using break-even analysis to make decisions

• CONTRIBUTION PER UNIT=   selling price - variable cost per unit
• TOTAL CONTRIBUTION=   total revenue - variable costs
• MARGIN OF SAFETY- the amount of spare production capacity that a business has before reaching the breakeven point
• BREAKEVEN POINT- that point at which the business makes neither a profit nor a loss. Where total sales revenue is equal to total costs.
• BREAKEVEN FORMULA=    Fixed Costs

                                                Contribution per unit

The breakeven point is the number of units that need to be produced for all of the costs of the firm to be covered. If the firm is making neither a profit nor a loss. It is breaking even.

Key assumptions of Breakeven Analysis:

• All units of output are sold
• All costs remain constant
• The selling price remains unchanged

This is the difference between the current output level and the breakeven output.

CURRENT OUTPUT   -   BREAKEVEN OUTPUT

• FIXED COSTS- as a business grows in size then their costs will rise. e.g. they might need to employ more full-time staff or to rent a larger building

• VARIABLE COSTS- items such as raw materials (stock) are likely to change in price throughout the year. Also, wages are likely to go up and down depending upon how busy you are as a business.

• SELLING PRICE- you might suddenly be facing higher levels of competition and need to adjust your prices.

The uses of Breakeven Analysis to Small Businesses:

• Its a quick and easy method that inexperienced business owners can use to provide them with an idea of the quantity they need to sell in order to cover all of their costs and to make profit.

• It is an important element of the business plan and the bank or other investors will expect to see evidence of some breakeven analysis to assess your level of risk. e.g. are you operating with a very small margin of safety?

• It allows you to carry out 'What-if?' analysis. This means that you can use computer modelling to assess the impact upon sales of a change in price or other costs.

BENEFITS

• quick and easy technique
• shows profit levels at different levels of output
• Allows  'what-if' analysis
• helps with decision making
• provides a target

PROBLEMS

• assumes all costs remain constant and all output is sold- unrealistic!
• ignores all external influences upon sales e.g. new competetion
• reliant upon accurate research data
• it is only a forecast!