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

Chapter 11: Calculating Costs, Revenues and Profits

Price
 
Definition: the amount paid by a consumer to purchase 1 unit of a product.
 
A business must set a price that is:
- High enough to cover the costs of making the product
- Low enough to attract customers

 
Total Revenue
 
Definition: A measure of the income received from an organisation's activities.
 
Total Revenue= Quantity of units sold  x  Price per unit
 
Also called: Income, revenue, sales revenue, sales turnover or turnover.
 

Profit
 
Definition: The difference between the income of a business and its total costs.
 
Profit= Total Revenue - Total Costs
 
Ways to improve profit:
- Increase sales revenue
- Decrease Costs
 

Costs
 
1. Total Costs Definition: The sum of fixed costs and variable costs
 
Total Costs= Fixed Costs +  Variable Costs
 

2. Fixed Costs Definition: Costs that DO NOT VARY directly with output in the short run (e.g. rent)
 
Fixed Costs: Machinery, Rent and rates, Salaries, Administration, Vehicles, Marketing, Lighting and heating

 
3. Variable Costs definition: Costs that DO VARY directly with output in the short run (e.g. raw materials)

Variable Costs: Raw materials, Wages of operatives/direct labour, Power

Wages and salaries?

Wages are paid to operatives who make the product - measured per hour - a variable cost

Salaries are paid to staff who are not directly involved in production - measured per annum - a fixed cost


Semi-variable costs

Semi-variable costs are costs that combine elements of fixed and variable costs.

Example: A worker may be paid a set wage plus a bonus for each extra item she produced.
The set wage is a fixed cost and the bonus is a variable cost.



Effect of changes in Output on Costs

The total costs are rising at a slower rate than output because only the variable costs are increasing as output increases.

When output changes by a certain %, the total variable costs will change by the same %.



Relationship between costs and price 

In lots of industries, increases in costs are 'passed on' to consumers in the form of higher prices. 
These costs could be raw materials for example.
Business theory says this would lead to a fall in demand (and possibly sales revenue).
But demand is less likely to fall if every business increases its prices. This is likely when all firms are affected in the same way.
All firms will want to try and maintain a PROFIT MARGIN.

Profit Margin is the difference between the selling price of the item and the cost of making/buying that item).