Unit 3.3 : Break-even Analysis

Question 1

Contribution

Answer 1

1. The sum of money that remains after all direct and variable costs have been taken away from the sales revenue
2. It is essentially the amount each unit pays towards fixed costs once variable costs have been covered
3. Contribution analysis can help a business to identify products that are relatively profitable and ones that might need more attention

Contribution per unit = price - average variable costs
Total contribution = (price - average variable costs) * Quantity sold

Question 2

Profit (in terms of contribution)

Answer 2

Profit = Total contribution - total fixed costs

Question 3

How to increase profit

Answer 3

1. Increasing sales of the product, which raises the total contribution (gross profit)
2. Reducing variable costs, perhaps through negotiating better deals with current suppliers or seeking new suppliers that are more competitive
3. Reducing fixed costs and overheads, perhaps through better financial control or the use of cost and profit centres

Question 4

Uses of contribution analysis

Answer 4

1. Pricing strategy - helps a business to set prices for each of its products to ensure there is positive contribution
2. Product portfolio management - Can help managers to decide which products should be given higher investment priority
3. Make-or-buy decisions
4. Break-even analysis

Question 5

Break-even analysis

Answer 5

1. A business can only survive in the long term if its revenues exceed its costs.
2. A business can be in 3 different financial situations - loss, break-even, and profit

Question 6

Loss

Answer 6

when costs of production exceed the revenues of the business

Question 7

Break-even

Answer 7

1. when the revenues of the business equal the costs of production
2. neither a profit nor a loss is made
3. TC = TR

Question 8

Profit

Answer 8

when revenues exceed costs of production

Question 9

Breakeven formula

Answer 9

Breakeven quantity = fixed costs / contribution per unit

Question 10

Margin of safety

Answer 10

1. Margin of safety measures the difference between a firm’s sales volume and the quantity needed to break-even
2. quantity sold over and above the breakeven level of output
3. If there is a positive MOS, the firm is making a profit, whereas a negative safety margin means the firm makes a loss
4. Margin of safety = level of demand - break-even quantity

Question 11

Target profit level of output

Answer 11

(fixed costs + target profit)/contribution per unit

Question 12

Breakeven revenue

Answer 12

fixed costs / (1 - direct costs/price)

Question 13

Break-even target price

Answer 13

(fixed costs + direct costs) / production level

Question 14

Capacity Utilisation rate

Answer 14

Capacity utilisation measures a firm’s existing level of output as a proportion of its potential output.

Capacity utilisation = Actual output / Productive Capacity (maximum output)

Question 15

Limitations of a break-even analysis

Answer 15

1. Information may be unreliable as it is based on forecasts and predictions - predictive model
2. Assumes selling price stays the same regardless of output
3. Assumes that fixed costs stay the same
4. Assumes that variable costs per unit stays the same - ignoring purchasing economies
5. Assumes all output is sold
6. Only suitable for analysis of single products
7. Only considers quantitive factors

Question 16

Advantages of a break-even analysis

Answer 16

1. managers are able to read off from the graph the expected profit or loss to be made at any level of output
2. Can show the margin of safety

Question 17

Target profit

Answer 17

Target profit = Total revenue - Total costs