Chapter 28- break-even analysis Flashcards
Break even analysis
- another tool which businesses can use in order to aid the decision making process
Break even point or level can be found by:
- using a chart
- calculating (using a formula)
- using a graph
Why is break even analysis used?
- it is used to find the level of output necessary to cover all costs
What is break even?
- it is the point where total revenue covers (is equal to) the total costs
Finding the break even level by chart
- break even may be found using a chart
- where total revenue (tr) is equal to the total costs (tc)
- may be time consuming to produce a chart in order to find the break even level
- there is a quicker method available which uses a formula for calculation
Finding the break even level by formula
- to calculate the break even point contribution can be used
Break even= fixed costs/ contribution per unit
CPU= price - variable costs per unit
- this break even figure can now be used to assess whether it is possible to achieve this number of sales
What happens to the number of goods that need to be sold to break even when price increases and therefore increasing the cpu?
- will be less in order to break even
Finding the break even level by graph?
Fixed costs: do not alter with the level of output
- therefore presented with a horizontal straight line
- fixed costs will exist even if no output is taking place and therefore are drawn starting at ‘x’
Variable costs: vary directly in proportion to the level of output
- as output increases the level of variable costs increases
Total costs: they are the addition of fixed and variable costs
- total cost line doesn’t start at 0
- even when business is not producing any goods it still has costs (fixed costs)
Revenue line: total revenue= price x level of output
- total revenue line will be a line with the same gradient as it is assumed that there is only one price which does not change
- level of the price will determine the gradient of the total revenue line
- the higher the price the steeper the total revenue line
- if the price falls the gradient of the total revenue line will fall
Once the individual lines are known, the break even point and level can be established
- this is where the total revenue line cuts the total cost line
Knowing the break even level of output will enable a business to?
- assess profit if output is above the break even
- a business can easily assess its level of profit or loss by looking at its particular level of output
Any output level to the right of break even will be?
Profitable
Any output level to the left of break even will be?
Loss is incurred
What happens to the break even level of output when price increases?
- it falls
- profit will be earned at an earlier/lower level of output
- no guarantee that the output will be sold at the higher price
Margin of safety
- graph also allows business to see its margin of safety
- calculated by subtracting the actual level of output from the break even level of output
- (difference between actual and break even level of output)
- allows a business to assess the consequences of any change in its circumstances that may affect its output, its prices or its costs
What happens due to an increase in costs?
- moves the total cost line upwards
- break even level of output increases
- margin of safety falls in size
A business will find this useful because it can assess the impact of any changes in either the actual level of output or the break even level
Smaller the margin of safety
- the less flexibility the business has to deal with any change in circumstances
What does margin of safety allow a business to know?
- the likely effects on the profit of the business; the lower the margin of safety the lower its profits
When there is no difference between break even level of output and actual level of output what isn’t being made?
- no profit is being made
Target level of profit
- goal for a business
- once the break-even level is calculated it is possible for a business to decide on a required level of profit (target level)
- done in the form of a calculation using the formula for break even
Non current costs (fixed costs or overheads) + target profit)/ contribution per unit
(Number of goods which will need to be produced to achieve this target level of profit)
Benefits of break even analysis
- tables and diagrams that show break even analysis are easy to view, comprehend and interpret. This makes it a valuable tool and doesn’t take a long time to calculate or use
- break even analysis is a beneficial management tool to aid the decision making process
- it can be used to show the level of profit at a given level of output and to set targets for achieving profits
- margin of safety can be established
- possible to assess the consequences of changes in circumstances by looking at the margin of safety
Limitations of break even analysis
- based on using predicted figures
- direct or variable costs may change depending upon the quantities involved
- as the level of production increases the opportunities to gain the benefits of economies of scale will have an effect on the unit costs
- calculating total revenue relies on just price but discounts may be offered
- sometimes some uncertainty as to whether costs are fixed or variable
- no certainty that all goods will be sold
