32 Break-even 2.2.

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Theme 2

Key points
1. Calculating contribution (selling price - variable cost per unit).
2. Break-even point (total fixed costs + total variable costs = total revenue).
3. Using contribution to calculate break-even point.
4. Margin of safety.
5. Interpretation of break-even charts.
6. Limitations of break-even analysis.

Getting started
receives an order for 1,000 pairs of trousers. The variable costs
Anna Powell runs a company that provides a 24-hour taxi are 7.50 a pair and they will be sold for 9.00 a pair. The total
service from Huddersfield to Manchester Airport. Fixed costs contribution made by the order is:

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each month are usually 3,000 and variable costs are 10 per
trip. Anna charges 40 per trip. In the summer months (June to Total contribution= total revenue - total variable cost
September) the business can make 250 trips a month. = (9.00 1,000) (7.50 1,000)
= 9,000 7,500
Calculate the total cost of 250 trips to the airport in June (Total
= 1,500
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cost = fixed cost + variable cost). Calculate the total revenue
from 250 trips to the airport. How much profit is made from
250 trips? How many trips would be needed in a month for the
business to break even?
The 1,500 in this example will contribute to the textile
companys fixed costs and profit. The total contribution can also
be calculated by multiplying the unit contribution by the number
of units sold.

Contribution Total contribution= unit contribution x number of units sold

Craig Eckert sells second-hand cars. His last sale was 990 = (9.00 7.50) 1,000
for a Golf GTI. He bought the Golf at a car auction for 890. = 1.50 1,000
The difference between what he paid for the car and the price = 1,500
he sold it for is 100 (990 890). This difference is called
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the contribution. It is not profit because Craig has fixed costs
Exam Tip
to pay such as rent, insurance and administration expenses. Contribution can be used to calculate the profit made by a
Contribution is the difference between selling price and variable business. The formula needed is:
costs. In this case the selling price was 990 and the variable
Profit = Total contribution Fixed costs
cost was 890. The 100 will contribute to the total fixed costs
of the business and the profit.
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Contribution per unit and total Question 1

contribution
A business might calculate the contribution on the sale of a
single unit, or the sale of a larger quantity, such as a whole
years output.
Unit contribution In the above example the unit contribution
was calculated. It was the contribution on the sale of one unit, a
single car. The formula for calculating the unit contribution is:
Contribution per unit= selling price variable cost
= 990 890
= 100
Total contribution When more than one unit is sold the total
contribution can be calculated. For example, a textile company
Westwood Holdings is a manufacturer of camping trailers.
The factory is located near Dover and nearly 70 per cent of the
companys output is exported to France, Italy and Spain. The
fixed costs are 200,000 per annum and the variable costs are
500 per trailer. The trailers are sold for 800.
(a) What is meant by the term contribution?
(b) Calculate the contribution made by each trailer.
(c) Calculate the profit made by Westwood Holdings if 2,000
trailers are made and sold in a year.
(d) Due to a new entrant in the market, Westwood Holdings is
forced to lower its price to 650 in the coming year. Calculate
the impact the price cut will have on annual profit.

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Break-even point
Businesses, particularly those that are just starting up, often
like to know how much they need to produce and sell to break
even. If a business has information about fixed costs and variable
costs and knows what price it is going to charge, it can calculate
how many units it needs to sell to cover all of its costs. The
point where total costs (fixed costs + variable costs) are exactly
the same as total revenue is called the break-even point. The
level of output a business needs to produce so that total costs
are exactly the same as total revenue is called the break-even
output. It makes neither a profit nor a loss.
Worked example
A business produces 1,000 units and sells them for 50
each. Total fixed costs are 10,000. Variable costs are 40 per
unit. So total variable costs are 40 1,000 = 40,000
Therefore:
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Total costs = 10,000 + 40,000 = 50,000
Total revenue = 50 1,000 = 50,000
Total revenue and total costs are exactly the same at 50,000.
Therefore the business will break even at this level of output. So
the break-even output is 1,000 units.
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Calculating break-even using contribution
It is possible to calculate the break-even output if a firm knows
the value of its fixed costs, variable costs and the price it will
charge. The simplest way to calculate the break-even output is
to use contribution. The following formula can be used.
Fixed costs
Break-even output = revenue is 150,000.
Contribution
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Worked example
Joseph Cadwallader makes wrought-iron park benches. His fixed
costs (FC) are 60,000 and variable costs (VC) 40 per bench.
He sells the benches to local authorities across the country for
100 each. Therefore contribution is given by: 100,000. This is when 1,000 benches are produced. So
Contribution = selling price - variable cost
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Contribution = 100 - 40
Contribution = 60
Once the contribution has been calculated the number of
benches Joseph needs to sell to break even can then be
determined.
Fixed costs
Break-even output =
Contribution
60,000
= 1,500 benches, profit is shown by the vertical gap
60
= 1,000 benches
Joseph Cadwalladers business will break even when 1,000 park
benches are sold.
Managing business activities
Question 2
Karen Ficenec assembles presentational gift packs that
she sells online. She operates from a small warehouse in
Swindon that she rents for 400 per month. She incurs other
fixed costs of 100 per month and sells the gift packs for 10
each (including postage and packaging). She employs two part-
time staff and variable costs are 8 per gift pack.
(a) Calculate the monthly break-even output for Karen Ficenecs
business.
(b) Calculate the total cost and total revenue at the break-even level
of output.
(c) Calculate the profit made by the business if 2,000 gift packs are
sold in a month.
Break-even chart
The use of graphs is often helpful in break-even analysis.
It is possible to identify the break-even point and break-even
output by plotting the total cost and total revenue equations
on a graph. This graph is called a BREAK-EVEN CHART.
Figure 1 shows the break-even chart for Jack Cadwalladers
business.
Output is measured on the horizontal axis and revenue,
costs and profit are measured on the vertical axis. What does
the break-even chart show?
The value of total cost over a range of output. For
example, when Jack produces 1,500 benches total costs
are 120,000.
The value of total revenue over a range of output. For
example, when Jack produces 1,500 benches total
Break-even charts can show the level of fixed costs over
a range of output. For example, the fixed costs for Jacks
business are 60,000.
The level of output needed to break-even. The break-
even point is where total costs equal total revenue of
the break-even output is 1,000 benches.
At levels of output below the break-even output, losses
are made. This is because total costs exceed total
revenue. At an output of 500 a 30,000 loss is made.
At levels of output above the break-even output, a profit is
made. This profit gets larger as output rises. At an output
of 1,500 a profit of 30,000 is made.
The relationship between fixed costs and variable costs as
output rises. At low levels of output fixed costs represent
a large proportion of total costs. As output rises, fixed
costs become a smaller proportion of total costs.
The profit at a particular level of output. If Jack produces
between the total cost and total revenue equations.
It is 30,000.
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Break-even Unit 32

Figure 1 Using break-even analysis

Break-even analysis is used in business as a tool to make
Break-even chart for Jack Cadwallader
decisions about the future. It helps answer what if questions.
Cost, revenue, profit (000) For instance:
180 if price went up, what would happen to the break-even point?
170 Total
160 revenue if the business introduced a new product line, how many
150 would the new product have to sell to at least break-even?
140 Profit
130 if the business is just starting up, what has to be the level of
Total
120 cost output to prevent a loss being incurred?
110 Break-even point what will happen to the break-even point if costs are forecast
100 Variable
90 to rise?
80 cost
would the break-even point be lower if components were
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60 Fixed bought in from outside suppliers rather than being made
50 cost in-house?
40 Loss
30 Break-even analysis is also found in business plans. Banks often
20 ask for business plans when deciding whether or not to give
10 a loan. So break-even analysis can be vital in gaining finance,
0
0 100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600
especially when starting up a business.

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(Benches)
Margin of safety
What if a business is producing more than the break-even
output? It might be useful to know by how much sales could fall
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before a loss is made. This is called the MARGIN OF SAFETY. It
refers to the range of output over which a profit can be made.
The margin of safety can be identified on the break-even chart
by measuring the distance between the break-even level of
output and the current (profitable) level output. For example,
Figure 2 shows the break-even chart for Jack Cadwallader. If Jack
produces 1,200 benches the margin of safety is 200 benches.
This means that output can fall by 200 before a loss is made. If
Jack sells 1,200 benches the chart shows that total revenue is
120,000, total cost is 108,000 and profit is 12,000.
Businesses prefer to operate with a large margin of safety.
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This means that if sales drop they still might make some profit.
With a small margin of safety there is a risk that the business is
more likely to make losses if sales fall.
Figure 2
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Limitations of break-even analysis
Break-even analysis does have some limitations. It is often
regarded as too simplistic and some of its assumptions
are unrealistic.
Output and stocks It assumes that all output is sold, so that
output equals sales, and no stocks are held. Many businesses
hold stocks of finished goods to cope with changes in demand.
There are also times when firms cannot sell what they produce
and choose to stockpile their output to avoid laying off staff.
Unchanging conditions The break-even chart is drawn for a
given set of conditions. It cannot cope with a sudden increase in
wages and prices or changes in technology.
Accuracy of data The effectiveness of break-even analysis
depends on the quality and accuracy of the data used to
construct cost and revenue functions. If the data is poor and
inaccurate, the conclusions drawn on the basis of the data are
flawed. For example, if fixed costs are underestimated, the level
of output required to break-even will be higher than suggested

Break-even chart showing the margin of safety for Jack by the break-even chart.
Cadwalladers business
Cost, revenue, profit (000) Non-linear relationships It is assumed that the total revenue
180 and total cost lines are linear or straight. This may not always be
170
160 Total the case. For example, a business may have to offer discounts
150 revenue on large orders, so total revenues fall at high outputs. In this
140
130 Total case the total revenue line would rise and then fall, and be
120 cost
110 curved. A business can lower costs by buying in bulk. So costs
100 may fall at high outputs and the costs function will be curved.
90
80
70 Multi-product businesses Many businesses produce more
60 Margin
of
50
safety than one single product. It is likely that each product will have
40
30 different variable costs and different prices. The problem is
20 how to allocate the fixed costs of the multi-product business to
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0 each individual product. There is a number of ways, but none is
0 100 200 300 400 500 600 700 800 900 1,000 1,100 1,200 1,300 1,400 1,500 1,600 perfect. Therefore, if the fixed costs incurred by each product is
(Benches)
inaccurate, break-even analysis is less useful.

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 Managing
Marketing
business
and
activities
people

Stepped fixed costs Some fixed costs are stepped. For
example, a manufacturer, in order to increase output, may
need to acquire more capacity. This may result in rent
increases and thus fixed costs will rise sharply. Under these
circumstances it is difficult to use break-even analysis.
Maths tip
The break-even chart can be used to work out the price
charged and the variable cost per unit. For example, look at the
total revenue at the break-even level of output and divide this
by the break-even output. To calculate the variable cost you
need to look at the total cost at the break-even level of output,
subtract fixed costs and then divide the answer by the break-
even level of output.

Case study
Figure 3

GOWDA CHANDA LTD Break-even chart for Gowda Chanda Ltd

000
70
Gowda Chanda runs a plastics recycling plant. The business Total revenue
incurs quite high monthly fixed costs, which include leasing 60

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charges for premises and machinery. He also employs five staff.
Figure 3 shows a monthly break-even chart for the business in 50
Total cost
November. The planned output for the month is 1,000 tonnes
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and the margin of safety is also shown on the chart.
Unfortunately there was a machinery breakdown on 12
AF 30

Margin Of Safety
November and the monthly output was only 700 tonnes.
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Essential repairs had to be carried out which stopped
production for several days. 10

0
0 2 4 6 8 10 12 14
Tonnes 00s

(d) Explain the impact on Gowda Chanda Ltd of the machinery

(a) What is meant by the margin of safety? (2 marks) breakdown. (4 marks)
(b) Calculate the price charged for pellets per tonne. (4 marks)
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(e) Evaluate the usefulness of break-even analysis to Gowda
(c) Calculate the variable cost per tonne of pellets. (4 marks) Chanda Ltd (12 marks)

Key terms Knowledge check

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Contribution the amount of money left over after variable
costs have been subtracted from revenue. The money
contributes towards fixed costs and profit.
Break-even to make just enough to cover costs.
Break-even output the output a business needs to
produce so that its total revenue and total costs are the
same
Break-even chart a graph containing the total cost and
total revenue lines, illustrating the break-even output.
Break-even point the point at which total revenue and
total costs are the same.
Margin of safety the range of output between the break-
even level and the current level of output, over which a profit
is made.
1. A product sells for 10 and the variable costs are 8.50.
What is the contribution per unit?
2. A clothes retailer buys 240 jumpers for 27. The jumpers are
sold for 39 each. What is the total contribution made by the
jumpers?
3. If total contribution is 120,000 and fixed costs are 96,000,
what is the profit?
4. If total variable costs are 450,000 and contribution is
225,000, what is the total revenue?
5. How can the contribution be used to calculate the break-even
level of output?
6. How can the break-even level of output calculation be checked?
7. What effect will a price increase have on the margin of safety?
8. What effect will a fall in fixed costs have on the margin of safety?
9. State three uses of break-even analysis.
10. State three limitations of break-even analysis.

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