Break-even Analysis (AQA AS Business): Revision Note

The value of break-even analysis

• Break-even analysis is a financial tool used to determine the point at which the business revenue equals its expenses, resulting in neither profit nor loss

• It helps businesses understand the minimum level of sales or output they need to achieve to cover all costs

  • This helps managers make informed decisions about pricing and production volumes

• It is particularly useful for communicating with stakeholders, including investors or lenders

  • It demonstrates the financial viability of the business and gives an insight into potential return on investment

Revenue and costs

• Break-even analysis takes into account three main components

The components of break-even analysis

Sales revenue

• Sales revenue is the value of the units sold by a business over a period of time

  • E.g. the revenue earned by Apple Music from sales of music downloads 

  • Sales revenue is a key business performance measure and must be calculated to identify profit

  • Sales revenue is calculated using the formula

  
   

  • Sales revenue increases as the sales volume increases

Costs

• In preparing goods and services for sale, businesses incur a range of costs

  • Some examples of these these costs include purchasing raw materials, paying staff salaries and wages and paying utility bills, such as electricity 

• These costs can be broken into different categories

  • Fixed costs (FC) are costs that do not change as the level of output changes

    • These have to be paid whether the output is zero or 5,000 

  • Variable costs (VC) are costs that vary directly with the output

    • These increase as output increases & vice versa

  • Total costs (TC) are the sum of the fixed and variable costs 

Fixed costs

• The firm has to pay its fixed costs, which do not change, irrespective of whether the output is zero or 100,000 units

• The fixed costs for this firm are $4,000

Variable costs

• The variable costs initially rise proportionally with output, as shown in the diagram

• At some point, the firm will benefit from a purchasing economy of scale, and the rise will no longer be proportional

Total costs

• The total cost is the sum of the variable and fixed costs at each level of output

• Total costs cannot be zero, as all firms have some level of fixed costs

Constructing and interpreting breakeven charts

• A breakeven chart is a visual representation of the breakeven point and is used to identify the following:

  • Fixed costs, total costs and revenue over a range of output

  • The breakeven point — where total costs are equal to revenue

  • Profit or loss made at each level of output

  • The margin of safety

Diagram: Breakeven chart

Diagram analysis 

• Fixed costs do not change as output increases

  • A2B Limited's fixed costs are £8,000, and these do not change, whether the business produces zero units or 500 units 

• Total costs are made up of fixed and variable costs

  • At zero units of output, they are made up exclusively of fixed costs

  • At 500 units, the total variable costs equate to £11,800

  • This line slopes upwards because total variable costs increase as output increases 

• The revenue line also slopes upwards

  • At zero units of output, the revenue is £0

  • At 500 units, the total revenue equates to £11,800

  • Revenue will increase with the output

  • The line will slope more steeply than the total costs and will cross the total costs line at some point 

• The breakeven point is the point at which the total costs and the revenue lines cross each other

  • The breakeven level of output for A2B Limited is 324 units

• The margin of safety can be identified as the difference on the X-axis between the actual level of output (in this case, 450 units) and the breakeven point (324 units)
  

• The profit made at a specific level of output can be identified as the space between the revenue and total costs lines

  • In this instance, the profit made at 450 units of output is £14,400 - £11,250 = £3,150

Illustrating changes to price, output and costs on the breakeven chart

• Changing any of the variables of breakeven (selling price, variable cost per unit or total fixed costs) changes the breakeven point and level of profit the business can expect to achieve

Changes in variables and the breakeven point

Increased selling price

• An increase in the selling price increases revenue at each level of output from R₁ to R₂

• The breakeven point falls from BEP₁ to BEP₂

• Profit on each unit of output greater than the breakeven point is increased

Increased variable costs

• An increase in variable costs increases total costs at each level of output from TC₁ to TC₂

• The breakeven point rises from BEP₁ to BEP₂

• The profit on each unit of output is greater than the amount the breakeven point is reduced

Decreased variable costs

• A decrease in variable costs reduces total costs at each level of output from TC₁ to TC₂

• The breakeven point falls from BEP₁ to BEP₂

• The profit on each unit of output is greater than the amount the breakeven point is increased

Increased fixed costs

• An increase in fixed costs increases total costs at each level of output from TC₁ to TC₂

• The breakeven point increases from BEP₁ to BEP₂

• The profit on each unit of output is greater than the amount the breakeven point is decreased

Decreased fixed costs

• A decrease in fixed costs reduces total costs at each level of output from TC₁ to TC₂

• The breakeven point falls from BEP₁ to BEP₂

• The profit on each unit of output is greater than the amount the breakeven point is reduced

The benefits and limitations of break-even analysis

Benefits of break-even analysis

Limitations of break-even analysis

Using break-even analysis to inform decisions