Break_even_analysis_2024 (5)

3.3 BREAK-EVEN ANALYSIS

Definition

• Break-even analysis: This is a financial calculation to determine the point at which total revenues (TR) equal total costs (TC), meaning that no profit or loss occurs.

Key Formulas

• Total Revenue (TR) = Price per unit × Quantity sold

• Total Cost (TC) = Fixed Costs (FC) + Variable Costs (VC)

• Break-even Quantity (BEQ) = Fixed Costs / (Price per unit - Variable Cost per unit)

• Profit/Loss = TR - TC

Break-Even Chart

• A graphical representation of TR and TC.

• The area where TR and TC intersect represents the break-even point, indicating the quantity where profits and losses equalize.

• Example: If BEQ = 10,000 units, producing and selling 10,000 units will result in zero profit/loss.

Components

• Fixed Costs (FC): Costs that do not change with the production volume. Examples include rent, salaries, and machinery.

• Variable Costs (VC): Costs that vary directly with the quantity produced (e.g., raw materials).

Safety Margin

• Safety Margin: The difference between actual output and break-even quantity.

• Formula: Actual Output - Break-even Quantity.

• Example: If actual output is 17,000 units and BEQ is 10,000, then Margin of Safety = 7,000 units.

Target Profit Output

• Target Profit: Desired profit level that a business aspires to achieve.

• Formula: Target Profit = Fixed Costs + Desired Profit Contribution per unit.

• Example: If the target profit is $100,000, this needs to be factored into the pricing strategy.

Break-Even Revenue

• The minimum revenue needed to cover all costs.

• Formula: Fixed Cost Contribution per unit × Price per unit = Break-even Revenue.

Break-Even Price

• To calculate break-even price, consider both fixed costs and direct costs.

• Formula: (Fixed Cost + Direct Cost per unit) / Production Level.

Changes in Variables Impacting Break-Even Point

• Changes in Price: An increase in price can reduce BEQ; a decrease increases BEQ.

• Changes in Fixed Costs: An increase in FC shifts the BEQ to the right.

• Changes in Variable Costs: If VC increases, the BEQ will also increase.

Limitations of Break-Even Analysis

• Assumption of Linear Costs: Assumes fixed and variable costs increase in straight lines, which is often unrealistic.

• Non-Sale of All Produced Output: Assumes all output produced is sold; this may not be the case.

• Static Analysis: Conducts analysis as if prices and costs remain constant, which may not reflect market dynamics.

• Does not consider external factors: Ignore market competition, demands, and economic changes that could affect outputs and pricing.