Chapter 12: Using breakeven analysis to make decisions

Contribution

• Contribution looks at whether an individual product or activity is helping the business to make a profit.
• If the sales revenue of a product is greater than the direct costs, the product is contributing towards either paying off the fixed costs or making a profit (if the fixed costs have already been covered).

Contribution Per unit: Selling price per unit - Variable cost per unit

e.g. if a pen cost 20p to make and they sell the candle for £1.00. The contribution per unit is 80p (£1.00 - 0.20p)


Total Contribution: 

Contribution per unit x Number of units sold

OR
Total Sales Revenue - Variable Costs


Profit using contribution:

Total Contribution - Fixed Costs


Breakeven Analysis

Breakeven Analysis is: A study of the RELATIONSHIP between total costs and total revenue to identify the output at which a business breaks even (i.e. makes neither a profit nor a loss).

Breakeven Analysis makes the following assumptions:

• The selling price per unit stays the same, regardless of the number of units sold
• Fixed costs remain the same, regardless of the number of units of output.
• Variable costs per unit stay the same, regardless of output.
• Every unit of output that is produced is sold.

Calculating a Breakeven Output

1. Using a formula

Breakeven Output: The level of output at which total sales revenue is equal to total costs of production.

Example:  £10,000       
                 £1.00 - 0.20p    = 12,500 units

2. Using a Graph - Break even chart

What is the Margin of Safety?

Definition: The difference between the actual output and the breakeven output.

This is like the firm's 'safety net'.


Changes to the breakeven Chart

How to lower the breakeven Output

1. Lower Fixed Costs

e.g. Lower rent (move to an area which is cheaper) or Lower Salaries.

HOWEVER - Less footfall, decreasing salaries could decrease motivation, workers could leave, replacement workers may not be as good at their job.

2. Lower Variable Costs

e.g. Use cheaper raw materials, pay workers lower wages

HOWEVER- Decrease Quality, Decrease motivation of workers

3. Increase Sales Revenue

e.g. Increase selling price or sell more products

HOWEVER - A higher price can reduce demand, promotional costs in order to sell more.


Usefulness of Breakeven Analysis to a start-up Business

• A new firm can use breakeven analysis to calculate how long it will take to reach the level of output needed to make a profit. Is the business viable? Useful if likely to have cash-flow problems as business can predict its profit level . Can help gain financial support, such as a bank overdraft.
• Simple and straightforward way to prove a business plan will succeed financially. Can also show the margin of safety. For example, if sales forecasts are optimistic, the business can calculate how much sales can fall before it drops below the quantity needed to breakeven.
• This data can be used as a key element in persuading bank managers or investors to give financial support to the start up.
• Will be used to plan its expected results, a 'best case' scenario and a 'worst case' scenario - the MAX and MIN level of profit to be made. Can indicate the level of risk involved in the start-up.
• Allows a firm to use 'what if?' analysis. Show different breakeven outputs and changes in profit level that could arise from changes in price or fixed costs or variable costs. Business can ascertain most profitable price or if business is feasible. Can also be done on individual products/services.

Strengths of Breakeven Analysis

1. Can show the different levels of profit arising from the various levels of output and sales that might be achieved --> Can predict profit levels (if number of units sold is known) --> This can help the business to plan its future objectives and strategies.

2. The calculations are quick and easy to complete --> saving business time --> Possible Inaccuracy? --> But is a quick ESTIMATE before they decide whether to go ahead.

3. Can foresee future changes --> e.g. Higher wage costs or lower prices --> Examine impact on individual product in range --> May be successful now but vulnerable in the future (or vice versa)

4. Used to discover point where a particular target profit level is made --> Must calculate target profit output by adding the target profit to fixed costs.

Weaknesses of Breakeven Analysis

1. Information may be unreliable --> Based on forecasts --> Even with market research it is difficult to predict the number of customers who will buy from the firm --> Or actual production costs could change (esp. if there is a break down of equipment or shortage of raw materials).

2. Sales are unlikely to be exactly the same as output --> Likely that some output will remain unsold (esp. perishable goods) --> Wastage of raw materials

3. In practice, the selling price might change as more is bought and sold --> Or will the firm have a fixed selling price?

4. Fixed Costs may not stay the same as output changes --> At particular levels of output new machines and even new buildings may need to be purchased.

5. Analysis assumes that variable costs per unit are always the same --> Ignoring factors such as bulk buying