2.2.3 Break-Even

• Definition:

  Calculated when a business is earning enough sales revenue to pay for all its costs.

  It is not yet making a profit but it is not recording a loss either.
• B.E.P = Fixed costs / Contribution Margin per unit
• Contribution margin per unit = Selling price - Variable cost per unit
• Contribution definition:

  It looks at whether an individual product (or activity) is helping the business to make a profit.
• Total Contribution = contribution per unit x no. units sold
• Margin of Safety definition:

  Refers to the additional units a business sells, over and above their break-even point and effectively when they start making a profit.
• M.o.S = ACTUAL output - BREAK-EVEN output
• Break-Even (B-E) Analysis

  • Focuses entrepreneur on how long it will take before a start-up reaches profitability
  • Simple and straight forward way of discovering if the business is viable and helps to set targets
  • Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred
  • Can help to analyse 'best case' and 'worst case' scenarios. Helps to consider the level of risk involved
  • Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher break-even output)
  • Allows a business to ask 'what if?' questions with different price levels, fixed costs and variable costs. It can also be used to help persuade financial institutions to lend money
• Weaknesses of break-even analysis

  • Unrealistic assumptions - products are not sold at the same price at different levels of output; fixed costs do vary when output changes
  • Sales are unlikely to be the same as output. Some output will remain unsold
  • Variable 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), which would reduce variable cost per unit.
  • In reality the selling price may change as products are sold (or not). Also, the fixed costs may not stay the same. If there is a large increase in output new machinery may need to be purchased
• Break-even analysis should be seen as a planning aid rather than a decision-making tool