Using break-even analysis to make decisions
By the end of this unit you should understand:
o the meanings of break-even and contribution
o how to calculate break-even output
o how to draw and complete break-even charts
o how to read a break-even chart and illustrate profit or loss
o the impact of price and cost changes on break-even output and break-even charts
o the advantages and disadvantages of using break-even analysis.
What are break-even and contribution?
At the break-even level of output a business makes neither a loss nor a profit.
Contribution can be defined as the difference between sales revenue and variable costs of production.
Contribution is calculated through the use of the following formula:
Contribution = revenue - variable costs
The following information is needed for the calculation:
o the selling price of the product
o the variable cost of producing a single unit of the product
o the fixed costs associated with producing the product.
This information is used within the formula set out below:
Break-even output = fixed costs/selling price per unit - variable cost per unit
The break-even chart
Can be put a break-even chart on this slide, please and mark break-even point on it.
Break-even and changing variables
Break-even can deal with more complex circumstances including:
analysing the impact of changing costs and/or prices on the profitability of the business
deciding whether to accept an order for products at prices different from those normally charged.
The advantages of break-even analysis
• It is a simple technique allowing most entrepreneurs to use it without the need for expensive training.
• It is a technique that can be completed quickly, providing immediate results.
• Its use can be of value in supporting a business's application to a bank for a loan.
• By using break-even charts a business can forecast the effect of varying numbers of customers on its costs, revenues and profits.
The disadvantages of
It assumes that all products are sold.
It is a simplification of the real world. Businesses do not sell all their products at a single price.
Costs do not rise steadily as the technique suggests.
A break-even analysis will be only as accurate as the data on which it is based.
Which one of the following statements relating to break-even output is true?
a) It is the level of output at which sales revenue equals total costs.