the break-even point and the current level of output. It shows how far output can fall with the business still achieving break-even. “

Question 7

What is the “total revenue (TR)”?

Answer 7

Total revenue = selling price x output

Question 8

What is the “total fixed cost (TFC)”?

Answer 8

Sum of all costs that do not vary directly with production

Question 9

What is the “total cost (TC)”?

Answer 9

Sum of both Total fixed cost + Total variable costs

(this curve starts ABOVE the TFC curve)

Question 10

What would happen to this graph if the “price per unit” falls?

Answer 10

TR = Fall, decrease in gradient
BEP = increase (more Q for BEP)
MOS = decreases
Profit = decreases

Question 11

What would happen to this graph if the “fixed cost” rises?

Answer 11

TFC + TC = move upwards
BEP = increase (more Q for BEP)
MOS = decreases
Profit = decreases

Question 12

What would happen to this graph if the “variable cost per unit” falls?

Answer 12

TC = gradient becomes less steep
BEP = decreases (less Q for BEP)
MOS = increases
Profit = increases

Question 13

Where is the break-even level on a break-even diagram?

Answer 13

The point where Total cost = total revenue

Question 14

What are some of the benefits of using a break-even diagram?

Answer 14

• It allows companies to set targets for the minimum level of sales needed for survival.
• Using these targets, incentives can be put in place for sales teams, helping to ensure at least the break-even point is reached.
• The company can see how changes in output may affect profit levels.
• The company can see how changes in price levels may affect profit levels.
• The company can see how changes in costs may affect profit levels.
• It can be used to evaluate whether a company’s factory has enough capacity to reach the desired level of margin of safety.
• Banks can ask for break-even analysis in a business plan when deciding whether to give a loan.

Question 15

What are some of the LIMITATIONS of using a break-even diagram?

Answer 15

• It assumes that zero inventory is held, which is highly unlikely.
• All economies of scale are ignored.
• It assumes that all customers pay the same price, which is very unlikely.
• It can only be used for a single, standardised product.
• Poor quality data may lead to misleading conclusions being drawn.
• It assumes that all conditions remain the same, e.g. it doesn’t allow for a sudden increase or decrease in prices or variable costs.
• Total revenue and total costs may not always be linear, but it assumes that they are.
• A separate break-even analysis is needed for each product a company produces because each product has different variable costs and different prices.