Break Even Analysis

Contribution
• sum of money that remains after all direct and variable costs have been
taken away from the sales revenue.
• contributes towards paying fixed costs of production.
• Contribution per unit = P- AVC
• Total contribution = (P - AVC) x Q
• Profit = Total contribution – TFC
• any product that makes a positive contribution is worth considering as it
helps towards the payment of the firm's fixed costs (and hence profits).
 Uses of contribution analysis
• Pricing strategy: set prices in a way to ensure ensure there is contribution
being made towards payment of fixed and indirect costs.
• Product portfolio management: products with a higher total contribution
tend to be given precedence in investment.
• Allocation of overheads to cost and profit centres
• Make-or-buy decisions: CTM or CTB
• Special order decisions
• Break-even analysis
• Cost Centre: a distinct division of a business for which costs can be calculated.
• Profit centre: a distinct division of a business for which costs and revenues
can be calculated.
Break-even analysis
• Break-even - when the revenues of the business equal the costs of
production.
• 1. TR = TC
▫ PXQ = TVC+TFC
• 2. Break even = Fixed Costs / Contribution per unit
Margin of Safety (MOS)
• shows the extent to which demand (for a product) exceeds the BEQ.
• Expressed in terms of quantity and not monetary terms.
• Margin of safety = Level of demand minus Break-even quantity
• the smaller the MOS, the more vulnerable a business becomes to
changes in the market.
• express the margin of safety as a percentage of the BEQ because this
puts the MOS figure into context and allows better comparisons to be
made.
• MOS = (ACTUAL DEMAND – BEQ)/BEQ X 100
Target Profit
• The break-even chart can be used to determine the level of output that
is needed to earn a given level of profit.
• Target profit output = (fixed costs + target profit) /contribution per unit
Changes in break even
• Windcheater Car Roofracks
• The sole owner of Windcheater Car Roofracks needs to expand output as
a result of increasing demand from motor-accessory shops. Current
output capacity has been reached at 5,000 units per year. Each rack is
sold to the retailers for $40.
• Production costs are:
• ■ direct labour $10, direct materials $12, fixed costs $54,000
• The owner is considering two options for expansion:
• Option 1: Extend the existing premises, but keep the same method of
production. This would increase fixed costs by $27,000 per year, but
direct costs would remain unchanged. Capacity would be doubled.
Changes in break even
• Option 2: Purchase new machinery, which will speed up the production
process and cut down on wasted materials. Fixed costs would rise by
$6,000 per year, but direct costs would be reduced by $2 per unit. Output
capacity would increase by 50%.
• Construct break-even charts for these two options.
• Identify the break-even point for each.
• ■ What is the maximum profit obtainable in each case?
• ■ If demand next year is expected to be 7,000 units, what would be the
margin of safety in both cases?
• ■ Which option would you advise the owner to choose? Give both
numerical and non-numerical reasons for your decision.
Changes in break even
• 2. The owner of Windcheater Car Roofracks discovers that the fixed
costs for Option 1 will in fact be 20% greater than planned. Use a break-
even chart to determine the new break-even point and then use the
equation to verify it.
• 3 In Option 2 the increase in fixed costs is now planned to be $8,000 and
the direct costs fall by $2.50 per unit:
• ■ explain why the direct costs might fall
• ■ determine the new break-even point.
Changes in Break Even
• The difference between short-term and long-term profits as prices in
the short term may have to be reduced to gain customers.
• The level of demand is subject to change due to change in taste and
preferences of the customer.
• Profit depends on the level of risk involved, low risk means break even
reached early and vice versa.
• Innovation and the introduction of new technologies
• Case study: 3.3.6
Changes in Break Even
• Changes in price
Changes in costs
• Increase in fixed costs
Increase in variable costs
Benefits
• Break-even charts provide an easy and visual means of analysing a firms financial
position at various levels of output.
• At a glance, by using the charts, the management of a business is able to determine
the profit or loss, margin of safety, break-even quantity, and break-even revenue or
cost.
• Formulae can also be used to give more accurate results when calculating the above.
• Changes in prices and costs and their impact on profit or loss, breakeven point, and
margin of safety can be compared by using the charts or by calculation.
• Break-even analysis can be used as a strategic decision-making tool such as deciding
on key investment projects or whether a business should relocate or merge with
another firm.
• Produce and/or sell a single, standardised product, Operate in a single market, Make
products to order
Drawbacks
• Break-even analysis assumes that all the output produced by firms is
sold with no possibility of stocks being built up or held. In reality, many
businesses may hold stocks to cater or any sudden changes in demand.
Stocks may also build up because goods cannot be sold.
• It assumes that all revenue and cost lines are linear. This is not always
the case. Offering price reductions o discounts will influence the slope
of the revenue line. The slope of the variable cost line will also change if
a firm pays overtime wages in an effort to increase output. This change
will then influence the slope of the total cost line.
• semi-variable costs are not represented on the break-even chart.
• not be very useful in changing or dynamic business environments.
 Drawbacks
• The accuracy and quality of the cost and revenue data used determine the
effectiveness of break-even analysis. garbage in, garbage out (GIGO)
• Fixed costs may change at different levels of activity. It would be preferable
to represent these fixed costs as a stepped line.
• Other quantitative and qualitative factors that can alter the costs, revenues
and output of the business are ignored.
• BEA is really only suitable for single-product firms that sell all of their
output. For firms with a broad product portfolio, overheads have to be split
between the various products in a rather subjective way.