Chapter 3.

3 Break-even analysis

Contribution refers to the sum (addition) of money that remains after all direct and variable costs
have been taken away from the sales revenue. It is the amount available to contribute towards
paying fixed costs of production.

The formula for contribution per unit is therefore:

Contribution per unit= P – AVC

P is the price, AVC is the average variable costs

The total contribution is the unit contribution multiplied by the quantity of sales (Q):

Total contribution= (P - AVC) x Q

Example:

If a firm sells chairs at $100 each while the variable costs are $45 per chair, then the business makes
a contribution of $55 per chair.

Contribution per unit= P – AVC

Contribution per unit= 100 – 45 = 55$

This is not the actual profit made because fixed costs have not yet been accounted for.

However, each chair sold 'contributes' (adds) $55 towards the payment of the firm's total fixed costs
(TFC). Once these have been covered, further sales will contribute towards the profit of the business.
In other words:

Profit= Total contribution – TFC

Profit can be increased in the following ways:

• Increasing sales of the product, which raises the total contribution (or gross profit).
• Reducing variable costs, perhaps through negotiating better deals with current suppliers or
seeking new suppliers that offer more competitive prices.
• Reducing fixed costs and overheads, perhaps through better financial control or the use of
cost and profit centers

Contribution analysis can help a business to identify products that are relatively profitable and ones
that might need more attention. Data in Table 3.3.a that shows how contribution analysis is used.

Table 3.3.a suggests that all products are profitable because the unit contribution is positive. Hence,
the sale of each product contributes positively towards the fixed costs of Cafe Cuppa. The strongest
product is the Mocha; despite its relatively high unit cost of production, it earns the firm $3.40
contribution per unit sold. The most vulnerable product is the Spring Water which only earns Cafe
Cuppa $1 contribution per unit sold. It is important to also know the number of units sold before
concluding which product is the most profitable. In general, any product that makes a positive
contribution is worth considering as it helps towards the payment of the firm's fixed costs (and
hence profits).

Contribution analysis has several uses for businesses:

1. Pricing strategy: Contribution analysis helps a business to set prices for each of its products
to ensure there is contribution being made towards payment of fixed and indirect costs.
2. Product portfolio management: The analysis can help managers to decide which products
should be given investment priority. Products with a higher total contribution tend to be
given priority. Products that earn a low unit contribution rely on high sales volumes to avoid
being withdrawn or replaced by other products.
3. Allocation of overheads to cost and profit centres The use of contribution analysis can
ensure that cost allocation is done in a fair manner.
4. Make-or-buy decisions Contribution analysis can help a business decide whether it should
produce (make) the products or purchase them (buy) from suppliers.
5. Special order decisions These occur when a customer places an order at a price that differs
from the normal price charged by the business. The price could be higher (such as shorter
delivery times) or lower (because the customer is buying a large amount of the product).
Whether the business takes on this special order will largely depend on the total
contribution made from such a deal.
6. Break-even analysis A business breaks even when neither a profit nor a loss is made. This
occurs at the level of output where total costs equal total revenue, TC = TR.
Break-even is a key objective of new and unestablished firms. Hence, businesses need to pay
careful attention to their cash-flow situation by monitoring and controlling the money
coming into the business (revenues) and the money leaving the firm (costs).

Break-even analysis

Managers of all businesses are concerned with the difference between revenue and costs. A
business can only survive in the long term if its revenues exceed its costs, i.e. if it is profitable. Break-
even analysis is a management tool that can be used for this purpose.

In financial terms, a business can be in one of the following situations at any point in time:

• Loss - when costs of production exceed the revenues of the business

• Break-even - when the revenues of the business equal the costs of production
• Profit - when revenues exceed costs of production.

Carrying out a break-even analysis (BEA) can inform managers of two things:

• Whether it is financially worthwhile to produce or launch a particular good or service

• The expected level of profits that the business will earn if all goes according to plan.
Example: A jeans retailer has fixed costs of $3,500 per month. Variable costs are $10 per pair of
jeans, and the selling price is $30. There are three ways that can be used to determine the break-
even point:

1. Using the TR= TC rule

The break-even quantity (BEQ) can be calculated by comparing total sales revenues with total
costs. Recall from Unit 3.2 that total revenue is calculated as Price x Quantity sold and that Total
Costs consist of both fixed and variable costs. The BEQ can then be calculated as:

o TR=TC
o P x Q = TFC + TVC
o 30Q = 3,500 + 10Q
o 30Q-10Q = 3500
o 20Q = 3,500
o Q= 3500/20
o Q = 175 pairs of jeans

2. Using the contribution per unit rule

Break even= Fixed Costs/Contribution per unit

This is the quicker of the two quantitative methods of calculating break even. Using the above
figures, we get:

Unit contribution = Price minus average variable costs

Unit contribution= P – AVC

=$30 - $10 = $20

Therefore, the BEQ = $3,500 / $20 = 175 pairs of jeans.

3. Interpretation from a break-even chart.

In Figure 3.3.a below, the break-even level of output can be seen on the x-axis at the point
where TC= TR, i.e. 175 pairs of jeans.

All three methods give the same answer, the business needs to sell 175 pairs of jeans each month to
reach break-even.
The chart also shows that any sales beyond the break-even level of output generates a profit,
whereas selling less than the BEQ means the firm makes a loss for that month (see Figure 3.3.b).

(a) Break even quantity = Fixed Costs/Contribution per unit

Contribution per unit = P-AVC

= 35-10 = 25$

Break even quantity = 20,000/25 = 800 rides

(b) Total revenue at the break-even quantity:

Revenue= Price x Quantity (at the break-even quantity)
= 35 * 800 = 28000$

(c) Total cost = total variable cost + total fixed cost

= (10*800) + 20,000= 8000+20,000 = 28,000$

(d) Profit = Total Contribution – TFC

Total Contribution = contribution per unit * Q
= 25*855 = 21,375$
Profit = 21,375 – 20,000 = 1,375$ per month
The margin of safety

The margin of safety (MOS) measures the difference between a firm's sales volume and the quantity
needed to break-even, it shows the extent to which demand (for a product) exceeds the BEQ.

A positive MOS means that the firm makes a profit, whereas a negative safety margin means the
firm makes a loss. It is calculated using the formula:

MOS= Level of demand minus Break-even quantity

Example: if the demand for the jeans retailer in the previous example is 280 pairs per month, then
the safety margin is 105 units (i.e. 280 minus 175).

This means that the business can sell 105 pairs of jeans less than its current level without making a
loss (see Figure 3.3.c). Hence, the smaller the MOS, the more vulnerable (at risk) a business becomes
to changes in the market.

Many businesses prefer to express the margin of safety as a percentage of the BEQ because this puts
the MOS figure into context and allows better comparisons to be made. In this case, the MOS is 60%
higher than the break-even level of output, i.e. (105/175) x 100. Hence, the MOS can reveal the
degree of risk involved in a business decision.