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3.3 BREAK-EVEN ANALYSIS (FURTHER USES OF BREAK-EVEN ANALYSIS (Calculations…
3.3 BREAK-EVEN ANALYSIS
DEFINITION
The level of output at which
total costs equal to total revenue
METHODS OF CALCULATING BREAK-EVEN
Graphical Method
The total costs line begins at the level of fixed costs but the follow the same gradient as variable costs
Sales revenue starts at the origin and increase at a constant rate
The variable cost line start from origin and increase at a constant rate
The point at which the total costs and sales revenue line cross is the break-even
The fixed cost line is horizontal showing that the cost are constant at all output level
Profit is shown by the positive difference between sales revenue and total costs
The y-axis is the costs and sales revenue meanwhile the x-axis is the units of output
Maximum profit is made at maximum output and is shown on the graph
Formula Method
The formula is - fixed costs / contribution per unit
Contribution per unit is the selling price of s product minus direct costs per unit
Break-even level of output can be calculated using contribution
Profit or loss can be predicted through total contribution
Total contribution is unit contribution multiply with the output
If total contribution of a product exceeds the fixed costs for the period, a profit has been made
If total contribution of a product is less than the fixed costs for the period, a loss has been made
The Table Method
The Quantity sold, fixed costs, variable costs and total costs are tabulated
Revenue is determined when price is multiplied by the quantity
Profit later is being determined
FURTHER USES OF BREAK-EVEN ANALYSIS
Can be used in determining a operations management decisions
Can be used in choosing between two locations for a new factory
Can be used in determining a marketing decision
Calculations involved;
Calculating target break-even revenue
fixed cost / [1- (direct cost / price)]
Calculating target price
(fixed costs/production level) + direct cost
Calculating output to achieve target profit
(fixed cost + target profit) / contribution per unit
EVALUATION OF BREAK-EVEN ANALYSIS
BENEFITS
Can make comparisons between different options by constructing new charts
The equation produces a precise break-even result
Provides useful guidelines to management
Use to assist managers when taking important decisions
Charts are easy to construct and interpret
LIMITATIONS
No allowance made for stock levels ob the chart since it is assumed all units produced are sold
Cost and price data are often estimated and the actual data might vary from those that are used
Not all costs can be conveniently classified into fixed and direct costs at which welcoming the introduction of semi-variable cost
It is unlikely that the fixed costs will remain unchanged at different output levels
The assumptions of costs and revenues represented by straight line is unrealistic