break even analysis

break even analysis

Break-even analysis illustrates how many units of a product must be sold to cover the fixed and variable costs of production.

(Break Even = Total Fixed Costs / (Selling Price - Variable Cost Per Unit))

fixed costs

Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same.

In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.

Examples of fixed costs: Rent and rates, Research and development, Marketing costs

variable costs

Variable costs are those costs which vary directly with the level of output.

Examples of variable costs:

- Raw materials, Direct labour, Fuel and Revenue-related costs such as commission.

direct variable costs

Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost center.

Examples include: Raw materials and the wages of those working on the production line.

indirect variable costs

Indirect variable costs cannot be directly attributable to production, but they do vary with output.

Examples include: Depreciation (where it is calculated related to output - e.g. machine

hours), maintenance and certain labour costs.

semi-variable costs

There are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall and/or complexity of the business.

For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully- resourced finance department.

However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required.

total cost

The sum of the Fixed Cost and total variable cost for any given level of production.

(Fixed Cost + Total Variable Cost)

sales revenue

Selling Price x The Number of Units Sold

profit (or loss)

The monetary gain (or loss) resulting from revenues after subtracting all associated costs.

(Total Revenue - Total Costs)

contribution per unit

Selling Price – Variable Cost per unit

margin of safety

Actual number of units sold – BE Point.

desired profit

Required unit sales for a given desired profit can be calculated as follows:

Unit Sales = Fixed Costs + Target Profit /

Contribution Margin per Unit

what if analysis

The purpose of looking at the effect of changes in assumptions is to understand what happens to profit as key data in the business changes.

This is usually referred to as what if analysis

It is important to be able to assess what might cause the breakeven output of a business to change and to be able to calculate and assess the impact of such changes.

advantages of break even

 It is a good budget planning approach,

 It allows visual identification of sales revenue, fixed, variable and total costs at a glance

 There can be immediate identification of break-even point and margin of safety.

 It informs management on different profit levels at different pricing decisions.

 It can predict potential profits at different level of production and sales revenue.

 As part of a business plan, it can be used to acquire funding from banks and investors.

 It tracks the changes of all its factors, sales revenue, fixed costs and variable costs through a ‘what if’ analysis and how these changes in factors, individually or in unison affect the overall profit and margin of safety.

 Break-even can be calculated quickly and easily / easy for non accountants / inexperienced managers to understand

 Decisions about future investments can be made before capital is spent

disadvantages to break even analysis

Many of the factors involved in break-even are assumptions based on historical data and future predictions. Some demand assumptions are not based on reality.

 Sales revenue(price) is not fixed and can fluctuate due to changes in demand and competition.

 Unpredicted events can occur, which makes the break-even analysis unreliable. Consumer tastes can change quickly and affect demand for products.

 New competitor innovations can change demand in a very dynamic market.

 Both sales volume and costs are best guestimates and are based on predictions which can produce misleading data.

 Variable costs are not fixed and can decrease as volume increases through economies of scale, bulk buying.

 Decisions are based on break-even point, not on potential profit levels

 The time aspect of money is not considered

 The graphs show a linear relationship with output levels

 The information may be unreliable

 The SP may differ throughout the year

 FC do not remain the same.