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									Break-Even Analysis

      What is it?
    By John Birchall
            What is it? - 1
• In business we have TWO types of COSTS
• We measure costs in the Long run and
  short run - what does this mean?
• When making a product or service we incur
  DIRECT and INDIRECT costs- what are
• We need to know how much PROFIT each
  unit of output gives us =
        How might we use this
• Comparing profits        • Judging balance
  over a period of time      between fixed and
• giving advice on how       variable costs
  profitability can be     • assessing one firms
  improved                   costs against another
• noting other non-        • is the level of profit
  financial factors that     sustainable
  might influence          • forecast v outcome
  performance of             and variance
  business                   awareness
              What is it? - 2
• Finds minimum output and sales needed to
  cover costs
• even at 0 output you incur FIXED COSTS
• Price equals revenue, so total sales x price =
  Total Revenue
• We want to know how much money we
  make from each unit of sale =
  CONTRIBUTION. Price per unit - direct
             What is it? - 3
• This is the contribution that each unit of
  sale makes towards covering FIXED
  COSTS i.e. those that DO NOT vary with
• Or once the Fixed Costs have been covered
  how much PROFIT each unit of sales
• Let’s take a simple example
             What is it? - 4
• We sell a product for 8 euros and its has
  Direct Costs of 6 euros.
• The contribution per unit will = Euro 2.
• A product with a price of 7 euros and direct
  costs of 3 euros will make a contribution of
  4 euros per unit sold.
  contribution per unit x number of units.
• 200x 4euros = 800 euros
       Assumptions we make
• The selling price remains the
  same,regardless of the number of units sold
• Fixed Costs remain the same,regardless of
  the number of units of output
• Variable Costs vary directly in proportion
  to output
• Formula = Fixed Costs
  (euro)/Contribution per unit (euro)
             What is it? - 5
• A product with a price of 9 euros and direct
  costs of of 4 euros will contribute 5 euros
  for EVERY unit sold.
• At 5 euros per unit the company would need
  to sell 400 units in order to pay FIXED
  COSTS of 2000 euros and so BREAK
• e2000/e9 - e4 = e5 = 400 units
    Costs and Contributions - 1
• Firms have to buy FIXED ASSETS and
  these have to paid for.
• As production begins so Variable Costs take
• Added together they make Total Costs.
• It is unlikely that low levels of sales will
  produce a profit
    Costs and Contributions - 2
• As sales INCREASE so Fixed Costs
  become less of a burden.
• The AVERAGE COST falls.
• For example, if output is 100, the Fixed
  Costs =E10000/100= 100 per unit BUT if
  sales expand to 2000 the Average Costs fall
  to just 5 per unit.
• So high levels of output and sales are good
    Costs and Contributions - 3
• In our example(see diagram) the break even
  point is 2000, at which level the sales
  revenue and costs are 16000.
• But is it good business to just break even?
• No, you need a margin of safety. This is the
  difference between the ACTUAL output
  and the break even output. Actual = 3000
  and break even = 2000, then 1000 = margin
  of safety
    Costs and Contributions - 4
• Contribution - Strengths and Weaknesses
• Strengths - managers have an overview,
  even in multi-product companies, fixed
  costs are allocated and no room for
  discussion, pricing can use contribution as
  part of decision on its level
• Weaknesses - pricing using contribution
  take no account of market conditions
    Costs and Contributions - 5
• Weaknesses continued - some costs cannot
  easily be classified as either fixed or
• In the long run fixed costs change and the
  original contribution is no longer relevant
• But it does give us a guide as to where sales
  need to be in order to cover costs and begin
  to make a profit
       Break Even - its uses - 1
• Whether to start trading
• whether to make and introduce a new
• the likely profit points ( or losses) resulting
  from sales forecasts
• analysing the impact of changing variables
• ( costs and price changes) on the
  profitability of the business
      Break Even - its uses- 2
• Deciding whether to accept an order for
  products at prices different from those
  normally charged.
• Let’s look at what changes might arise and
  what we would have to do.
      Changes in Variable - 1
Rise in        Greater output   Costs up, so
variable costs is needed to     more needs to
               break even       be sold to b/e
Fall in        Smaller output    Each sale less
variable costs needed to        costs, lower
               break even       b/e point
Rise in fixed Greater output    More costs
costs          needed to        before profit.
               break even       Higher b/e
      Changes in Variables - 2
Fall in fixed   Smaller output Costs are
costs           to b/e         lower fewer
                               sales to b/e
Rise in selling Earlier b/e    Fewer sales to
price           (inelastic?)   b/e greater
Fall in selling Later break    How to do
price           even = more this? 4 p’s
                sales          altered etc?
       Special Order Decisions
• Do you accept a new      • The products will
  order?                     NOT be re-sold, so
• Likely to accept even      undercutting the firm’s
  if price lower than        normal selling price
  usual if-                  (price discrimination)
• price exceeds variable   • other benefits could
  costs of production        come e.g new markets
• the business has
  sufficient spare
  capacity to meet the
    Uses of break even analysis
• Different levels of      • Conduct ‘what if’
  profit at varying levels   surveys
  of output                • say what if the selling
• discover at which level    price changed, or the
  of output you start to     variable costs altered
  make profits               or the fixed costs
• new entrants can           changed
  decide if worthwhile
• quick and easy to do
   Disadvantages of break even
• Information may not      • Do fixed costs remain
  be reliable                the same across all
• Sales and output and       output range?
  unlikely to be exactly   • Do selling prices
  the same                   remain fixed and the
• the analysis is            same for each
  STATIC - new               customer?
  calculation and          • Do variable costs
  diagram need for each      remain
  change                     static(economies of

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