4.2.

3 Break-even analysis

The concept of break-even

Before aiming to make a profit, a business must first make sure that it covers all the cost
it has spent on production or providing services. A business must therefore aim to find
out the minimum number of products or services it must sell to cover its costs. This is
called break-even.

The formula:

Total revenue = total cost

or

Profit (or loss) = 0 = Total revenue - costs

● Break-even analysis - is used to calculate the minimum level of output a business

needs to produce and sell to cover its costs.
● Break-even level of output - is that level of output which, if sold, will generate a
total revenue that will exactly equal to the cost of producing that level of output.
At the break-even level of output a business will make neither a profit nor a loss.

Now that Geoff has set a selling price of $3 per unit of a light bulb, he is able to extend
his table of cost information at different level of output to conclude total revenues from
sales of a light bulb.

Geoff can identify that break-even level of output as 3000 light bulb per month
If 3000 light bulb are sold each month at a price of $3, then his total revenue will be
$9000 per month ($3 x 3000 unit sold) which is exactly equal to the total cos of their
production of $9000 (fixed cost of $3000 + total variable cost of $6000)

Plotting

Break-even chart - shows the total revenues, costs and therefore total profit or loss of
the business at different levels of output.

The minimum level of output must be produce and sell each month is found at the point
where is total revenue line crosses its total cost line

note:

total cost line is the red line

total revenue is the blue line

At every level of output below 3000 light bulbs per month, the business will make a loss
as the total revenue line will be below the total cost line. The area between them is the
area of loss.

In contrast, At every level of output above 3000 light bulb per month, the business will
make a profit as the total revenue line will be above the total cost line and the area
between them is therefore the area of profit.
A Business should plan to have a margin of safety by
producing and selling more than its needs to break-even
Geoff forecasts sales of 6000 light bulbs per month.

If he sells 3000 light bulbs per month, he break-even.

Sales of 6000 light bulbs per month would give him a margin of safety of 3000 light
bulbs per month.

Margin of safety = Actual output - Break even output

3000 = 6000 - 3000

Break-even analysis is used to make important production
and pricing decision

Break-even analysis is a business planning tool. This can help a business to make
decision based on prediction of what would happen if costs change. Cost that can
change are:

● Fixed costs
● Variable cost

Geoff his break-even chart to look at the effect of a rise in his variable costs of
production from $2 per light bulb to $2.40. This has the effect of moving the total cost
line from TC1 to TC2. From the chart, Goeff realizes he will have to produce and sell
5000 light bulbs each month just to break even if his costs rise in this way.
Geoff also considers what would happen instead if he was only able to sell each light
bulb at a price of $2.75. This would have the effect of reducing the profit margin on each
unit sold from $0.50 to $0.25. Total revenue and therefore profit would be lower each
month.

In the chart below, the total revenue line moves from TR1 to TR2. As a result, Geoff will
need to make and sell at least 4000 light bulbs each month to break-even.
Because Geoff intends to produce 6000 light bulbs each month, the two charts show he
will still be able to make a profit from their sale even if his variable cost increases to
$2.40 per unit or he has to cut his selling price to $2.75 per unit.

Producing and selling 6000 light bulbs each month therefore provides Bright Light with a
"safety margin"over and above a break-even level of output and sales of either:

● 3000 light bulbs each month(if price is $3 per unit),

● 4000 per month (if variable cost rise by $0.40 per unit) or
● 5000 per month (if price cut is to $2.75)

Limitations of break-even analysis