5 Break-Even Analysis Flashcards
How are fixed costs shown on a break-even analysis?
A straight horizontal line on fixed output (as fixed costs stay the same regardless of output such as rent and managers’ salaries).
How are variable costs shown on a break-even analysis?
Start at zero and slope upwards.
Total Costs
Fixed Costs + Total Variable Costs
At the Break-Even Level of Output…
Fixed Costs = Contribution
Total Revenue = Total Costs
Total Revenue
Selling Price Per Unit x Quantity
Sales can be expressed as…
Volume (100,000 units) OR Value (£150,000)
Break-Even Definition
The number of items that a business must sell to reach break-even, after reaching break-even, each additional unit sold will contribute toward profit.
Strengths of a Break-Even Forecast
Allows calculation of minimum sales needed to survive or succeed, can be set as a target to motivate workforce.
Integral part of business plan to secure finance.
Can calculate profit or loss - decision making aid.
Helps to plan capacity needed for factories or stores.
Can predict the outcome of changing variables.
Assess impact of changes in level of output and revenue.
Weakness of Break-Even Analysis
Only indicates sales needed, does not ensure actual sales will materialise.
Does not consider external factors such as conflicts or rising costs.
In reality, fixed costs can vary.
Ignores changes in variable costs/selling price as items are bought or sold in large quantities.
Based upon predicted costs and revenues.
Margin of Safety
How much the actual output is above the break-even level.
Actual Output Level - Break Even Level of Output
Total Contribution
Money generated each time goods are sold, first pays its own variable costs and then contributes toward fixed costs. Until there is enough contribution, the business cannot start to make a profit.
Sales Revenue - Total Variable Costs
Contribution per Unit
How much is left to contribute firstly to fixed costs and secondly to profit.
Selling Price Per Unit - Variable Cost Per Unit
Break Even Level of Output Equation
Fixed Costs / Contribution per Unit
Changing Variables
Where the break-even analysis is often based on assumption that costs and revenue will remain static, this is not the case.
What could cause fluctuations in Fixed Costs?
landlord puts rent up
bank changes interest rates
management wants a pay increase
What could cause fluctuations in Variable Costs?
raw materials change in price
minimum wage is increased
utility companies change prices
What could cause fluctuations in Selling Price?
new competition enters the market
positive word of mouth increases demand
What is the difference between profit and profitability?
Profit is a sum of money whereas profitability relates profit to the size of the business to allow greater understanding of the sum and better judgement.
Two ways to measure the size of a business?
Sales Revenue
Capital Employed - all money invested within a business by its owners.
Profitability Definition
A measure of financial performance that compares a business’ profits to some other factor (size or revenue). Measured by profit margins and return on capital employed.
Profit Margin
(Profit / Sales Revenue) x 100
Provides analysis of financial performance and relate profit to size, comparison of performance of forms that vary in size. LOSS = NEGATIVE PM
Gross Profit Margin
(Gross Profit / Turnover) x 100
The higher the GPM, the more efficient the firm is at controlling its direct costs and turning sales into gross profit. Not as useful as it does not include indirect costs (overheads).
Operating Profit Margin
(Operating Profit / Turnover) x 100
The higher the OPM, the more efficient the firm is at turning sales into operating profit. LOSS = NEGATIVE MARGINS
Profit for the Year
(Profit for the year / Turnover) x 100
The higher the margin, the more efficient the firm is at controlling all costs and turning sales into overall company profit. Analyses overall performance with all activities and investments including taxation, investments and interest paid or received.
Methods of improving profit - increasing revenue
Increases prices as long as PED is inelastic.
May be able to decrease prices to drives sales, as long as PED is elastic.
Increase sales volume.
Methods of improving profit - reduce costs
Reduce number of substandard products/decrease wastage.
Reduce overheads and expenses.
Reduce maintenance/operating costs.
Reduce cost of production (outsourcing or moving production).
Improve efficiency/increase capacity utilisation.
Difficulties Improving Profits
Cost of implementing methods of improving profit.
Impact on brand image.
Reactions of customers.
Impact upon and reaction from staff.
Keeping up with rival firms.
Capital Structure
Represents the finance provided to a business to enable it to operate over the long-term. It refers to the balance of the finance in terms of how much is equity (share capital) and how much is in the form of debt.
Equity
Capital provided by shareholders/owners of a business. Includes: share capital invested into the business; retained profit rather than paid out of dividends.
Debt
Outstanding payments the business has yet to pay out to suppliers or other benefactors. Usually in the form of long term business loans or mortgages and debentures.
Gearing and Capital Structure
A financial ratio that considers the capital structure of a business. Examines the relative mix of debt capital as compared with the total capital employed by a business.
