UNIT: 5.3 – Break-even Analysis pg. 642 Understand/practice break-even analysis & margin of safety IB Business Management

Fixed or Variable? Direct or Indirect? Rent Wages Salaries Materials Insurance Commission Utilities

Breaking Even Business can be in one of the following financial situations: Loss: costs exceeds revenue Break-Even: costs equal revenue Profit: revenue exceeds costs

Breaking Even Break-even point exists where a business makes neither profit nor loss This occurs at the level of output where total costs equal total revenue Typically a goal of new firms

Contribution  What is the purpose of calculating contribution? Unit contribution = P - AVC Any product w/ a positive contribution will help pay some of the FC of the company  Contribution analysis gives 3 ways profits can be improved: Increase sales revenue Reduce VC Reduce FC

Meaning of Break-Even Point Total Costs = Total Revenue when output reaches the break-even point Any sales above the break-even quantity will generate a profit Sales below the break-even level will yield a loss

Break-even Analysis  A business can only survive in the long run if revenue > costs  New firms especially want to determine the level of sales needed to generate a profit

Break-Even Analysis Two purposes for conducting a break- even analysis, which helps determine: If its financially worthwhile to produce a particular good or service (such as introducing a new product) Amount of profit that business is likely to earn if things go according to plan

Break-Even Analysis Example Jeans retailer has fixed costs of $2,500 per month Each pair of jeans sells for $30 $10 in variable costs per pair of jeans What is the break-even point?

Calculating Break-Even Point Method 1 Identify where total costs equal total revenue on a break-even chart The break-even point is the position where the total cost line intersects the total revenue line (TC=TR)

Calculating Break-Even Point Method 2 Using the TC = TR rule: TFC + TVC = Price x Quantity (Q) = 30Q 2500 = 20Q 125 = Q (pairs of jeans)

Calculating Break-Even Point Method 3 Unit contribution is difference between a product’s price and variable cost Contribution = Price – VC Break-Even Point = TFC / Unit Contribution $2500 $30-10 = 125 pairs

Break-Even Example Use the unit contribution method to calculate the break-even quantity for a firm that has the following financials: TFC = $200,000 AVC = $5 Price = $30 P - AVC = unit contribution Break-even = fixed costs unit contribution

Margin of Safety Measures difference between firm’s current sales quantity & break-even point Positive margin means that firm is making a profit Always shown in units, not dollars! Safety margin = level of demand – breakeven qty.

Margin of Safety Example Demand for jeans is 200 pairs per month Break-even point is 125 pairs per month Safety margin is 75 units ( = 75) This means the business can sell 75 fewer pairs of jeans before losing money.

Constructing a Break-even Chart  Rules to follow when constructing BE chart: Draw/label TFC line Draw/label TC line. Q = 0; TC start at ??? Draw/label TR line. Q = 0; TR starts at ??? X-axis is labeled as “Output” or units Y-axis is labeled as “Costs, Revenues, Profit” $$$