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Break-Even Analysis

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Break-Even Analysis

No entrepreneurs want their company to make losses. They run businesses to make a profit and earn money. However, to make sure it happens, first, they need to know what the bare minimum is to keep their businesses running and then think about goals they want to achieve.

Break-even analysis, in other words, cost-volume-profit analysis indicates how many units the firm has to produce and sell before it recovers its total costs. When a business achieves a break-even level of output and sales, it recovers all of its costs. To conduct the break-even analysis, it is essential to calculate the break-even level of output.

Example problem and solution

How to calculate the break-even level of output?

There are two ways to calculate the break-even level of output:

1) Formula:

2) Break-even chart (including variable costs, fixed costs, total costs and revenue)

Fixed costs are costs that remain the same (in the short term) regardless of the number of units produced, for example, rent and rates.

Variable costs are costs that rise and fall in direct proportion to the number of units produced, for example, raw materials used in production or direct labour.

Total costs are fixed costs and variable costs added together.

Contribution per unit is total revenue from the sale of one unit. It is the selling price minus variable costs.

Company E produces e-bikes. A rental cost of a factory is £8,000 a month and the cost of heat and light there is £6,000 a month. The selling price per e-bike is £2,000. The cost of materials per e-bike is £400. How many e-bikes per month does the company have to produce and sell to reach the break-even level of output?

First, we need to calculate fixed costs.

Then, contribution per unit.

Finally, break-even level of output.

Break-Even Analysis, How to calculate the break-even level of output, break-even chart, StudySmarterFigure 1. Break-even Chart for Company E, StudySmarter

R = revenue

TC = total costs

FC = fixed costs

VC = variable costs

🔴 = break-even level of output

To create a break-even chart (see Figure 1), we need to plot both fixed costs (FC) and variable costs (VC). Then, adding them together, we arrive at total costs (TC). Lastly, we have to plot revenue according to the number of units produced (R). The point where the revenue and total costs lines cross is the break-even level of output.

This means that company E has to produce 9 e-bikes a month to reach the break-even level.

Margin of safety

The margin of safety is the difference between the current level of output and the breakeven level of output. It considers the number of units produced and the number of units that need to be produced in order to achieve the break-even level of output. In other words, it is the amount sales can decrease before a company reaches the break-even level of output and fails to make a profit.

The formula for calculating the margin of safety is the following:

(Margin of safety based on company E and assuming that it produces and sells 15 bikes a month)

The margin of safety can also be expressed as a percentage:

It means that company E produces and sells 6 units or 40% more than it has to in order to reach the break-even level.

Target profit

The target profit is an expected amount of profit that the shareholders and/or managers of a business expect to achieve by the end of a specified accounting period. It states how many units a company needs to sell in order to achieve desirable profit.

The formula for calculating the target profit is the following:

(Based on company E and assuming that a target profit is £15,000)

It means that company E has to produce and sell 18.13 units, or 19 units in total, in order to achieve the target profit of £15,000.

Advantages and disadvantages of break-even analysis

AdvantagesDisadvantages
It provides a measurement of profit and losses at different levels of production and sales.It assumes that sales prices are constant at all levels of output.
It predicts the effect of changes in sales prices.It assumes production and sales are the same.
It analyzes the relationship between fixed and variable costs.It may be time-consuming.
It predicts the effect of cost and efficiency changes on profitability.It can only apply to a single product or a single mix of products.

Break-Even and Profitability Analysis - Key takeaways

  • Break-even is a level of production at which the costs of production equal the revenues for a product.

  • The break-even level is calculated by dividing the total fixed costs of production by the contribution per unit. However, it can also be determined using a chart.

  • The margin of safety is the difference between the current level of output and the breakeven level of output.

  • Target profit is the expected amount of profit that the shareholders and/or managers of a business expect to achieve by the end of a specified accounting period.

  • The break-even analysis has advantages, such as being able to predict the effect of changes in sales prices and disadvantages, as it can only be applied to a single product or a single mix of products.

Frequently Asked Questions about Break-Even Analysis

The Break-even analysis problem is solved by dividing total fixed costs divided by contribution per unit.

Break-even analysis indicates how many units the firm has to produce and sell before it recovers its total costs. 

For example, if a business has a £200 break-even point, it must reach that level to cover its costs.  

Break-even = total fixed costs divided by contribution per unit. 

We use break-even analysis to determine the number of units to sell to cover the costs of a business. 

Profit/loss measurement, predicts the effect of changes in sales prices and analyzes the relationship between fixed and variable costs. 
assumes that sales prices are constant at all levels of output, assumes production and sales are the same. 

Final Break-Even Analysis Quiz

Question

What is break-even analysis?

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Answer

It is a calculation of how many units a company has to produce and sell to recover its total costs.

Show question

Question

What is a fixed cost?

Show answer

Answer

Rent

Show question

Question

What is a target profit?

Show answer

Answer

Target profit is an expected amount of profit that the shareholders and/or managers of a business expect to achieve by the end of a specified accounting period.

Show question

Question

What are the advantages of break-even analysis?


Show answer

Answer

  • It provides a measurement of profit and losses at different levels of production and sales

  • It predicts the effect of changes in sales prices

  • It analyzes the relationship between fixed and variable costs

  • It predicts the effect of cost and efficiency changes on profitability

Show question

Question

What are the disadvantages of break-even analysis?


Show answer

Answer

  • It assumes that sales prices are constant at all levels of output

  • It assumes production and sales are the same

  • It may be time consuming

  • It can only apply to a single product or single mix of products

Show question

Question

What is the margin of safety?

Show answer

Answer

Margin of safety is the difference between the current level of output and the breakeven level of output.

Show question

Question

What is the margin of safety formula?


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Answer

Margin of safety = level of output - break-even level of output

Show question

Question

What are fixed costs?

Show answer

Answer

Fixed costs are costs which remain the same (in the short term) regardless of the number of units produced, for example, rent and rates. 

Show question

Question

What are variable costs?

Show answer

Answer

Variable costs are costs that rise and fall in direct proportion to the number of units produced, for example, raw materials used in production, direct labour. 

 


Show question

Question

What are total costs?

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Answer

Total costs are fixed costs and variable costs added together.


Show question

Question

What does contribution per unit mean?

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Answer

Contribution per unit is total revenue from sales of one unit. It is the selling price minus variable costs.


Show question

Question

What is the other name for the break-even analysis?

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Answer

cost-volume-profit analysis 

Show question

Question

What are the four elements of the break-even chart?

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Answer

  • variable costs
  • fixed costs
  • total costs
  • revenue 

Show question

Question

Fixed costs and variable costs added together are called...


Show answer

Answer

total costs.

Show question

Question

In the break-even chart, FC stands for...

Show answer

Answer

fixed costs.

Show question

Question

Which of these is a fixed cost?

Show answer

Answer

rent

Show question

Question

Which of these is a variable cost?

Show answer

Answer

direct labour

Show question

Question

Break-even analysis is also called...

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Answer

cost-volume-profit analysis.

Show question

Question

A disadvantage of break-even analysis is that it assumes that __ are the same.

Show answer

Answer

production and sales

Show question

Question

An expected amount of profit that the shareholders and/or managers of a business expect to achieve is called...


Show answer

Answer

target profit.

Show question

Question

The margin of safety is the difference between the current level of output and ...


Show answer

Answer

the breakeven level of output. 

Show question

Question

If the break-even level of output is 8.75, how many units does a company has to produce to achieve the break-even level of output?

Show answer

Answer

9

Show question

Question

When a business achieves a break-even level of output and sales, it recovers all of its ...


Show answer

Answer

costs.

Show question

Question

Which of these is a variable cost?

Show answer

Answer

raw materials

Show question

Question

Which of these is a fixed cost?

Show answer

Answer

all of them

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