Calculating profitability involves first working out the minimum level of sales required to cover all costs.
At low levels of sales, a business is not selling enough units for revenue to cover costs. A loss is made. As more items are sold, the total revenue increases and covers more of the costs. The breakeven point is reached when the total revenue exactly matches the total costs and the business is not making a profit or a loss. If the firm can sell at production levels above this point, it will be making a profit.
Establishing the breakeven point helps a firm to plan the levels of production it needs to be profitable.
The breakeven point can be calculated by drawing a graph showing how fixed costs, variable costs, total costs and total revenue change with the level of output.
Here is how to work out the breakeven point - using the example of a firm manufacturing compact discs.
You can assume the firm has the following costs:
Fixed costs: £10,000. Variable costs: £2.00 per unit