3.3 Break-even analysis Flashcards
Break-even analysis
Break-even analysis is a management tool used to calculate the level of sales needed to cover all costs of production. Thereafter, further sales generate a positive safety margin, and hence profit
for the business.
Break-even chart
Break-even chart is the name given to the graph that shows a firm’s costs, revenues and profits (or loss) at various levels of
output.
Break-even point
Break-even point refers to the position on a break-even chart where the total cost line intersects the total revenue line, i.e.
where TC = TR.
Break-even quantity
Break-even quantity refers to the level of output that generates neither profit nor loss. It is shown on the x-axis on a break-even
chart.
Contribution per unit (or unit contribution)
Contribution per unit (or unit contribution) is the difference between the selling price of a product and its variable costs of
production, i.e. P - AVC. The surplus goes towards paying fixed costs.
The margin of safety (MOS)
The margin of safety (MOS) is the difference between a firm’s level of demand and its break-even quantity.
Margin of safety =
Level of demand minus Break-even quantity
A positive MOS means the firm can decrease output (sales volume) by that amount without making a loss. A negative MOS means the firm is making a loss,
Profit
Profit is the positive difference between a firm’s revenue and its costs. On a break-even chart, profit is shown at all levels of output beyond the break-even quantity.
Exam tip!
it is quicker to use the total contribution to calculate profit than it Is to calculate the difference between total costs and total revenue,
i.e. gross profit = (P - AVC) x Q,or TR -TVC.
special order decision
A special order decision occurs when a customer places an order at a price that differs from the normal price charged by the business,
Total contribution
Total contribution is the unit contribution (P - AVC) multiplied by the quantity of sales (Q),
i.e. total contribution = (P - AVC) XQ.
It is, essentially, a firm’s gross profit.
The effects of changes in price or cost on the break-even quantity,
profit and margin of safety,
5 factors:
• The difference between short-term and long-term profits It might be necessary to reduce prices (subsequently increasing the break-even quantity) in order to attract customers. In the long term, prices can be increased once a loyal customer base has been established.
• The level of demand is subject to change Factors that affect demand, such as changes in income or fashion, will
alter the BEQ and hence the value of profits.
- Profit depends on the level of risk involved Whilst low risk projects generally lead to a quicker BEQ, the value of
the profits is likely to be low. High-risk projects, such as the Airbus A380 (see Question 3.3.7), have the potential
of huge amounts of profits but have a high BEQ. Innovation and the introduction of new technologies Dell computers, Dyson vacuum cleaners and Apple iPads
have generated sales and profits far in excess of their original forecasts. - Luck! Every business needs a little bit of luck to succeed. External factors such as changes in exchange rates, unemployment, national income and interest rates (see Unit 1.5) can have a direct impact (positive or negative)
on the profitability of businesses.
The benefits of break-even analysis. A03
3+3
- useful management decision-making
tool for asking ‘what if’ questions
-The model provides a quick
graphical focus on the cost and revenue structures of different scenarios and projects.
-BEA can be used to make realistic predictions rather than relying on simple guesswork.
(For example, a restaurateur can use past data and experience to estimate the
average cost of a meal, the average number of customers on different days and the average price paid for each meal. This data can therefore help a multi-product firm to work out its break-even level of sales, albeit somewhat inaccurately perhaps.)
BEA is particularly beneficial to businesses that:
• Produce and/or sell a single, standardised product.
• Operate in a single market.
• Make products to order, i.e. all output is
sold.
The limitations of break-even analysis. A03
The assumptions of the break-even model are hardly ever met by most businesses:
3p
BEA assumes
• that all cost functions are linear. In reality, cost curves are unlikely to be linear because economies of scale (and hence lower average costs of production) can be gained by operating on a larger scale. Fixed costs might also change, perhaps due to an increase in rent,
• that the sales revenue function is linear. In reality, customers would demand discounts for larger orders, thereby distorting the sales revenue line. Indeed, managers know that to sell more, a business might need to reduce its prices. Also, a linear sales revenue function ignores price discrimination (see Unit 4.5) used by many businesses (charging different prices to different groups of
customers, such as adults and children).
• that the business will sell all of its output.
However, in reality most businesses will have some unsold stock, which do not generate cash but cost the firm money
248 (storage and insurance costs, for example). Furthermore, unsold stock might need to be sold at a discount (thereby reducing the profits) to make space for new incoming
The limitations of break-even analysis. A03
Other limitations of break-even analysis include:
• As a static model, BEA might not be very useful in a dynamic business environment. For example, it ignores the possibility that production costs can and do change at short notice, such as fluctuating exchange rates which affect the costs and revenues of exporting firms. The use of dedicated computer software, such as spreadsheets, can help to update data more easily, but each set of break-even calculations will only be valid for one point in time.
• As with all financial and numerical predictions, the principle of garbage in, garbage out (GIGO) applies. Unrealistic and obsolete data input will generate unconvincing results. Hence, the accuracy of BEA largely depends on the validity of the original data (used to generate the calculations) and on management skillsand
experiences (to estimate costs and revenues).
• Other quantitative and qualitative factors that can alter the costs, revenues and output of the business are ignored. For example, BEA ignores the impacts of staff working under increased pressures to maximise output, such as demotivation and declining productivity. The reaction of
competitors, the availability of spare capacity and access to finance are also ignored in BEA.
• BEA is really only suitable for single-product firms that sell all of their output. For firms with a broad product portfolio, overheads have to be split between the various products in a rather subjective way. Although there are softwareprogrammes that can help managers to calculate multiproduct break-even, these do not truly represent the break-even for each product.
BEA Common mistake
Students often state a benefit of calculating the break even point ensures that the business will cover its costs
and hence make a profit. This is not the case, as BEA is a management tool to help decision-making; it does not guarantee a profit will be made and it is possible for the safety margin to be negative.
