Session 7

Accounting - 1

Accounting – Break even point, etc.

Definitions
 Break-even point is that point of activity (measured as sales volume)
where total sales and total costs are equal (neither profit nor loss).
 Margin of safety is the difference between the break-even sales and the
normal level of sales.
 Operating Leverage measure a company’s fixed costs as a percentage of
its total costs. It is used to evaluate the breakeven point of a business, as
well as the likely profit levels on individual sales.
 Sunk Fixed Costs are payable whether the organisation is open or closed,
e.g. rent or security.
 Avoidable or out-of-pocket fixed costs are saved during short-term
periods of closure, e.g. lightning and heating

Concepts
Break-Even Point (BEP) and Margin of safety
 Break-even point (unit) = Fixed cost / Contribution per unit
o With target profit = (Fixed costs + Target profit)
 Breakeven point (revenue) = Fixed costs /( Contribution /Sales ratio)
o With target profit = (Fixed costs + Target profit)
 Percentage margin of safety
o (Expected sales less break-even sales) / Expected Sales
 Session 7
Accounting - 2

Operating Leverage
 High operating leverage
o Large proportion of company´s costs are fixed costs
o Earns large profit on each incremental scale
o Must attain sufficient sales volume to cover its substantial fixed
costs.
o After covering fixed costs, company can earn a major profit on
sales
 Low operation leverage
o Large proportion of the company’s sales are variable costs
 Only incurs if there is a sales
o Firm earns a small profit on each incremental sale
o Does not have to generate much sales volume in order to cover its
lower fixed costs
o Earn a profit at low sales levels but does not earn outsized profit
when generating additional sales.
 In practice
o A small percentage change in sales can result in a dramatic
increase (or decrease) in profits.
o Careful when forecasting its revenues in these situations: a small
forecasting error translates into much larger errors In both net
income and cash flows.
`Limiting factor´ situations
 Breakeven analysis is used for short-term decision-making. It does have
limitations and any solution must be interpreted with care!
o Linearity assumption (Cost and revenue)
 Change in price?
o All costs may be split into fixed and variable elements
 Semi-Variable costs?
o Fixed costs are constant
 Long-Term?
o Variable cost per unit is constant
 New production strategy?
o Selling price per unit is constant
 Changing demand/competitors
o Production = sales (no stock)
 Work-in-progress and build-up
 Session 7
Accounting - 3

o Single product or mix.

The Decision Rule (Short-Term Analysis)
 Under circumstances of short-term closure, it is only worth opening if the
avoidable costs are covered.
o Only works in the short-term as in the long-run there will be a loss.
 Short-term contribution maximisation may mean
o Reduction in product range
o Loss of customer goodwill
o Loss of valued/large customers
o Reduction in quality/service
 But, also take into consideration the qualitative factors
o Only on quantitative factors can be wrong
o Consider the social and environmental costs
o