Break-even Calculations (AQA A Level Business): Revision Note

Introduction to break-even analysis

• Break-even analysis is a tool that helps a business work out exactly how much it needs to sell to cover all of its costs

• The point at which total revenue is exactly equal to total costs is called the break-even point;

  • Any sales above this point generate profit

  • Any sales below it result in a loss

• To carry out a break-even analysis, a business needs three pieces of information

  • Its fixed costs - costs that do not change with output

  • Its variable costs per unit - costs that change with each unit produced

  • Its selling price per unit - the price charged to customers

• From these three figures, a business can calculate its break-even point, its margin of safety and its potential profit or loss at any level of sales

Costs and revenue

Fixed costs

• Fixed costs are costs that stay the same regardless of how many units the business produces or sells

  • They must be paid even if the output is zero

• Examples of fixed costs include rent, insurance, manager salaries, loan repayments and equipment lease payments

Example

Nova Water Bottles pays £16,000 per month in rent, salaries and insurance. Whether it produces 1,000 bottles or 10,000 bottles, these costs remain £16,000.

Variable costs

• Variable costs are costs that change in direct proportion to output

  • As more units are produced, total variable costs rise

  • As fewer are produced, they fall

• Examples of variable costs include raw materials, packaging, direct labour paid per unit and delivery costs per item

Example

Each water bottle Nova produces requires materials and packaging costing £8.

If Nova produces 5,000 bottles, total variable costs = 5,000 × £8 = £40,000.

If it produces 8,000 bottles, total variable costs = 8,000 × £8 = £64,000.

Total costs

• Total costs are fixed costs plus variable costs at any given level of output.

• They are calculated using the formula

$\mathrm{Total}\mathrm{costs}=\mathrm{Fixed}\mathrm{costs}+(\mathrm{Variable}\mathrm{cost}\mathrm{per}\mathrm{unit}\times \mathrm{Output})$

Example

If Nova produces 5,000 bottles, total variable costs = £16,000 + £40,000 = £56,000

If it produces 8,000 bottles, total variable costs = £16,000 + £64,000 = £80,000

Revenue

• Revenue is the total income a business earns from selling its products or services

• It is calculated using the formula

$\mathrm{Revenue}=\mathrm{Selling}\mathrm{price}\mathrm{per}\mathrm{unit}\times \mathrm{Quantity}\mathrm{sold}$

Example

Nova sells 5,000 bottles at £22 each. Its total revenue is £22 x £5,000 = £110,000

Contribution

• Contribution refers to a product’s selling price minus the variable costs directly involved in producing that unit

  • It is used to calculate the break-even point

Contribution per unit

• Contribution per unit is calculated using the formula

$\mathrm{Contribution}=\mathrm{Selling}\mathrm{price}\mathrm{per}\mathrm{unit}-\mathrm{Variable}\mathrm{costs}\mathrm{per}\mathrm{unit}$

• It is called 'contribution', as this amount contributes towards paying the fixed costs of the business

  • Once fixed costs have been fully covered, the contribution starts to contribute to the profits of the business

Total contribution

• Total contribution is the combined contribution from all units sold

• It is calculated using the formula

$\mathrm{Total}\mathrm{contribution}=\mathrm{Contribution}\mathrm{per}\mathrm{unit}\times \mathrm{Quantity}\mathrm{sold}$

• Once the total contribution equals total fixed costs, the business has broken even

• Any contribution beyond that point becomes profit;

  • Total contribution < Fixed costs → Loss

  • Total contribution = Fixed costs → Break-even

  • Total contribution > Fixed costs → Profit

Break-even output

• The break-even output is the level of output at which total revenue is exactly equal to total costs and where the business is making neither a profit nor a loss

• The break-even point is expressed in units (e.g. the number of scented candles) and is calculated using the formula

$\mathrm{Break}-\mathrm{even}\mathrm{point}=\frac{\mathrm{Fixed}\mathrm{costs}}{\mathrm{Contribution}}$

• Identifying the break-even point allows a business to understand how many items it needs to produce and sell to cover all costs before it starts to make a profit

  • Each subsequent unit sold past this point will generate profit for the business

Margin of safety

• The margin of safety is the difference between the actual level of output of a business and its break-even level of output

• The margin of safety can be calculated using the following formula

$\mathrm{Margin}\mathrm{of}\mathrm{safety}=\mathrm{Actual}\mathrm{level}\mathrm{of}\mathrm{output}-\mathrm{Break}-\mathrm{even}\mathrm{level}\mathrm{of}\mathrm{output}$

Purpose and value of break-even analysis

• Break-even analysis is a widely-used planning tool that gives businesses a clear, picture of the relationship between their costs, their sales and their financial position

• Rather than relying on gut feeling, managers can use break-even analysis to make more informed decisions;

  • Setting a selling price

  • Deciding whether to launch a new product

  • Judging whether the business can withstand a fall in demand

• It is particularly valuable before a business commits to a course of action, because it allows managers to model different scenarios and understand the financial consequences before any money is spent

Main uses of break-even analysis

Setting targets

• It tells a business the minimum level of sales needed to avoid a loss, which can be used to set realistic sales targets for the team

Assessing viability

• Before launching a new product or business, managers can calculate whether break-even output is realistically achievable

Supporting loan applications

• Banks and investors often ask for break-even analysis as part of a business plan to assess financial risk

Evaluating the impact of change

• Businesses can model the effect of a price change, a rise in variable costs, or increased fixed costs on the break-even point before making decisions

Calculating the margin of safety

• This helps managers understand how much of a buffer the business has and how vulnerable it is to a fall in demand

Limitations of break-even analysis