Break-even Flashcards
Break-even
A business will always want to know how many products (or services) they need to sell in order to cover their costs. This is normally the bare minimum a business will aim to achieve.
When a business is breaking even, there is no profit and no loss (revenue = total costs).
Break-even output
The output a business needs to produce so that its total revenue and total costs are the same
calucation of break-even output
fixed cost divided by contribution per unit
contribution
contribution is the difference between the selling price per unit and the variable cost per unit is known as the contribution towards covering the business’s fixed costs.
contribution per unit
selling price -variable cost per unit
Margin of safety
The margin of safety in a business is the difference between output level (when output is above break-even) and break-even output.
Benefits of break-even
Break-even provides a simple and easily understood representation of costs, revenue and potential profit.
Break-even is also useful as part of a business plan and can help when seeking a loan.
It also allows the use of ‘what-if’ analysis. Using ‘what-if’ analysis, business owners can judge the impact of a number of costs and revenue variables on profitability. For example, the effect of an increase in fixed costs by 10% could be quickly judged, and the same applies to potential changes in variable costs and revenues. Using this method, the impact of the changes on break-even output, margin of safety and profitability can be measured.
Restrictions and limitations of break-even
The use of ‘what-if’ does not fully overcome the weaknesses of break-even. The first problem is that the method assumes only one product is produced and sold; in the real world of business, this is rarely the case. This initial problem can be overcome if a business (e.g. a sandwich shop) sells a similar range of products as, in this case, an average cost and revenue per customer can be estimated.
The method also assumes that all goods are produced and sold at the same price. Most businesses have wastage through damaged stock, poor quality stock, etc., and it is likely that at least some products (end of line) will be discounted.
The linear relationship of costs/revenue to output/sales can also be questioned. In each case, economies of scale are likely to come into play, breaking down the relationship.
Some fixed costs are stepped. This occurs when a business acquires more capacity, whereby costs such as rent may increase. This sharp rise in fixed costs makes it difficult to apply break-even analysis
Evaluation of Breakeven Analysis
it depends on how accurate data on prices and costs is and whether it is easy to forecast whether it will change.
it allow the business to analyse what if situations.
