UNIT 3.3 BREAK EVEN ANALYSIS The learning outcomes (or assessment objectives) are: Total contribution versus contribution per unit (AO2) ‘A break-even chart and the following aspects of break-even analysis (AO2, AO4): break-even quantity/point profit or loss margin of safety target profit output target profit target price The effects of changes in price or cost on the break-even quantity, profit and margin of safety, using graphical and quantitative methods (AO2, AQ4) The benefits and limitations of break-even analysis (AO3).INTRODUCTION o A business can be in any one of the following financial situations: o ¢ Loss — when costs of production exceed the revenues of the business o Break-even — when the revenues of the business equal the costs of production o ¢ Profit — when revenues exceed costs of © production.BREAK — EVEN ANALYSIS A02, Ao4 o Break-even exists when a business makes neither a profit nor a loss. o total costs equal total revenue, i.e. TC = TR. o Why do you think companies need to know the break-even point? » Whether it is financially worthwhile to produce or launch a particular good or service « The level of profits that the business is likely to earn if things go according to plan.CONCEPT OF CONTRIBUTION Ao2 o The concept of contribution is crucial to the understanding of break-even analysis. © Contribution is the money that remains after all direct & variable costs have been taken away from sales revenue o Any product that makes a positive contribution will help towards paying some of the fixed costs of the business © Total contribution is simply the unit contribution (P — AVC) multiplied by the quantity sold (Q),Product [Latte |Mocha English Orange | Spring ic) eres Wass Average unit 5.75 6.55 3.20 2.55 1.80 price Avg. variable 2.75 3.15 0.95 1.05 0.80 costs Unit 3.00 3.40 2.25 1.50 1.00 Contribution Here all products are profitable because the unit contribution is positive The sale of each product positively contributes to fixed costs of the Café Which is the strongest product? >Which is the most vulnerable product? Here it is important to know how many products are sold before concluding which product is most profitable eCommon mistake ‘Contribution i nol the sae as value added, hough the io terms ae often confused by students: © Unit contibution = Price minus Average variable cost, ie. P- AVC (2 Value added per unit = Price minus Average total costs, ie, P- ATC ‘This means that value added considers both variable and xed costs of production, whereas nit contribution only considers the cost of goods Sold (COGS) or the vaable costso Profit can be increased in the following ways: 1. Increase sales (marketing strategies, growth strategies) 2, Reduce variable costs e.g. better deals with suppliers, cost effective production 3. Reduce fixed costs and overheads e.g. negotiate for cheaper rent, reduce company expensesUSES OF CONTRIBUTION ANALYSIS o Pricing Strategy » Set prices to ensure there is a contribution made towards indirect and fixed costs o Product Portfolio Management » Managers can decide which products should be given investment priority o Break-even Analysis o Make-or-buy decisions « The difference between the contribution of making and buying the product is likely to determine the decision 0 Allocation of overheads to costs and profit centers @CALCULATION OF BREAK-EVEN o A jeans retailer has fixed costs of $3500 p.m. Variable costs are $10 per pair of jeans and selling price is $ 30. | TR=TC rule Px Q = TFC + TVC 30 Q= 3500 + 10 Q 20Q = 3500 Q=175 pairs of jeans Fixed costs Break-even quantity = ———— i Selling price — Average variable costEXAMPLE: SELLER OF OYSTERS AT A MARKET STALL IN GREENWICH MARKET, LONDON, UK o Price of each oyster is £1.25 o Variable cost of each oyster is £0.45 © The rent (its only fixed costs) is £200 per week 0 So, the BEQ = £200 + (£1.25 — £0.45) = 250 oysters o At this level of output, the total revenue o £1.25 x 250 = £312.50 o If the firm sells 250 oysters, the total costs © £200 + (£0.45 x 250) = £200 + £112.50 = £312.50 o Hence, the firm will break even at 250 units (250 oysters), when the TR = TC = £312.50BREAK-EVEN DIAGRAM : Costs and Revenues () 3128 200 250 Sales quantity (oysters) Let’s Practice break even analysis (see worksheet ppt) Constructing a Break Even Chart (2 min watch) bitty ‘www.youtube.com/watch?v=OyEcQ_mQOlE&t=110sMARGIN OF SAFETY o The margin of safety measures the difference between a firm’s sales volume and the quantity needed to break-even, i.e. it shows how much demand (for a product) exceeds the break-even quantity. © The larger the positive difference between sales output and BEQ, the safer the firm will be in terms of earning profits. © Apositive margin of safety (or safety margin) means that the firm makes a profit, whereas a negative safety margin means the firm makes a loss.o Consider the following example: if the demand for the jeans retailer is 280 pairs per month, then the safety margin is 105 units (i.e. 280 minus 175). o This means that the business can sell 105 pairs of jeans less than its current level and still not make a loss o Hence, the smaller the safety margin the more vulnerable a business becomes to changes in the market. Remember that MOS is expressed in terms of UNITS & not monetary value Costs and Revenves 6) Output (pairs of jeans p/m) Breakeven avanti Lea of demandCalculating the margin of safety Tread itisa manufacturer ofhiking shoes Play’ produces wooden toys or children. Cost and revenue data for both businesses are shown in the table below. ‘Margin of safety (units) ‘Margin of safety (%) 2 Galeulate the missing figures for |, il and lll in the table above. [3marks] b Comment on which firm has the better margin of safety. [marks]o Kaleys Jewellery Ltd. Sells handmade necklaces at an average price of $260 with variable costs averaging $120 per unit. Fixed costs are $ 3500. Plot Break even chart. Calculate & show the revenue at the point of breakeven Cont and Revenues © TR Prot Tc 3800 [Toss Brea-even pot | : apart (pairs of jeans pm) 28 \Laveat-eenqunttyLisa Chan's Day-Care Centre activi Lisa Chan runs a children's day-care centre. The main clients are working parents, who pay a fixed $20 per child for the whole day. Children at the centre learn through play and are engaged in such as art, music, dance and physical education. The business is open for an average of 22 days each month. The firms expected costs and revenue for the nextyear are as follows: Calculate the sum of the fixed costs. Calculate the break-even quantity per month. Capacity 25 children per day Damand {20% of capacity rice ‘320 per child per day Materials ‘$4 per child Rent $600 per month Salaries $7,000 per month ‘Administration | $100 permonth Power 35140 per month Assuming the business works at 80% of Its capacity, calculate the margin of safety. Construct a fully labelled break even chart for Lisa Chan's Day-Care Centre, Identity the break-even point, the break-even output and the safety margin on your chart. Examine the strenaths and weaknesses of using break-even analysis for a business such as Lisa Chan's Day-Care Centre. [2marks] [2marks) [2marks] [5 marks] Barks} [6 marks)TARGET PROFIT AND REVENUE © Target profit output (or target profit quantity) is the quantity of sales required to reach the firm’s target profit. Fixed costs + Target profit Target profit quantity =| ——— == SS __ get proft quantity = = sing price — Average variable cost co Target profit is the amount of profit that a firm aims to earn. The target profit for each level of output can been seen in a break-even chart by comparing the total cost and total revenue lines. o Target price is the amount customers need to pay per unit in order for the firm to break-even or to reach a particular target profit. Target pice = Average Fixed Cost + Average Variable Cost D Target price = (Total Fixed cae * “Output) + Average Variable CostTARGET PROFIT AND REVENUE o Kaleys Jewellery Ltd. Sells handmade necklaces at an average price of $260 with variable costs averaging $120 per unit. Fixed costs are $ 3500. If the firm wants to earn a target profit of $5600 per month, what should the sales amount be? Let’s Practice break even analysis (see worksheet ppt) o Alternative approach: © Target Profit= TR-TC 5600 = 3500 - 2600 - 1200 9100 = 1400 Hence Q = 65 units (target profit output) © Target revenue can be worked out TR = $260 x 65 = $16900 TC = $3500 + ($120 x 65) = $ 11,300 e@ Therefore, target profit is $16,00 - $11,300 = $ 5600Phoebe's Art Studio Ltd. Phoebe's Art Studio Ltd, has overhead costs of $3,000 per month, variable costs of $5 per unit and an average selling price of $20, There are typically 500 customers each month but the fimm's maximum capacity is 600 clients. a Calculate the break-even quantity for Phoebe's Art Studio Ltd. [2marks} b Calculate the margin of safety for the business. [2 marks} ¢ Construct a break-even chart for Phoebe's Art Studio Ltd. [Smarks} ‘Suppose in the subsequent period that rents increase, thereby raising the firm's overhead costs to $4,000. In addition, average selling price has been reduced to $17 and this has increased demand to 520 clients pet month Calculate the new break-even quantity and comment on your findings. [3marks] e Ilustrate the new break-even level of output on your original chart. [3marks] {Explain whether the change in price was a sensible decision, [amarks] Q3.3.5 eCHANGES IN BREAK-EVEN A02, AO4 In reality, actual profits (or losses) are likely to be different from those predicted in a BEA. Consider the impact of the below mentioned factors on the Break even: o Level of demand changes — affected by fashion, changes in income o Profit also depends of the level of risk involved » Whilst low-risk projects generally lead to a quicker BEQ, the monetary value of profits is likely to be low. o Higher costs of production (fixed and/or variable costs) will increase the break-even quantity.CHANGES IN BREAK-EVEN AO2, AO4 o The difference between short run and long run _ profits. + Short Run: It may be necessary to lower prices (and hence break-even occurs at a higher level of output) in order to attract customers to a firm's products. * long term: prices can be increased once a loyal customer base has been established. o Innovation and the introduction of new technologies. « Dell, Apple iPads have generated sales far in excess of their original forecastsLIMITATIONS OF BREAK-EVEN ANALYSIS AO3 © BEA assumes that all cost functions are linear (straight line) * AVC change due to economies of scale * FC change perhaps due to an increase in rent. Hence a ‘stepped’ fixed cost line, rather than a horizontal line oBEA assumes that is produced only one product by the business OF or firms with more than one type of product, overheads have to be split between the products in a rather subjective way oBEA ignores qualitative factors Staff working under increased pressure OCompetitors reactionLIMITATIONS OF BREAK-EVEN ANALYSIS © It assumes that the business will sell all of its output. » Reality: unsold stock, which do not generate cash but cost the firm money (in terms of storage and insurance costs, for example). » Furthermore, unsold stock might need to be sold at a discount (thereby reducing the profits) -BEA assumes the sales revenue function is Linear Ulgnores that customers may demand discounts for larger orders (change in TR line) OQReduced prices to stimulate demand Qignores price discriminationHIGHER LEVEL EXTENSION: LIMITATIONS OF BREAK-EVEN ANALYSIS o BEA is a static model so might not be very useful in a dynamic business environment. © Costs can change in the short run due to fluctuating exchange rates (affect the costs and revenues of exporting firms.)o It provides decision-makers with useful information about forecast costs, revenues and profits. o As a visual tool, the predictions can be easily interpreted. o As a strategic decision-making tool, it can help to reduce high-risk decisions. o It is highly suitable for single-product businesses. o It is useful for analysing and predicting the effects of changes in price and/or costs on the profitability of the business.° ° BENEFITS OF BREAK EVEN ANALYSIS Product portfolio management — BEA helps to assess the expected BEQ prior to the launch of a new product, thereby helping firms to manage their product portfolio Make-or-buy decisions — As the name suggests, these decisions refer to a firm’s choice of whether to produce a product itself or to buy it from a supplier. BEA shows the relative benefits of either decision. Risk assessment — Calculating the margin of safety helps managers to gauge the level of risk involved in a particular project Special order decisions — Special orders are a typical and/or one- off orders for which a business will charge a price that differs from the norm. For E.g.- , some customers might demand speedier delivery times oj changes to the product specification, thereby raising production ol BEA helps to assess whether the change in profits — by accepting tht special order — is worthwhile e (see Box 3.3b).