2. What breakeven is all about• Understanding the breakeven position is key to assessing the feasibility of a start-up• Calculating contribution and breakeven is an important analytical method• However, it makes certain assumptions, so you need to be aware of the limitations
3. Contribution• Contribution looks at the profit made on individual products• It is used in calculating how many items need to be sold to cover all the business total costs (variable and fixed)• Contribution is the difference between sales and variable costs of production
4. Contribution - formulae Contribution = total sales less total variable costsContribution per unit = selling price per unit less variable costs per unit Total contribution can also be calculated as: Contribution per unit x number of units sold Profit = Contribution less Fixed Costs
5. Contribution – example calculation• Data Contribution per unit = £10 - £5 = £5 – Quantity sold: 5,000 units Total Sales = 5,000 x £10 – Selling price per = £50,000 Total Variable Costs = 5,000 x £5 = unit: £10 £25,000 – Variable cost per Total Contribution = £50,000 - £25,000 unit: £5 = £25,000 – Fixed costs: Profit = £25,000 - £10,000 £10,000 = £15,000
6. breakeven output: introduction• Three methods of calculating breakeven level of output• A table (or spreadsheet) showing sales and costs over different levels of output• A formula which you can use to calculate breakeven output• A graph which charts sales and costs
7. Breakeven analysis: key assumptions• In order to do breakeven analysis, you have to make some important assumptions – Selling price per unit stays the same, regardless of the amount produced – Variable costs vary in direct proportion to output – i.e. variable cost per unit is the same – All output is sold – Fixed costs do not vary with output – they stay the same• These assumptions are not always realistic – a key limitation of breakeven analysis
9. Method 2 – Using a formulaContribution per unit = selling price per unit less variable cost perunitIn this example, contribution per unit = £10 less £4 = £6 per unitUsing the formula:breakeven output (units) = Fixed costs (£) / Contribution per unit (£)breakeven output = £40,000 divided by £6 = 6,666Note: breakeven output is always expressed in terms of unitsSo breakeven output = 6,666 unitsTip: If the information is available, it is always quicker andeasier to use a breakeven formula rather than use a tableor draw a chart
10. Method 3 – breakeven Chart• We’ll lead you through the stages of completing a breakeven chart• You may be asked to complete a breakeven chart in an exam• However, it is most important to understand the concepts used in constructing the chart
11. breakeven chart – Step 1 100 The first step is to produce two axes: 90 The vertical axis shows the value of sales & costs 80 The horizontal axis shows the outputSales and costs (£’000) 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000)
12. breakeven chart – Step 2 100 The next step is to add the fixed cost line. Remember that we assume fixed costs don’t 90 change with the level of output. So the fixed cost 80 line (in red below) is a horizontal line, showingSales and costs (£’000) £40,000. 70 60 50 Fixed costs 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000)
13. breakeven chart – Step 3 100 Next we add the variable costs. We assume that variable costs vary directly with output. In our example, the variable cost per unit is £4. 90 So variable costs for 1,000 units will be £4,000, and at 5,000 units 80 they will be £20,000. Remember that you only need to plot aSales and costs (£’000) couple of points to be able to draw the straight line (in yellow 70 below). 60 50 Fixed costs 40 30 Variable costs 20 10 0 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000)
14. breakeven chart – Step 4 Next step is to add the variable costs to the fixed costs for each level of output. 100 This is important. Remember that to calculate breakeven we need to know total costs. The total cost line is shown in green on the chart. 90 80Sales and costs (£’000) 70 Total costs 60 50 Fixed costs 40 30 Variable costs 20 10 0 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000)
15. breakeven chart – Step 5 Total sales 100 Having dealt with costs, 90 we can now draw the line for total sales. Remember 80Sales and costs (£’000) that we assume that all 70 output is sold for the Total costs same selling price (in this 60 case - £10 per unit). So 50 total sales for 2,000 units will be £20,000; 10,000 Fixed costs 40 units will make £100,000 of sales. The total sales 30 line is drawn in blue Variable costs 20 10 0 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000)
16. breakeven chart – Step 6The last step is to use these lines to identify certain information from the chart.First, the breakeven output - the point where total sales = total costs. So theoutput is the point where the total sales line crosses the total costs line (e.g.where the blue line crosses the green line). Find this point on the chart and thenfollow a vertical line down to the output (horizontal) axis. You can see this bringsus to 6,666Another thing you can notice from the chart is the over a range of output, totalcosts are higher than total sales (green line higher than the blue line). Thatmeans that in this range, the business is making losses. This is the loss-makingrange of output.If the actual output is more than the breakeven output, the business will bemaking a profit. In our example, any output more than 6,666 units will meanprofits are earned.The difference between the actual output and the breakeven output is known asthe “margin of safety”. For example, if actual output were 8,000 units, then themargin of safety = 8,000 units less 6,666 units = 1,334 units.
17. Total sales100908070 Total costs6050 Fixed costs4030 Variable costs20100 1 2 3 4 5 6 7 8 9 10 Units of Output (‘000) breakeven chart – Step 6
18. Effects on breakevenChange Effect on Effect on breakeven Contribution per Unit OutputHigher selling price Higher LowerLower selling price Lower HigherHigher variable cost per Lower HigherunitLower variable cost per Higher LowerunitIncrease in fixed costs No change HigherDecrease in fixed costs No change Lower
19. Strengths of breakeven analysisStrengthsFocuses on how long it will take before a start-up reaches profitability –the required outputHelps entrepreneur & finance-providers better understand the viabilityand risk of a business ideaMargin of safety calculation shows how much a sales forecast can proveover-optimistic before losses are incurredIllustrates the importance of keeping fixed costs down to a minimumCalculations are quick and easy
20. Limitations of breakeven analysisLimitationsUnrealistic assumptions – products are not sold at the same price atdifferent levels of output; fixed costs do vary when output changesSales are unlikely to be the same as output – there may be some build upof stocks or wasted output tooVariable costs do not always stay the same. For example, as output rises,the business may benefit from being able to buy inputs at lower prices(buying power)Most businesses sell more than one productA planning aid rather than a decision-making tool
21. Exam Tips• Focus your studies on understanding how various changes in the business can affect the breakeven level of output. A breakeven chart can help you illustrate this, but it is more important to understand why the changes affect breakeven output, and what a business can do in response• Dont assume that breakeven analysis is a proven, scientific method. It makes lots of assumptions about the ability of the business to identify which costs are variable and which are fixed - in reality this can be quite tough• breakeven analysis is particularly useful for a new business or for any business which is loss-making or barely making profits
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