http://www.bized.ac.

uk

Break Even Analysis and Short

term profit planning
 Break-Even Analysishttp://www.bized.ac.uk
• Break-Even Analysis is used to
– predict future profits/losses
– predict results eg produce Product A or Product
B
• Break-Even Point is when Sales Revenue
equals Total Costs
• at this point no profit or loss is incurred
• the firm merely covers its total costs
• Break-Even Point can be shown in graph
form or by use of formulae
 Break-Even Analysishttp://www.bized.ac.uk
In order to calculate how profitable a product will be,
we must firstly look at the Costs involved -
There are two basic types of costs a company incurs.

• Variable Costs
• Fixed Costs
Variable costs are costs that change with changes in production
levels or sales. Examples include: Costs of materials used in the
production of the goods. This is also referred as direct cost of
.
the company Direct material, direct labor, direct variable cost

Fixed costs remain roughly the same regardless of sales/output

levels. Examples include: Rent, Insurance and Wages
 Break-Even Analysis
http://www.bized.ac.uk

• TOTAL COSTS
– Total Costs is simply Fixed Costs and Variable Costs
added together.

TC = FC + VC
– As Total Costs include some of the Variable Costs then
Total Costs will also change with any changes in
output/sales.
– If output/sales rise then so will Total Costs.
– If output/sales fall then so will Total Costs.
 Break-Even Analysis http://www.bized.ac.uk

The Break-even point occurs when Total Costs equals

Revenue (Sales Income)

Revenues (Sales Income) = Total Costs

At this point the business is not making a Profit nor
incurring a Loss – it is merely covering its Total Costs

Let us have a look at a simple example.

Bannerman Trading Company

opens a flower shop.
 Break-Even Analysis http://www.bized.ac.uk

Fixed Costs:
• Rent: Rs.400
• Helper (Wages): Rs.200

Variable Costs:
• Flowers: Rs.50 per unit

Selling Price:
• Flowers: Rs.2 per unit

So we know that:
Total Fixed Costs = Rs.600
Variable Cost per Unit = Rs.0.50
Selling Price per Unit = Rs.2.00
 Break-Even Analysis SP = £2.00
http://www.bized.ac.uk
VC = £0.50
FC = £600

• We must firstly calculate how much income from

each bunch of flowers can go towards covering the
Fixed Costs.

This is called the Unit Contribution.

Selling Price – Variable Costs = Unit Contribution
Rs.2.00 – Rs.0.50 = Rs.1.50
• For every bunch of flowers sold Rs.1.50 can go
towards covering Fixed Costs
 SP = Rs.2.00
Break-Even Analysis http://www.bized.ac.uk
VC = Rs.0.50
Now to calculate how many units must Unit CPU =
be sold to cover Total Costs (FC + VC) Rs.1.50
FC = Rs.600
This is called the Break Even Point
Break Even Point =
Fixed Costs  Unit Contribution
Rs.600  Rs.1.50 = 400 Units

Therefore 400 bunches of flowers must be sold to Break

Even – at this the point the business is not making a
Profit nor incurring a Loss – it is merely covering its
Total Costs
 Break-Even Analysis http://www.bized.ac.uk

Lets try another example:

Selling Price per unit = Rs.5
Variable Cost per unit = Rs.2
Fixed Costs = Rs.300
How many units must be sold in order to Break
Even?
 Break-Even Analysis SP = £5.00
http://www.bized.ac.uk

First calculate the Unit Contribution VC = £2.00

SP – VC = Unit Contribution FC = £300

£5.00 - £2.00 = £3.00

Now calculate Break Even point by using the

formula –
Fixed Costs  Unit Contribution
£300  £3.00 = 100 units
Therefore 100 units must be sold in order to Break
Even
 Break-Even Analysis http://www.bized.ac.uk

Lets try another example:

A firm has Fixed Costs of £1,200.
The Selling Price is £6 per unit and the
Variable Costs are £3 per unit.

How many units must be sold in order to Break

Even?
 Break-Even Analysis SP = £6.00
http://www.bized.ac.uk

First calculate the Unit Contribution VC = £3.00

SP – VC = Unit Contribution FC = £1,200

£6.00 - £3.00 = £3.00

Now calculate Break Even point by using the

formula –
Fixed Costs  Unit Contribution
£1,200  £3.00 = 400 units
Therefore 400 units must be sold in order to Break
Even
Break-Even Analysis and Margin of safety http://www.bized.ac.uk

Break Even can also be used to calculate Profit (or Loss)

at a given level of output

For example:
J Bannerman sells cricket bats. How much profit/loss is
made when 5000 cricket bats are sold?

Each cricket bat is sold for Rs.20

Variable Costs per cricket bat are Rs.10
Fixed Costs total Rs.24,000
 Break-Even Analysis SP = Rs.20.00
http://www.bized.ac.uk

VC = Rs.10.00
Firstly, calculate Unit Contribution
FC = Rs.24,000
SP – VC = Unit Contribution
Sales = 5,000 units
Rs.20.00 – Rs.10.00 = Rs.10.00
Now calculate Total Contribution when 5,000 golf
clubs are sold
Unit Contribution x no of units = Total Contribution
£10.00 x 5,000 = £50,000
Now calculate Net Profit at 5,000 units
Total Contribution – Fixed Costs = Net Profit
£50,000 - £24,000 = £26,000
 http://www.bized.ac.uk

Margin of safety (MOS)

• MOS = Budgeted Sales – Break even point *CPU
• = 5000 -2400* 10.00
• = Rs.26,000.00
 Break-Even Analysis SP = £2.50
Fixed Costs =
http://www.bized.ac.uk

Rent Rs.1,050
Insurance Rs. 200
Caroline Wilson owns a florist shop. Total FC Rs.1,250
She buys each bunch of flowers for Rs.1.49 and special
wrapping paper for Rs.3 per roll. Each roll of
wrapping paper will wrap 300 bunches of flowers. Rent
of her premises is Rs.1,050 per month and she pays
monthly insurance of Rs.200. Caroline sells each
bunch of flowers for Rs.2.50.
Calculate the Break even point and revenue 11. Monthly
profitability
 Break-Even Analysis and Target profithttp://www.bized.ac.uk

concept
Another Example

Calculate how many units need to be produced

in order to achieve a Net Profit of £25,000 given
the following information

Fixed Costs Rs.30,000. Selling price per unit

Rs.50 and VC per unit Rs.40.00
 Answer http://www.bized.ac.uk

Number of units = Fixed cost + Target Profit / CPU

required to earn a
target profit

= 30,000 + 25,000 / 10.00

= 55,00 units
 http://www.bized.ac.uk

Break-Even Analysis
The formulae used so far assumes that Unit Costs
are known ie Unit Selling Price and Unit
Variable
Cost.
When no unit costs are known, the Profit/Volume
Ratio should be used instead
Contribution to sales ratio (C/S) http://www.bized.ac.uk

P/V Ratio (Profit/Volume Ratio) =

Contribution per unit / Selling price per unit x 100

Higher the C/S ratio higher the profitability of the

product.

C/S can also be used to calculate the break even revenue

Sales at BEP = Fixed Costs / C/S Ratio
 http://www.bized.ac.uk
Profit/Volume Ratio
For Example

Selling price per unit Rs.80.00

Variable cost per unit Rs.40.00
Fixed Costs Rs.120,000

Calculate the C/S Ratio and the BEP value

 http://www.bized.ac.uk

Break-Even Chart The Break-even point

occurs where total
Costs/Revenue TR TC revenue equals total
VC costs – the firm, in
this example would
have to sell Q1 to
generate sufficient
revenue (income) to
cover its total costs.

BEP

FC

Q1 Output/Sales
 http://www.bized.ac.uk

Break-Even Chart If the firm chose

At present, this
Costs/Revenue to set price higher
TR (p = £3) TR (p = £2) TC firms sells each
than £2 (say £3)
unit for £2 –
VC the TR curve
Break Even point
would be steeper
is at Q1
– they would not
have to sell as
many units to
break even

BEP

BEP
FC

Q2 Q1 Output/Sales
 LIMITING FACTORS http://www.bized.ac.uk

• Under normal circumstances, the best-

paying product is that which shows the
highest contribution per £ of sales
• Certain circumstances make this
inappropriate eg
• a factory producing a particular range of
products may depend on a highly skilled
labour force
• If skilled labour is in short supply in the
locality of the factory, then labour is
termed a limiting, or key, factor
 LIMITING FACTORS http://www.bized.ac.uk

• The most important criterion now will be

the optimum use of labour
• This is expressed by the contribution per
labour hour
• Direct labour is only one example of a
limiting factor
• Other examples could be
– direct materials
– machine hours
– factory capacity
 For Example http://www.bized.ac.uk

• In a situation where labour is scarce (ie

direct labour = limiting factor), advise
management which of Products X and Y is
more profitable
Product XProduct Y
Selling Price £100 £100
Contribution %
(P/V Ratio) 35% 30%
Direct Labour
Hours per unit 25 hours 20 hours
 Answer http://www.bized.ac.uk

Under normal circumstances Product X would

be the better paying product because of its
higher P/V Ratio
However, when the limiting factor is labour,
Product Y becomes the better paying
product:
Product X Product Y
Contribution Per Direct 35% x £100 30% x £100
Labour Hour
25 20
= £1.40 = £1.50
 PRODUCT MIX http://www.bized.ac.uk

A business may produce a number of products but at

the same time be unable to meet total demand for
all products due to a limiting factor eg machine
hours or labour hours.
In this case the business would decide on the
optimum use of the limited resource by producing
all of the demand for the product which yields the
highest contribution per the limiting factor.
Having produced all of the demand from that
product, the business would produce the next
highest contribution per the limiting factor and so
on until full capacity is reached.
 For example http://www.bized.ac.uk

A business can produce Products A, B and C.

A B C
Contribution per labour £2 £1 £3
hour
Labour hours per unit 4 4 3

Total demand in units 5,000 5,000 10,000

The factory is limited to 60,000 labour hours.

How many units of each Product should be produced
to maximise profit?
 Answer http://www.bized.ac.uk

Produce in the order of the highest Contribution

per Labour Hour ie C then A then B

C A
Demand 10,000 5,000
Labour hrs/unit 3 4

Total lab hrs 30,000 20,000

Total labour hours required to produce all demand for

C then A = 50,000 labour hours.
 Answer http://www.bized.ac.uk

If Total Labour hours available equals 60,000

and 50,000 is used producing Products C
and A, then 10,000 labour hours are left to
produce as many units as possible for
Product B
Product B uses 4 labour hours per unit,
therefore only 2,500 units of Product B can
be produced within the available 60,000
labour hours
 http://www.bized.ac.uk

Assumptions of Break Even

Analysis
• All Fixed and Variable costs can be
identified
• Variable costs are assumed to vary
directly with output
• Fixed costs will remain constant
• Selling prices are assumed to remain
constant for all levels of output
 http://www.bized.ac.uk

Assumptions Continued

• The sales mix of products will remain

constant – break even charts cannot
handle multi-product situations
• It is assumed that all production will be
sold
• The volume of activity is the only
relevant factor which will affect costs
 Limitations of Break Even http://www.bized.ac.uk

Analysis
• Some costs cannot be identified as precisely
Fixed or Variable
• Semi-variable costs cannot be easily
accommodated in break-even analysis
• Costs and revenues tend not to be constant
• With Fixed costs the assumption that they
are constant over the whole range of output
from zero to maximum capacity is unrealistic
 Limitations Continued http://www.bized.ac.uk

• Price reduction may be necessary to

protect sales in the face of increased
competition
• The sales mix may change with changes
in tastes and fashions
• Productivity may be affected by strikes
and absenteeism
• The balance between Fixed and Variable
costs may be altered by new technology