BREAK EVEN ANALYSIS

COSTS, SCALE OF PRODUCTION AND BREAK EVEN ANALYSIS

 THE CONCEPT OF BREAK-EVEN CHARTS
• ‘BREAK-EVEN’ IS A VERY IMPORTANT IDEA FOR ANY BUSINESS – ESPECIALLY A
NEWLY SET UP BUSINESS. THE BREAK-EVEN LEVEL OF OUTPUT OR SALES
INDICATES TO THE OWNER OR MANAGER OF A BUSINESS THE MINIMUM LEVEL
OF OUTPUT THAT MUST BE SOLD SO TOTAL COST ARE COVERED.
• AT THIS BREAK-EVEN LEVEL OF OUTPUT IT IS IMPORTANT TO NOTE THAT A
PROFIT IS NOT BEING MADE – BUT NEITHER IS A LOSS.
• THE ‘QUICKER’ A NEWLY SET UP BUSINESS CAN REACH BREAK-EVEN POINT THE
MORE LIKELY IT IS TO SURVIVE – AND GO ON TO MAKE A PROFIT. IF A BUSINESS
NEVER REACHES BREAK-EVEN POINT THEN IT WILL ALWAYS MAKE A LOSS.
• THE BREAK-EVEN LEVEL OF OUTPUT CAN BE WORKED OUT IN TWO WAYS – BY
DRAWING A BREAK-EVEN CHART OR GRAPH AND BY CALCULATION.
 DEFINITIONS

• BREAK-EVEN LEVEL OF OUTPUT IS THE QUANTITY THAT MUST BE

PRODUCED/SOLD FOR TOTAL REVENUE TO EQUAL TOTAL COSTS (ALSO KNOWN
AS BREAK-EVEN POINT).
• BREAK-EVEN CHARTS ARE GRAPHS WHICH SHOW HOW COSTS AND REVENUES
OF A BUSINESS CHANGE WITH SALES. THEY SHOW THE LEVEL OF SALES THE
BUSINESS MUST MAKE IN ORDER TO BREAK EVEN.
• THE REVENUE OF A BUSINESS IS THE INCOME DURING A PERIOD OF TIME FROM
THE SALE OF GOODS OR SERVICES. TOTAL REVENUE = QUANTITY SOLD × PRICE.
 DRAWING A BREAK-EVEN CHART

• IN ORDER TO DRAW A BREAK-EVEN CHART WE NEED INFORMATION ABOUT THE FIXED

COSTS, VARIABLE COSTS AND REVENUE OF A BUSINESS.
• FOR EXAMPLE, IN A SPORTS SHOE BUSINESS WE WILL ASSUME THAT:
• FIXED COSTS ARE $5000 PER YEAR
• THE VARIABLE COSTS OF EACH PAIR OF SHOES ARE $3
• EACH PAIR OF SHOES IS SOLD FOR A PRICE OF $8
• THE FACTORY CAN PRODUCE A MAXIMUM OUTPUT OF 2000 PAIRS OF SHOES PER YEAR.

• TO DRAW A BREAK-EVEN CHART IT WILL HELP IF A TABLE, SUCH AS THE ONE BELOW, IS
COMPLETED.
DRAWING A BREAK-EVEN CHART
 THE INFORMATION ON THE GRAPH

• THE Y -AXIS (THE VERTICAL AXIS) MEASURES MONEY AMOUNTS – COSTS AND
REVENUE.
• THE X -AXIS (THE HORIZONTAL AXIS) SHOWS THE NUMBER OF UNITS PRODUCED
AND SOLD.
• THE FIXED COSTS DO NOT CHANGE AT ANY LEVEL OF OUTPUT.
• THE TOTAL COST LINE IS THE ADDITION OF VARIABLE COSTS AND FIXED COSTS.
• DEFINITIONS - THE BREAK-EVEN POINT IS THE LEVEL OF SALES AT WHICH TOTAL
COSTS = TOTAL REVENUE.
BREAK EVEN CHART
 USES OF BREAK-EVEN CHARTS
• APART FROM IDENTIFYING THE BREAK-EVEN POINT OF PRODUCTION AND
CALCULATING MAXIMUM PROFIT – THERE ARE OTHER BENEFITS OF BREAK-EVEN
CHARTS.
• ADVANTAGES
• MANAGERS ARE ABLE TO READ OFF FROM THE GRAPH THE EXPECTED PROFIT OR LOSS
TO BE MADE AT ANY LEVEL OF OUTPUT.
• THE IMPACT ON PROFIT OR LOSS OF CERTAIN BUSINESS DECISIONS CAN ALSO BE
SHOWN BY REDRAWING THE GRAPH. CONSIDER AGAIN THE SPORTS SHOE BUSINESS.
WHAT WOULD HAPPEN TO THE BREAK-EVEN POINT AND THE MAXIMUM OUTPUT LEVEL
IF THE MANAGER DECIDED TO INCREASE THE SELLING PRICE TO $9 PER PAIR?
• THIS NEW SITUATION CAN BE SHOWN ON ANOTHER BREAK-EVEN CHART.
USES OF BREAK-EVEN CHARTS
 USES OF BREAK-EVEN CHARTS

• MAXIMUM REVENUE NOW RISES TO $18 000. THE BREAK-EVEN POINT OF PRODUCTION
FALLS TO 833 UNITS AND MAXIMUM PROFIT RISES TO $7000. SEEMS LIKE A WISE
DECISION! HOWEVER, THE MANAGER NEEDS TO CONSIDER COMPETITORS’ PRICES TOO
AND HE MAY NOT BE ABLE TO SELL ALL 2000 PAIRS AT $9 EACH.
• THE BREAK-EVEN CHART CAN ALSO BE USED TO SHOW THE MARGIN OF SAFETY – THE
AMOUNT BY WHICH SALES EXCEED THE BREAK-EVEN POINT.
• IN THE GRAPH ABOVE, IF THE FIRM IS PRODUCING 1000 UNITS, THE SAFETY MARGIN IS 167
UNITS (1000 – 833). HOWEVER, IF IT SELLS 2000 UNITS THEN THE MARGIN OF SAFETY IS 1167
UNITS.
• THE HIGHER THE MARGIN OF SAFETY, THE BETTER.
• IT MEANS THAT IF SALES WERE TO FALL FOR ANY REASON THEN IT IS LIKELY THAT THE
BUSINESS WILL STILL BE MAKING A PROFIT BECAUSE SALES HAVE TO FALL MUCH FURTHER
BEFORE THE BREAK-EVEN POINT IS REACHED OR EVEN A LOSS MADE.
 LIMITATIONS OF BREAK-EVEN CHARTS
• BREAK-EVEN CHARTS ARE CONSTRUCTED ASSUMING THAT ALL GOODS PRODUCED BY THE
FIRM ARE ACTUALLY SOLD – THE GRAPH DOES NOT SHOW THE POSSIBILITY THAT
INVENTORIES MAY BUILD UP IF NOT ALL GOODS ARE SOLD.
• FIXED COSTS ONLY REMAIN CONSTANT IF THE SCALE OF PRODUCTION DOES NOT CHANGE.
FOR EXAMPLE, A DECISION TO DOUBLE OUTPUT IS ALMOST CERTAINLY GOING TO INCREASE
FIXED COSTS.
• BREAK-EVEN CHARTS CONCENTRATE ON THE BREAK-EVEN POINT OF PRODUCTION, BUT
THERE ARE MANY OTHER ASPECTS OF THE OPERATIONS OF A BUSINESS WHICH NEED TO BE
ANALYSED BY MANAGERS, FOR EXAMPLE, HOW TO REDUCE WASTAGE OR HOW TO
INCREASE SALES.
• THE SIMPLE CHARTS USED IN THIS SECTION HAVE ASSUMED THAT COSTS AND REVENUES
CAN BE DRAWN WITH STRAIGHT LINES.
• THIS WILL NOT OFTEN BE THE CASE; FOR EXAMPLE, INCREASING OUTPUT TO THE CAPACITY OF A
FACTORY MAY INVOLVE PAYING OVERTIME WAGE RATES TO PRODUCTION WORKERS. THIS WILL
MAKE THE VARIABLE COST LINE SLOPE MORE STEEPLY UPWARDS AS OUTPUT EXPANDS
USES AND LIMITATIONS OF BREAK-EVEN
CHARTS
 BREAK-EVEN POINT: THE CALCULATION
METHOD
• IT IS NOT ALWAYS NECESSARY TO DRAW A BREAK-EVEN CHART IN ORDER TO
SHOW THE BREAK-EVEN POINT OF PRODUCTION. IT IS POSSIBLE TO
CALCULATE.
• THE CONTRIBUTION OF A PRODUCT IS ITS SELLING PRICE LESS ITS VARIABLE
COST.