4.2.3 Explain, Interpret and Use a Break-Even Chart IGCSE Business Studies 4.2.3 Explain, Interpret and Use a Break-Even Chart

LEARNING OBJECTIVES To understand the concept of break even To be able to construct, complete or amend a break-even chart To be able to interpret a given chart and use it to analyse a situation To be able to use a chart to make decisions To understand the limitations of break-even charts

Starter – 5 mins Match the definition with the correct key terms Label the lines on break even chart

Break-even 1. The graphical method Tutor2u Break-even simulator Use Tutor2u’s excellent Break-even Simulator on an interactive whiteboard to demonstrate the relationships between the various variables. Break-even 1. The graphical method

Costs and revenue task Bobby Stokes makes Glory™ Materials cost £2 and overheads are £1 million per month His factory has a capacity of 200,000 Glories™ Bobby sells Glory™ to wholesalers for £10 Construct a data table of his costs and revenue (FC, VC, TC, TR) for ranges of output from 0 to 200,000 units use increments of 20,000 units From the data table, sketch a graph with the y-axis scale ranging from £0 to £2,000,000 Identify the break-even point

Costs and revenue Output ('000) Fixed Cost ('000) Variable Cost ('000) Total Cost ('000) Total Revenue ('000)   20 40 60 80 100 120 140 160 180 200

Costs and revenue Output ('000) Fixed Cost ('000) Variable Cost ('000) Total Cost ('000) Total Revenue ('000) 1,000  1,000  0 20 40 1,040 200 80 1,080 400 60 120 1,120 600 160 1,160 800 100 1,200 240 1,240  1,200 140 280 1,280 1,400 320 1,320 1,600 180 360 1,360 1,800 2,000

Costs and revenue

Costs and revenue Break-even point

Costs and revenue quick questions Looking at your graph, how many Glories™ must Bobby produce if he is to break-even? Define break-even in a single sentence Reading from your graph, estimate the amount of profit/loss Bobby will make if he makes and sells: 60,000 Glories™ 160,000 Glories™

Costs and revenue Break-even point

Break-even Simulator (Tutor2u) task Management might be reluctant to increase price because: Increasing price might make the product more expensive than the competition Market research might indicate that customers are unwilling to pay more (in both cases, sales might fall heavily with the price increase) The target profit could be achieved by: Reducing variable costs (e.g. finding cheaper raw materials) Cutting fixed costs (e.g. moving to a cheaper factory, reducing the number of office staff etc.) Selling price should increase to £52 Margin of safety = 1,538 units. This is the difference between the break-even output and the expected output Use the simulator to find the total contribution and net profit when: Selling price = £50 Variable cost per unit = £26 Fixed costs = £350,000 (Expected output = 15,000 units) By how much should selling price change if the firm wishes to aim for a net profit of £40,000? What is the margin of safety at that output? What does this mean? Management is reluctant to raise price. Why do you think this might be? How else could they try to achieve this target profit? Total contribution = £360,000 Net profit = £10,000

Break-even analysis 2. Calculation method

Calculating break-even Contribution: Defined as ‘the contribution that selling a single unit makes towards fixed costs and profit’ Contribution = Price per unit – Variable Cost per unit Break-even point = Fixed costs contribution learn these equations!

Calculating break-even Example You manufacture CDs. You sell them to retailers for £8. The variable cost per CD is £1 and fixed costs are £70,000 What is the break-even output?

Calculating break-even Example A fast-food restaurant sells meals for £6 each The variable costs of preparing and serving each meal are £2 The monthly fixed costs of the restaurant amount to £3,600 How many meals must be sold each month to break even? If the restaurant sold 1,500 meals in April, what were the margin of safety and profit in that month?

Answer (1) Contribution = Price – VC = £6 – £2 = £4 Break-even point = 3,600 ÷ £4 = 900 meals

Answer (2) Margin of safety: The difference between the current output and the break-even output MoS = 1,500 – 900 = 600 meals Profit = TR – TC TR = P x Q = £6 x 1,500 meals = £9,000 TC = FC + VC = £3,600 + (£2 x 1,500) = £6,600 Profit = £9,000 – £6,600 = £2,400 [Have you spotted a much quicker way of calculating profit using the Margin of Safety?] Margin of Safety = 600 meals Contribution = £4 Profit = MoS x Contribution = £2,400

Break-even analysis Katie’s Cards

Breakeven analysis “Katie’s Cards” question Katie makes greetings cards. She has estimated that her fixed costs for the first six months of operation would be £3,000. The variable cost per card is estimated at 60p, and Katie set a selling price to retailers of £1.80 per card Showing your working, calculate Katie’s break-even output for her first six months in operation If she sells 3,000 cards, how much profit will she make?

Breakeven analysis “Katie’s Cards” question - answers Contribution = £1.80 - £0.60 = £1.20 Breakeven = £3,000 ÷ £1.20 = 2,500 cards Profit: Margin of safety = 3,000 – 2500 = 500 cards Profit = MoS x Contribution = 500 x £1.20 = £600

Break-even analysis MugUp task

Break-even analysis Task – MugUp Ltd MugUp Ltd has sufficient capacity to produce 120,000 drinking mugs per year The variable cost of producing each mug is 20p and fixed costs total £20,000 per year The mugs are sold to wholesalers for 60p each a. Calculate: contribution per mug break-even output the margin of safety if current output is 90,000 mugs profits at full capacity b. Assuming that unit variable costs, fixed costs and capacity remain unchanged, calculate the price that MugUp would have to charge wholesalers to obtain the target profit of £40,000 per year at full capacity output

Task – MugUp Ltd answers (a) Contribution per unit = 60p – 20p = 40p Break-even output = £20,000  £0.40 = 50,000 mugs Margin of safety = 90,000 – 50,000 = 40,000 mugs Profits at full capacity = Output above break-even  Contribution = 70,000  40p = £28,000 [or (Output  Contribution per unit) - FC = (120,000  40p) - £20,000 = £28,000]

Task – MugUp Ltd answers (b) [Sales x Contribution per unit] – FC = Profit [120,000 x Cont./unit] – 20,000 = 40,000 120,000 x Cont./unit = 60,000 Contribution per unit = 60,000 120,000 Contribution per unit = 50p Price = VC + Contribution per unit Price = 20p + 50p = 70p

Break-even analysis answers (b) – alternative method Target profit: Fixed cost + Target Profit Contribution per unit = Output 20,000 + 40,000 Price – 0.20 = 120,000 60,000 = 120,000 x Price – 0.20 60,000 120,000 = Price – 0.20 Price = 0.50 + 0.20 = £0.70

Break-even analysis Uses and limitations

Break-even analysis uses and limitations Break-even analysis only really works for a business with one product Involves so much simplification as to be worthless e.g. generalising costs into fixed and variable In reality (but not in exams!) the language of break-even is more important than the mathematics Break-even point Contribution Margin of safety

Quiz Time Grab the boards Try the quiz 1 – basics Quiz 2 – Break even and decision making