BREAK-EVEN ANALYSIS

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What this presentation covers






Content and design 2008 Osborne Books Limited
Break-even analysis, by calculation, by table,
and by graph
Interpretation of break-even analysis
Margin of safety
The nature of fixed and variable costs
Limitations of break-even analysis
The break-even point
Target profit
When to use break-even analysis
Contribution sales ratio
Content and design 2008 Osborne Books Limited
Fixed and Variable Costs
Fixed Costs
Fixed costs remain
fixed over a range of
output levels in the
short-term
Variable Costs
Variable costs vary
directly with changes
in output levels
For example: factory rent
For example: materials
and labour
There are also semi-variable costs which combine both a fixed and variable
element eg a telephone bill which has fixed rental and variable call charges.
Content and design 2008 Osborne Books Limited
The Break-Even Point

The formula for break-even in units of output is:
fixed costs ()
contribution per unit ()
contribution per unit () =
selling price per unit variable costs per unit
The break-even point is the output level (in units) at which
the income from sales is just enough to cover all the costs,
and the profit (or loss) is therefore zero.
Break-even point by calculation
Jason Sports Limited manufactures golf clubs and is able to
sell all that is produced.
Fixed costs of running the business = 10,000 per month
Selling price of each golf club = 30 each
Variable costs (materials and direct labour) = 10 per unit
What is the break-even point?
10,000
Using the formula, the break-even point in units of output is:
=
500 units
Fixed costs 4
Break-even point in
units per month
Selling price per unit less 4
variable costs per unit
30 - 10
Content and design 2008 Osborne Books Limited
units of
output
Break-even point by the table method
fixed costs variable costs total cost sales revenue profit/(loss)
A B C D
A + B D - C

100
200
300
400
500
600
700
10,000
10,000
10,000
10,000
10,000
10,000
10,000
1,000
2,000
3,000
4,000
5,000
6,000
7,000
11,000
12,000
13,000
14,000
15,000
16,000
17,000
3,000
6,000
9,000
12,000
15,000
18,000
21,000
(8,000)
(6,000)
(4,000)
(2,000)
nil
2,000
4,000
The break-even point (in units of output) is 500 golf clubs each month which
is the output when profit/(loss) is nil.

500
(10 per unit) (30 per unit)
Content and design 2008 Osborne Books Limited
Break-even point by the graph method
JASON SPORTS LIMITED: BREAK-EVEN GRAPH
5,000
10,000
15,000
0 100 200 300 400 500 600 700
costs and
revenues
units of output (per month)
total costs
sales
revenue
variable
costs
break-even point (500
units) where the total
costs line crosses the
sales revenue line.
fixed costs
20,000
Content and design 2008 Osborne Books Limited
Interpretation of break-even



(selling price variable costs) per unit x volume fixed costs
(the level of output or activity)
For example, for Jason Sports Ltd, the profit at 600 units =
Profit/(loss) =
(30 - 10) x 600 - 10,000 = 2,000 = 12,000 - 10,000
The break-even graph can show not only the break-even
point but also the profit or loss at any level of output/sales
contained within the graph.
To calculate profit or loss from the graph simply measure the
gap between sales revenue and total costs at a chosen number
of units, and read the money amounts off the vertical axis.
Another way to calculate the profit or loss at any level of
output/sales is the use the following formula:
Content and design 2008 Osborne Books Limited
The relationship between sales revenue, variable costs and
fixed costs may not always remain constant because:
The assumption that all output is sold may not be true.
Limitations of break-even analysis
The main limitations are:
The presumption that there is only one product may not be
correct.
External factors (such as rate of inflation) are not considered.
- sales prices may differ at different quantities sold
(for example because of discounts).
- variable costs may alter at different levels of output
(for example due to bulk buying of materials).
- fixed costs do not remain fixed at all levels of output
(for example if extra premises are needed).
Content and design 2008 Osborne Books Limited
Margin of safety


The margin of safety may be expressed:
sales volume (units) break-even point (units)

In units
In margin of safety in units x selling price ()
As a %
margin of safety in units x 100
sales volume (units)
eg Jason Sports Ltd at output of 700 units: 700 500 = 200 units
eg Jason Sports Ltd at output of 700 units: 200 x 30 = 6,000
eg Jason Sports Ltd at output of 700 units: 200 / 700 x 100 = 29%
The margin of safety is the amount by which sales exceed
the break-even point.
The margin of safety is important to management as it shows
the cushion which current production/sales gives beyond
the break-even point.
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Target profit


fixed costs () + target profit ()
contribution per unit ()
Number of units output
It is also possible to calculate the output that needs to be
sold in order to give a certain amount of profit (called the
target profit).
The formula for this is:
=
eg If Jason Sports Ltd requires a profit of 4,000 per month, the
calculation is:
10,000 + 4000
cont20
=
700 units with a sales value of
21,000
700 units at 30 each
Content and design 2008 Osborne Books Limited
Target profit (continued)

The target profit of 4,000 can also be shown by means of a
profit statement:
sales revenue (700 units at 30 each) 21,000
less variable costs (700 units at 10 each) 7,000
equals contribution (to fixed costs and profit) 14,000
Jason Sports Limited
less monthly fixed costs 10,000
equals target profit for month 4,000
Note that target profit can also be calculated by making use of the
contribution sales ratio (see next two slides).
Content and design 2008 Osborne Books Limited
Contribution Sales Ratio

The formula for contribution sales ratio is:
contribution ()
o selling price ()
The contribution sales (CS) ratio - also known as the profit
volume (PV) ratio - expresses the amount of contribution in
relation to the amount of the selling price.
Referring to Jason Sports Ltd the CS ratio (per unit) is:
=
20
30
0.6666 or 66.66%
In break-even analysis, if fixed costs are known, then the CS ratio can
be used to find the sales value at which the business breaks even, or the
sales value to give a target amount of profit (see next slide).
Content and design 2008 Osborne Books Limited
Contribution Sales Ratio (continued)

To find the sales value at which Jason Sports Ltd will break-
even using the CS ratio:
To find the sales value at which Jason Sports Ltd will achieve
a target amount of profit (say 2,000) using the CS ratio:
=
As the selling price is 30 the units of output to achieve the 2,000
profit above is 18,000 / 30 = 600 units.
10,000
0.6666
=
15,000
Fixed costs ()
CS ratio
=
fixed costs () + target profit
c CS ratio
10,000 + 2000
0.6666
=
18,000
Content and design 2008 Osborne Books Limited
Before starting a new business:
When to use break-even analysis
In order to see the level of sales needed to cover costs
or to make a particular level of profit.
When making changes within the business:
Break-even analysis will be used as part of the planning
process to ensure the business remains profitable.
To answer what if? questions:
Questions such as what if sales fall by 15%? and what
if fixed costs increase by 1,000? can be answered.
To evaluate alternative management viewpoints:
For example assessing how automation may affect profit.
Content and design 2008 Osborne Books Limited
Summary: break-even analysis
Break-even analysis distinguishes between fixed costs and
variable costs.
Margin of safety is the amount by which sales exceed the
break-even point.
The break-even calculation (number of units) is:
Break-even is the point at which neither profit nor loss is
made.
The relationship between sales revenue, and fixed costs
and variable costs is used to ascertain the break-even
point, by means of a calculation, a table, or a graph.
fixed costs ()
contribution per unit ()
The contribution sales (CS) ratio expresses the amount of
contribution in relation to the selling price.
Break-even analysis has a wide range of uses in business.
End of Presentation
Content and design 2008 Osborne Books Limited
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