5.5 Break-even Analysis

Question 1

What is break-even?

Answer 1

Break-even exists when a firm’s sales revenues cover all of its production costs.

The break-even quantity (BEQ) is the level of output where a business does not make either a profit or a loss.

(fixed costs)/(selling price - variable costs)

Question 2

What is the margin of safety?

Answer 2

The numerical difference between how much the business sells and its BEQ is known as the margin of safety (MOS)

estimated number of sales - break-even quantity = margin of safety

Question 3

What is the target profit output?

Answer 3

quantity of sales required to reach the firm’s target profit

(Fixed cost + Target profit) ÷ (Price – Average Variable Cost)

Question 4

What is target profit?

Answer 4

Target profit is the amount (value) of profit that a firm aims to earn within a given time period. The target profit for each level of output can been seen in a break-even chart by comparing the total cost and total revenue lines.

Target profit = Price × Quantity – [Fixed cost + (Average variable cost × Quantity)]

Question 5

What is target price?

Answer 5

Target priceis the amount customers need to pay per unit in order for the firm to break-even or to reach a particular target profit. The formula used to calculate the target price for break-even is:

Target price = Average Fixed Cost + Average Variable Cost

or

Target price = (Total Fixed Cost ÷ Output) + Average Variable Cost

Question 6

What are the limitations of break-even analysis?

Answer 6

Prices are assumed to be constant (the linear Total Revenue line is shown to have a constant gradient) but in reality many businesses offer price discounts to loyal customers and those who buy large quantities.

Costs are assumed to be constant (the Total Cost line is shown to be upwards sloping with a constant gradient) but in reality businesses are unlikely to experience constant average costs as its output or sales level increases. Instead, economies of scale (see Unit 1.5) enable firms to benefit from lower average costs as output (or the scale of production) increases, so the Total Cost (TC) line is highly unlikely to be linear in reality.

Changes in the external business environment will also have a direct impact on costs and revenues. For example, inflation will increase production costs and wages, whereas a fall in interest rates will reduce the costs of borrowing. These factors are not easy to consider in a break-even analysis.

Break-even analysis is ideal for businesses that sell a single good or service. It can be difficult to calculate break-even for businesses that sell a large range of goods and services, as prices and production costs differ.

As with all quantitative tools, the effectiveness of break-even analysis relies on the accuracy of the cost and revenue data used to make the predictions. Any inaccuracies and/or deliberate bias in the use of the quantitative data will invalidate the results of the break-even analysis.