Break-Even Analysis and Decision Making, Study notes of Decision Making

Download Break-Even Analysis and Decision Making and more Study notes Decision Making in PDF only on Docsity!

Break-Even Analysis and

Decision Making

Session 5 4th April 2019

A PRODUCT (OR ANY OTHER COST OBJECT ) CAN BE SAYED TO BE PROFITABLE (ECONOMICALLY AFFORDABLE) WHEN……

• It has a positive first contribution margin
• It creates volumes that cover any traceable fixed costs and offer a further contribution to covering common fixed costs ( a positive second contribution margin ) The first law of profitability: the variable cost is the maximum limit of the sale price [ Unit Price> Unit Variable Cost and then 1 st CM> 0 ] The second law of profitability : the 1 st Contribution Margin must cover any traceable fixed costs [ 2 nd MdC > 0 ]

The Profitability Laws

The Profitability Laws

• Unit sales price 4,00 3,00 2,00 1,
• Revenues 20.000,00 30.000,00 60.000,00 62.500,
• Variables Costs 4.350,00 7.900,00 21.300,00 32.500,
• First Contribution Margin 15.650,00 22.100,00 38.700,00 30.000,
• Traceable Fixed costs 33.000,00 33.000,00 33.000,00 33.000,
• Second Contribution Margin - 17.350,00 - 10.900,00 5.700,00 - 3.000,
• Unit Variable Cost 0,87 0,79 0,71 0,
• First Contribution Margin per unit 3,13 2,21 1,29 0,
• Break-Even volume 10.543,13 14.932,13 25.581,40 55.000,

Break-even Analysis Defined

❑ Breakeven analysis examines the short run relationship

between changes in volume and changes in total sales

revenue, expenses and net profit

❑ Also known as C-V-P analysis (Cost Volume Profit Analysis)

Linear Break-Even Analysis

❑ Over small enough range of output levels TR and TC

may be linear, assuming:

❑ Constant selling price

❑ Constant variable cost

❑ Firm produces only one product (no mix effect)

❑ No time lags between investment and resulting

revenue stream

Graphic Solution Method

❑ Draw a line through origin

with a slope of P (product

price) to represent TR

function

❑ Draw a line that intersects

vertical axis at level of fixed

cost and has a slope of MC

❑ Intersection of TC and TR is

break-even point

TR

TC

FC

Break-even point VC P 1 unit Q

1 unit Q Q

$’s

Costs/Revenue Output/Sales

FC

VC

TR TC

The Break-even point occurs where total revenue equals total costs. The firm, in this example would have to sell Q1 to generate sufficient revenue (income) to cover its total costs. Q

BEP

Breakeven Chart

Costs/Revenue Output/Sales

FC

VC

TR (p = € 2) TC

Q

If the firm chose to set price higher than € 2 (say € 3) the TR curve would be steeper

• they would not have to sell as many units to break even TR (p = € 3)

BEP

Q

BEP

At present, this firms sells each unit for € 2 – Break Even point is at Q Breakeven Chart - simulation

Costs/Revenue Output/Sales

FC

VC

TC

TR (p = € 2) Q

Loss

Profit

Any units sold above Break Even Point represents a Profit

BEP

Breakeven Chart - simulation

Equate total revenue and total cost functions and solve for Q TR = P x Q TC = FC + (VC x Q) TR = TC P x QB = FC + VC x QB (P x QB) – (VC x QB) = FC QB (P – VC) = FC QB = FC/(P – VC) Algebraic Solution

We must firstly calculate how much income from each bunch of flowers can go towards covering the Fixed Costs. This is called the Unit Contribution Margin Selling Price – Unit Variable Costs = Unit Contribution Margin €2.00 - €0.50 = €1. For every bunch of flowers sold € 1.50 can go towards covering Fixed Costs

SP = € 2.

VC = € 0.

FC = € 600

Example (2)

Now to calculate how many units must be sold to cover Total Costs (FC + VC) This is called the Break Even Point Break Even Point = Fixed Costs  Unit Contribution Margin € 600  € 1.50 = 400 Units Therefore 400 bunches of flowers must be sold to Break Even – at this the point the business is not making a Profit nor incurring a Loss – it is merely covering its Total Costs

SP = € 2.

VC = € 0.

UCM= € 1.

FC = € 600

Example (3)

❑ How many units must be sold to breakeven?

❑ How many units must be sold to achieve a

target profit?

❑ Should a special order be accepted?

❑ How will profits be affected if we introduce a

new product or service?

Decision Making and Break-Even

Analysis: Exemples

Key Terminology: Break-even Analysis

❑ Break even point: the quantity (or volume) at

which a company makes neither a profit or a loss.

❑ Contribution Margin per unit: the sales price

minus the variable cost per unit. It measures the

contribution made by each item of output to the

fixed costs and profit of the organisation.