Unit 3: Break-even analysis

You are planning to set up a mobile dog grooming business.

Make a list of costs that your business will incur in the first
6 months of operation.

Lesson objectives
 To explain the different types of costs through discussion and activity.
 To calculate break-even point and demonstrate the technique of drawing a break-
even chart.
 To apply break-even, revenue and cost calculations to a case study.

Classification of costs
The Break-even model involves looking at how revenues and costs behave at different levels
of output and then forecasting what happens to profit at different levels of output.

In the break-even model it is necessary to divide costs into their fixed and variable elements,
so it is important to first understand how different types of costs behave, so that we can
distinguish between them.

Fixed Costs

Costs which ___________ vary directly with the level of output.

Costs linked to __________ rather than business activity.

Fixed costs must be paid even if the business does not produce anything.

Examples of fixed costs:






So, it is more cost effective for businesses to use their premises intensively, as they pay
the same rent when producing high output as a low output.

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 How would fixed costs of £500,000 be represented graphically?

600

500

400
£000
300

200

100
0 10 20 30 40 50
Units

Variable Costs

Costs that _________ directly with the level of output.

Examples of variable costs include:





If output doubled then all of the above these costs would double. However, in reality
the costs do not necessarily increase proportionately to output, why is this?

How are variable costs represented graphically?

600

500

400
£000
300

200

100

0 100 200 300 400 500

000 units

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Semi-variable costs

Costs that are partly fixed and partly variable.

Examples include:
Vehicles Fixed =
Variable =

Telephone Fixed =
Variable =

How are semi-variable costs represented graphically?

600

500

400
£000
300

200

100
0 10 20 30 40 50
Units

Pit Stop

Explain the difference between fixed and variable costs in less than 20 words.

Now – revisit the list of costs you made for your mobile dog grooming business and
classify each cost into fixed, variable and semi-variable.

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The Break-even Model
A key area of business planning is being able to forecast
the point at which a profit is made on a decision.

The point is called the ‘break-even point’ It is critical:

 to determine the viability of a project
 to manage a project to a successful outcome.

Break-even occurs when neither a profit nor loss is made

Task - Holding a party in a community hall

Arrange the costs into the appropriate categories

Fixed costs Variable costs

Glass of champagne on entry

Hire of hall
Advertising
Party food
Other overheads
Balloons
Drink
Party bags
Hire of DJ

Calculating the break-even point

Contribution
Break-even calculations use the idea of ‘contribution’. This is where the
difference between the selling price and the variable cost of producing a
product, goes towards ‘paying off’ the fixed costs, or overheads of producing
that product.

Contribution = selling price -

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The break-even point can be pin-pointed on an accurate diagram, but it can be
more accurately calculated with the following equation, using the idea of
contribution:

Fixed cost = Break-even point

Contribution

A worked example
Student Summer Ball

Projections of costs:

Variable Costs £ Fixed Costs £

(overheads)
Food - per ticket sold 4 Hire of marquee 3,000
Drink - per ticket sold 7 Labour cost 1,000
Live music 500
Printing costs 100
Administration 200
Power 50
Total Total

Projections of revenue
Tickets will be £30 each and it is estimated that 600 (output) will be sold.

Calculation of revenue: __________ x _________ = _________

Summer Ball break-even point calculation:

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Profit calculation

Revenue – Total cost = Profit

fixed cost + total variable cost

Calculate the projected profit for the Summer Ball.

Margin of Safety
The margin of safety is the difference between the target level of output and
the break-even level of output. The margin of safety gives the business an
idea of how much room they have for sales to fall below the target level of
activity, before there is a danger of making a loss.

Target level of output – break-even point = margin of safety

Calculate the margin of safety for the Summer Ball

Explain what your calculated answer means.

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To draw a break-even chart you will need to use your knowledge of the different types
of costs and how they are drawn on a graph. Remind yourself by drawing in the lines
that represent the terms and give business examples of each:

Fixed Cost Variable cost

Total Cost Revenue

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 Drawing the break-even chart – for the Summer Ball
This is a graphical representation of the relationship between costs and revenues and
output. The diagram is built up by graphing each monetary variable against output.

Use graph paper to plot each of the following costs:

Fixed Costs
Fixed costs stay constant at £_________ as they do not vary with output, even if no tickets
are sold costs must be paid.

Total Costs
The fixed and variable costs are added together and plotted.

Calculate total cost at 600 units:

Revenue
The sales revenue is plotted first by calculating total sales revenue at the expected output –
in this case the number of sales of tickets.

Calculate total revenue:

Why is the revenue line drawn through the origin?

DRAW YOUR CHART

Check that your chart shows the correct break-even point. If it does not, what could
the reasons be for this?

Draw the margin of safety onto your diagram.

Indicate on your diagram, the level of expected profit.

End task:
If 63 tickets were sold a month, how many months would it take to sell the break-even
quantity?