3.3 Break-Even Analysis

Strengths of Break-even Analysis

1. Allows predictions about how much to to produce 2. Helps with decision-making about what to produce. 3. Can help reduce financial risk 4. Help with how to price products to make a certain level of profit 5. Good for short-term decisions

Limits of Break Even Analysis

1. Assumes many variables will not change (FC, VC) and are accurately predicted 2. Assumes all stock/output is sold 3. Does NOT consider impact of economies of scale or scope 4. Not very good for major long term decisions where costs may change

Target Price

Refers to decisions about what price a firm should set in order to achieve a certain level of revenue

Marginal Cost

The cost of producing ONE additional product. The marginal costs usually go down significantly after the firm achieves break even quantity as fixed costs have been paid for. The next unit sold will make more profit.

Target Profit Output

When a firm determines how many units must be sold (output level) to achieve a certain amount of desired profit.

Break-even analysis

a management tool used to calculate the level of sales needed to cover all costs of production. Thereafter, further sales generate a positive safety margin, and hence profit for the business.

Profit

is a positive difference between a firm's revenue and its cost. On a break-even chart, profit is shown at all levels of output beyond the break-even quantity.

Margin of Safety (MOS)

is the difference between a firm's level of demand and its break-even quantity. A positive MOS means the firm can decrease output (sales volume) by that amount without making a loss. A negative MOS means that the firm is making a loss.

Contribution per unit (unit contribution)

is the difference between selling price of a product and its variable costs of production, i.e. P - AVC. The surplus goes towards paying fixed costs.

Total contribution

is the unit contribution (P - AVC) multiplied by the quantity of sales (Q), i.e. total contribution = (P - AVC) x Q. It is, essentially, a firm's gross profit.

Special order decision

occurs when a customer places an order at a price that differs from the normal price charged by the business.

Break-even quantity

refers to the level of output that generates neither any profit nor loss. It is shown on the x-axis on a break-even chart.

Break-even point

refers to the position on a break-even chart where the total cost line intersects the total revenue line, i.e. where TC=TR.

Break-even chart

the name given to the graph that shows a firm's cost, revenues and profits (or loss) at various levels of output