Break-even 2.2.3

Break even - is the point at which a business is not making a profit or a loss i.e. it is just breaking even.

Break even output - Is the number of items that a business must sell to reach this point.

Contribution - The contribution is the difference between the sales revenue and the variable cost of each unit sold or made. SELLING PRICE - VARIABLE COSTS

Margin of Safety - is how much actual/current output is above the break even level of output

Profit - (MAX OUTPUT - Break even) x contribution or TR - TC

Loss - TC - TR

At break even point total costs must be the same as total revenue TR = TC 

Before reaching break-even, the business is performing at a loss. After reaching break even, each additional unit sold will contribute towards a profit.

CONTRIBUTION

When a sale comes in, the sales revenue will be the amount the item was sold at - selling price. This amount will then be used to cover its own variable costs that went in to making the product. What ever is left over is called a contribution/contribution per unit. This contribution will either go to the fixed costs if the business has not fully covered it from other sales or to profit if fixed costs have been paid for.

When we contribute, we give to something

In business, each time a product is sold or service provided, the revenue is used to pay for two costs

1. Its own variable costs
2. A contribution to the fixed costs of the business.

Until there are enough contributions to cover all the fixed costs, the business cannot start to make a profit.

When the business has sold enough products to fully pay off the fixed costs, any revenue from the further products sold will be used to :

1.  Pay its own variable costs
2. Any remainder will go to profit.

Each time an item is sold, the difference between the selling price and the variable cost is called the CONTRIBUTION PER UNIT

 If I sell t-shirts at £11.50 and each one costs me £4.00 to make then from each item sold there will be a contribution of £7.50.

TOTAL CONTRIBUTION

Total contribution = Total sales revenue - Total variable costs

If I sell 100 T-shirts at £11.50 each, the sales revenue will be £1150 and variable costs will be £4.00 per t-shirt so total variable costs is £400. Therefore, the contribution towards fixed costs is £750

BREAK EVEN OUTPUT USING CONTRIBUTION

Contribution per unit can be used to calculate break even output.

Fixed Costs / Contribution per unit = Break even output

So if I have fixed costs to manufacture the t-shirts at £15,000

Contribution per unit is still £7.50 (£11.50 - £4.00)

So Break even output would be £15,000 / £7.50 = 2000 units

The business would have to sell 2000 t-shirts to break even. If it sold 2001 t-shirts, the business would be making £7.50 profit as all fixed costs have been paid and the rest of the amount can be put towards profit margins.

MARGIN OF SAFETY

ACTUAL/ CURRENT OUTPUT LEVEL - BREAK EVEN LEVEL OF OUTPUT

So if t-shirts break even point is 2000 units but the business is actually outputting 3000 units, then the margin of safety is 1000 units. Margin of safety shows how much a business can fall before it starts making a loss. Generally, the greater the margin of safety, the better the position for the business.

CHANGING VARIABLES THAT AFFECT BREAK EVEN AND CONTRIBUTION

 

 Things that can change...

1. Fixed costs (Landlord puts rent up = increased fixed costs, Management want pay increase = increase in fixed costs) 
2. Variable costs (Raw materials price increases = increase in Variable costs)
3. Selling price (New competition enters the market = higher prices, unexpected increase in demand = higher prices)

STRENGTHS AND LIMITATIONS OF BREAK EVEN ANALYSIS 

STRENGTHS 

• Allows the business to calculate the minimum number of sales needed before starting to make a profit and therefore see if a venture is a viable option
• Can calculate the level of profit and loss at different levels
• Can predict the outcome of changing variables
• Provides a target
• An integral part of the business plan when trying to secure finance
• Aids decision making

WEAKNESSES  

•  Is based on predicted costs and revenues
• Even fixed costs can vary in reality, especially in the long run
• Ignores changes in variable costs or selling price as items are bought or sold in larger quantities
• Only indicates the number of sales needed, does not ensure actual sales will materialise