- Break-even is the point where total revenue = total costs, so the business is making no profit and no loss.
- Breakeven output = Fixed costs / Contribution per unit
- e.g. a business has fixed costs of £10,000 and the direct costs are £2.50 for each product made. The intended selling price is £15. £10,000 / £12.50 = 800 units.
- When calculated, a breakeven figure can be used to assess whether it is possible to achieve a certain number of sales.
- This formula can also be used to show the likely consequences for total revenue and breakeven output if there is a change in price. Increasing the price means that the contribution per unit will increase and, as a consequence, the number of goods that need to be sold to break even will fall.
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Deriving breakeven graphically
- Fixed costs do not alter with output and are therefore represented by a horizontal straight line.
- Variable costs (direct costs) vary directly in proportion to the level of output. The higher the variable costs, the steeper the diagonal line representing them. This line begins at zero.
- Total costs are calculated by adding together fixed and variable costs. This line does not start at zero.
- Total revenue = price x level of output. The slope or gradient of the total revenue line is determined by the price. The higher the price, the steeper the total revenue line will be.
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Margin of safety
- Margin of safety: the difference between the actual level of output and the breakeven level.
- Knowing its margin of safety can help a business to assess the impact on its profits of any change in either the actual level of ouput or the breakeven level.
- The smaller the margin of safety, the less flexibility the business has to deal with any change in circumstances.
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Advantages of break-even analysis
- Tables and diagrams are easy to view, understand and interpret.
- It is useful as a management tool to aid the decision-making process.
- It can be used to show the level of profit at a given level of output.
- The margin of safety can be established.
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Disadvantages of break-even analysis
- The direct or variable costs may change, depending on the quantities involved. A manufacturer is likely to be able to negotiate a discount for buying in large quantities.
- If batch production is being used, which may involve the production of fixed quantities for each batch, the breakeven level of production may not be obtainable. Producing in quantities of 50 in each batch, with a breakeven level of 840, means that the business would have to decide whether to produce 800, which would mean a loss, or 850, which is beyond the breakeven output but may be more than the demand for the product.
- It assumes that the firm sells everything that it produces without wastage, which often isn't true.
- Break-even analysis is for one product. Most businesses sell several products, and a separate graph for each product would be needed to give an overall picture of the profitable output level. This would get complicated.
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