Break Even Analysis

Break Even Analysis Break even

Break even is a level of output and sales where total costs equals total revenue At this point the firms is making neither profit nor loss At output above break even the firm will be in profit At output below break even the firm will be making a loss

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Assumptions

All other variables remain constant A single product is produced Costs can be divided into fixed and variable elements There is a linear (straight line) relationship between output and total costs variable costs per unit remain unchanged There is a linear relationship between output and sales revenue each unit is sold at the same price All output can be sold at the given price The analysis applies to the relevant range only

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Costs

Fixed costs Do not rise with output Examples
rent rates administrative costs interest payments

Variable costs Rise as output rises Examples :

cost of materials labour costs

Total costs = fixed costs + varable costs

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Total revenue

Also known as sales revenue or turnover Total revenue = quantity sold x price per unit This rises as sales rise If we assume that price is uniform throughout then there is a linear relationship between total revenue and sales volume

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Graphical analysis

Sales and costs ()
Breakeven point Sales revenue
Sales revenue less Total costs = profit

Total costs
Breakeven sales

Variable costs = total costs less fixed costs

Total fixed costs

Breakeven quantity

Sales / production (units)

Break Even Analysis Notes on the break even graph (1)

Fixed cost are shown as horizontal straight line Variable cost are added to the fixed costs Hence total costs start part way up the vertical axis Total sales revenue starts from the origin and rise in the form of a straight line Break even occurs at the intersection of total costs and total revenue We can read off both the break even quantity (horizontal axis) and break even revenue (vertical axis)

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Notes on the break even graph (2)

The triangles between the total cost and total revenue curves are areas of loss (to the left of break even point) or profit (to the right of the break even point) The actual profit or loss can be read off as the vertical distance between total cost and total revenue The gap between current output and sales and break even output and sales is known as the margin of safety

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Contribution

Contribution is equal to Sales revenue minus variable costs This is not the same as profit since so far only variable costs have been taken into account Contribution per unit = revenue per unit (i.e. price) minus variable cost per unit Contribution per unit can be regarded as that units contribution to: Fixed costs and Profits Once fixed costs have been covered the contribution is to profits

Break Even Analysis_v1

Dr. Harald Fien

Break Even Analysis Break even formulae

Contribution per unit = selling price minus variable costs per unit Break even (qu) = Fixed costs Contribution per unit Break even () = Fixed costs x Price Contribution per unit

Break Even Analysis_v1

Dr. Harald Fien

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Break Even Analysis Example

Given data Fixed costs: Variable costs per unit: Selling price per unit: 500k 13 19

Calculations Contribution per unit: (19 - 13) 6 Break even quantity: 500k/6 = 83,334 units Break even revenue: (500k/6) x 19 = 1,583,333 Note: for break output in quantity terms always round up to the nearest whole number. Never round down

Break Even Analysis_v1

Dr. Harald Fien

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Break Even Analysis Rise in selling price

As price rises the total revenue curve rises at a steeper angle Break even occurs at a lower level of Sales volume and Sales revenue Also at each quantity level profits will be higher than before But we are assuming the customers are not deterred from buying as a result of the higher price

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Dr. Harald Fien

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Break Even Analysis Rise in variable costs

The total cost curve starts at the some as before but rises at a steeper angle Break even occurs at a higher level of
sales volume sales revenue

At each quantity level profits will be lower

Break Even Analysis_v1

Dr. Harald Fien

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Break Even Analysis Rise in fixed costs

The starting point for total revenue moves up the vertical axis The new total cost curve is parallel with the old one but at a higher level Break even occurs at a higher level
sales volume sales revenue

Profits are lower at each level of sales

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Dr. Harald Fien

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Break Even Analysis Margin of safety

This is equal to current output minus break even output Measures how far sales can fall before the business starts to make a loss Once break even output/sales is reached then the contribution on each additional unit goes towards profit As a result we can calculate profits as follows: Profit = margin of safety x contribution per unit

Break Even Analysis_v1

Dr. Harald Fien

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Break Even Analysis Target rate of profit

We can adapt break even to calculate the level of sales needed to reach a profit target Treat the target level of profits as a kind of fixed cost Therefore output and sales needed to reach the target level of profits = fixed costs + profit target contribution per unit

Break Even Analysis_v1

Dr. Harald Fien

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Break Even Analysis Uses of break even analysis

A tool for use in planning A new start up business can estimate the required level of sales before it starts to make a profit Similarly it can be used in new product development to estimate sales needed to break even on a new product Measures profit at different level of sales It can be used in modelling what if scenarios It helps identify the impact of price or cost changes

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Dr. Harald Fien

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Break Even Analysis Limitations of break even analysis

Assumptions on which the analysis is based are not valid No costs are truly fixed -the divide between fixed and variable costs is not clear cut Cost curves are not necessarily linear. As output rises it does not follow that there will be a proportionate increase in sales Takes no account of economies of scale and bulk buying discounts Production and sales are assumed to be the same but it is unrealistic to assume that all output is sold at and at a uniform price It is a static model and needs to be reworked whenever there is a change in anyone of the variables The analysis is only as good as the information provided It ignores outside variables such as the reaction of competitors

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Dr. Harald Fien

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Break Even Analysis Lessons Learned

What is a break even analysis? Show a principal graphical break even analysis. What are uses of break even analysis? What are limitations of break even analysis?

Break Even Analysis_v1

Dr. Harald Fien

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