3.3 Break-even analysis Check your portfolios at Howthemarketworks.com

Warm Up: Break Even Analysis  How would you identify profit/loss on this graph?  At what point is the company just covering it’s fixed costs?  At what point is the company covering all of it’s costs (i.e. profit is zero)?

Definitions  Break-even chart – a graphical method that measures the value of a firm’s costs and revenues against a given level of output  Break-even quantity – a measure of output where total revenue equals total costs  Margin of safety – the output amount that exceeds the break-even quantity  Break-even chart – a graphical method that measures the value of a firm’s costs and revenues against a given level of output  Break-even quantity – a measure of output where total revenue equals total costs  Margin of safety – the output amount that exceeds the break-even quantity

Calculations/Formulas  Contribution per unit = price per unit – variable cost per unit  Total contribution = total revenue – total variable cost  Total contribution = contribution per unit x number of units sold  Break even output or quantity = fixed costs/contribution per unit  Margin of safety = current output – break even output  Contribution per unit = price per unit – variable cost per unit  Total contribution = total revenue – total variable cost  Total contribution = contribution per unit x number of units sold  Break even output or quantity = fixed costs/contribution per unit  Margin of safety = current output – break even output

Question: Tommy the Baker

Calculating Profit and Target Profit  Profit = Total Revenue – Total Cost  Profit = (P x Q) – (TFC + TVC)  Target Profit Output = Fixed Costs + Target Profit Contribution Per Unit  Profit = Total Revenue – Total Cost  Profit = (P x Q) – (TFC + TVC)  Target Profit Output = Fixed Costs + Target Profit Contribution Per Unit

Benefits of Break-Even Analysis  Easy and visual analysis  Ability to determine profit, break even level, margin of safety all in one chart  Changes in price and costs can be compared  Used as a strategic tool to decide on key investment projects or decisions to relocate or merge with another company  Easy and visual analysis  Ability to determine profit, break even level, margin of safety all in one chart  Changes in price and costs can be compared  Used as a strategic tool to decide on key investment projects or decisions to relocate or merge with another company

Drawbacks of Break-Even Analysis  Assumes all of the output being produced is sold  Assumes all revenues and costs are linear  Semi variable costs are not represented  Is not useful in changing or dynamic business environments  Unreliable or inaccurate data may influence conclusions reached  Fixed costs may change at different levels of activity  Assumes all of the output being produced is sold  Assumes all revenues and costs are linear  Semi variable costs are not represented  Is not useful in changing or dynamic business environments  Unreliable or inaccurate data may influence conclusions reached  Fixed costs may change at different levels of activity

Formative: Paolo’s Pasta