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Break-Even Analysis

Break-Even Analysis

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Published by bookboon
Troubles with the break-even analysis? In this free textbook you can read about a simple break-even point application as well as about more advanced analysis. Like the multi product break-even point, analysis in the service industry and discount and promotions.
Troubles with the break-even analysis? In this free textbook you can read about a simple break-even point application as well as about more advanced analysis. Like the multi product break-even point, analysis in the service industry and discount and promotions.

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Published by: bookboon on Nov 23, 2009
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12/31/2012

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Break-Even Analysis
 2Introduction
 
 Nikolaos Tsorakidis, Huron University, London Sophocles Papadopoulos, Huron University, London Michael Zerres, Universität Hamburg Christopher Zerres, Universität Kassel 
1. Introduction
 Break-Even analysis
is used to give answers to questions such as “what is the minimum level of salesthat ensure the company will not experience loss” or “how much can sales be decreased and thecompany still continue to be profitable”. Break-even analysis is the analysis of the level of sales atwhich a company (or a project) would make zero profit. As its name implies, this approach determinesthe sales needed to break even.
 Break-Even point 
(B.E.P.) is determined as the point where total income from sales is equal to totalexpenses (both fixed and variable). In other words, it is the point that corresponds to this level of production capacity, under which the company operates at a loss. If all the company’s expenses werevariable, break-even analysis would not be relevant. But, in practice, total costs can be significantlyaffected by long-term investments that produce fixed costs. Therefore, a company – in its effort toproduce gains for its shareholders – has to estimate the level of goods (or services) sold that coversboth fixed and variable costs.Break-even analysis is based on categorizing production costs between those which are
variable
(coststhat change when the production output changes) and those that are
 fixed 
(costs not directly related tothe volume of production). The distinction between fixed costs (for example administrative costs, rent,overheads, depreciation) and variable costs (for exampel production wages, raw materials, sellers’commissions) can easely be made, even though in some cases, such as plant maintenance, costs of utilities and insurance associated with the factory and production manager’s wages, need specialtreatment. Total variable and fixed costs are compared with sales revenue in order to determine thelevel of sales volume, sales value or production at which the business makes neither a profit nor a loss.
 
Break-Even Analysis
 3
2. Simple Break-Even Point Application
B.E.P. is explained in the following example, the case of Best Ltd. This company produces and sellsquality pens. Its fixed costs amount to 400,000 approximately, whereas each pen costs 12 to beproduced. The company sells its products at the price of 20 each. The revenues, costs and profits areplotted under different assumptions about sales in the break-even point graph presented below. Thehorizontal axis shows sales in terms of quantity (pens sold), whereas expenses and revenues in eurosare depicted in vertical axis. The horizontal line represents fixed costs (400,000). Regardless of theitems sold, there is no change in this value. The diagonal line, the one that begins from the zero point,expresses the company’s total revenue (pens sold at 20 each) which increases according to the levelof production. The other diagonal line that begins from 400,000, depicts total costs and increases inproportion to the goods sold. This diagonal shows the cost effect of variable expenses. Revenue andtotal cost curves cross at 50,000 pens. This is the break even point, in other words the point where thefirm experiences no profits or losses. As long as sales are above 50,000 pens, the firm will make aprofit. So, at 20,000 pens sold company experiences a loss equal to 240,000, whereas if sales areincreased to 80,000 pens, the company will end up with a 240,000 profit.The following table shows the outcome for different quantities of pens sold (Diagram 1):Pens Sold (Q) 20,000 50,000 80,000Total Sales (S) 400,000 1,000,000 1,600,000Variable Costs (VC) 240,000 600,000 960,000Contribution Margin(C.M.)160,000 400,000 640,000Fixed Costs (FC) 400,000 400,000 400,000Profit / (Loss) (240,000) 0 240,000
Diagram 1:
Different quantities of pens soldThe break-even point can easily be calculated. Since the sales price is 20 per pen and the variable costis 12 per pen, the difference per item is 8. This difference is called the
contribution margin per unit 
 because it is the amount that each additional pen contributes to profit. In other words, each pen soldoffers 8 in order to cover the fixed expenses. In our example, fixed costs incurred by the firm are400,000 regardless of the number of sales. As each pen contributes 8, sales must reach the followinglevel to offset the above costs Diaram 2:
Simple Break-Even Point Application

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