BREAK EVEN ANALYSIS (HL Content)

1. BREAK EVEN ANALYSIS (HL Content) Business & Management for the IB Diploma Program. Stimpson & Smith, 2012, p338-340.

2. Target Revenue & Profit • An adapted version of the break-even formula can be used if the business wants to determine a target profit level and establish the level of output required to achieve it. Target Profit Level of Output = Fixed Costs + Target Profit Contribution Per Unit

3. Target Revenue & Profit: Example • The target profit is $25,000. • Fixed Costs are $200,000. • The contribution per unit is $50. • The level of output to the earn the target profit is: $200,000 + $25,000 50 = 225,000 50 = 4500 Units.

4. How much should we sell the product for in order to reach a target profit? • In some cases, we may wish to know the selling pricerequired in order to reach a target profit. • The formula is as follows: Price = target profit + total costs output What do we mean by output? * The number of items (units) the company intends to produce.

5. Break Even Revenue • The amount of revenue needed to cover both fixed and variable costs so that the business breaks even. • Break Even Revenue can be calculated by the following formula: Break Even Revenue = Fixed Costs 1 – (Variable cost/price) • Of course we can also calculate break even revenue by simply calculating the break even quantity and multiplying by the selling price.

6. BREAK EVEN ANALYSIS– EVALUATIONUsefulness of Break Even Analysis • Charts are relatively easy to construct and interpret. • It provides useful guidelines to manage break even points, safety margins and profit/loss levels at different rates of output. • Comparisons can be made between different options by constructing new charts to show changed circumstances. • Charts could be amended to show the possible impact on the profit and break-even point of a change in the product’s selling price.

7. BREAK EVEN ANALYSIS – EVALUATIONUsefulness of Break Even Analysis • The equation produces a precise break-even result. • Break even analysis can be used to assist managers when taking important decisions, such as location decisions, whether to buy new equipment and which projects to invest in.

8. BREAK EVEN ANALYSIS – EVALUATIONLimitations of Break-Even Analysis • The assumption that costs and revenues are always represented by straight lines is unrealistic • Not all variable costs change directly or smoothly with output. Eg: Labor Costs may increase as output reaches maximum due to higher shift payments or overtime rates. • The revenue line could be influenced by price reductions made necessary to sell all units produced a high output levels. • The combined effect of these assumptions could be to create two break even points in practice.

9. BREAK EVEN ANALYSIS – EVALUATIONLimitations of Break-Even Analysis • Not all costs can be conveniently classified into fixed and variable costs. • The introduction of semi variable costs will make the technique much more complicated. • There is no allowance made for stock levels on the break even chart. It is assumed that all products are sold. • This is unlikely to be always the case in practice. • It is also unlikely that fixed costs will be remain unchanged at different output levels up to maximum capacity.