5.5 Break even analysis

Question 1

Contribution

Answer 1

refers to the sum of money that remains after all direct or variable costs have been taken away from the sales revenue of a product. surplus is the amount available to contribute towards paying the firm’s fixed costs of production

Contribution per unit = Price - Avg variable costs

Question 2

break even analysis

Answer 2

is important for new businesses as the owners will want to determine the level of sales that must be made to earn a profit. Break-even analysis is a quantitative tool that can be used for this purpose.

can inform managers
- whether it is financially worthwhile to produce or launch a particular good or service
- the expected level of profits that the business will earn if things go according to plan

Question 3

break even chart

Answer 3

diagrammatic representation of how total costs and total revenues change with increasing levels of production or sales, showing firm’s costs, revenues and profits at various levels of input.
a business can be in one of the following financial situations

Loss - TC>TR
Break even - TR=TC
Profit TR>TC

Question 4

uses of break even analysis for businesses

Answer 4

-produce and or sell a single, standardised product
-operate in a single market
-make products to order, so that all output is sold.

Question 5

Margin of safety

Answer 5

measures the difference between a firm’s sales volume and the quantity needed to break even. It shows the extent to which the demand for the firm’s product exceeds the BEQ.

• positive MOS means that the firm makes a profit, negative means a loss

Margin of Safety=
actual sales quantity - Break even quantity

Question 6

how to construct a break even chart

Answer 6

1. draw and label a horizontal TFC line
2. Draw the TC line and label it.
3. TR is labelled and drawn , starts at origin
4. x-axis is labelled as ‘output’ and measured in the appropriate unit of measurement, per time period
5. The y-axis is labelled as ‘Costs and revenues’ expressed in terms of currency
6. Title is also needed

Question 7

target profit output

Answer 7

sales volume or level of output required to achieve the target profit that business managers expect to achieve by the end of a given time period.
target profit output=
(fixed costs +target profit)/Contribution per unit

Question 8

Changes in break even

Answer 8

-the difference between short term and log-term profits, it may be necessary to reduce prices in order to attract customers, especially if demand is price elastic.
-level of demand is subject to change; will alter the BEQ
-profit depends on level of risks involved; forecasted profits might not materialise in reality
-innovation and introduction of new technologies
-non-price determinants of demand
-luck

Question 9

limitations of break even

Answer 9

-it assumes that all cost functions are linear
- assumes the sales revenue function is linear
-assumes that the business will sell all of its output
-static tool not very useful in a dynamic business environment. For example it ignores the possibility that production costs can and do hange at short notice, such as fluctuating exchange rates which affect the costs and revenues