Break-even

Dragon Shirts

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 Break-Even Analysis

Central Questions

• What is break-even?

• When would you user break-even?

• What financial information do you need to calculate break-even?

• How do you calculate total revenue?

Introduction

Break-even analysis is a technique widely used by production management

and management accountants. It is based on categorising production costs
between those which are "variable" (costs that change when the production
output changes) and those that are "fixed" (costs not directly related to the
volume of production).

Total variable and fixed costs are compared with sales revenue in order to
determine the level of sales volume, sales value or production at which the
business makes neither a profit nor a loss (the "break-even point").

Fixed costs are ……………………………………………………………………….

…………………………………………………………………………………………..

Variable costs are …………………………………………………………………….

…………………………………………………………………………………………..

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Listed below are certain costs which a business may face. Label them as
either Fixed Costs (FC) or Variable Costs (VC).

Packaging Insurance

Rent Delivery costs

Raw materials Rates

Salaries Accountancy costs

Commissions

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In an exam you may be asked to calculate the break-even point for a firm.
Marks will be awarded for accuracy and presentation

Remember the following points:

You must ensure that you take a sharp pencil and a ruler into the exam.
Scruffy diagrams will lose marks.

Take care when you plot your points on the break-even diagram. A small error
made when plotting points can lead to a big error when calculating the break-
even point.

Take your time when producing a break-even diagram. This type of task is
usually worth a significant number of marks.

Make sure that axes and lines are correctly labelled – don’t and you will lose
marks.

When drawing your axes always use the largest scale possible. A small scale
tends to amplify errors.

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A worked example.

Dragon Shirts Ltd, based in Bridgend manufactures men’s shirts. It has a

factory which has a maximum output of 70,000 shirts a year. The
management accountant has provided the following information so that the
break-even level of output can be pinpointed:

Selling price per shirt £20

Variable cost per shirt £10

Total fixed cost per year £400,000

Step 1
Choose an appropriate scale for your diagram.

i. Plot the quantity of shirts sold on the X axis. The maximum number of
shirts which could be sold is 70,000.

ii. Plot the revenue and costs on the Y axis. The maximum revenue is
£20 x 70,000 units = ?

Step 2
Draw the fixed cost line on the graph

This line will be horizontal and straight as fixed costs are set at £400,000
regardless of the level of output.

Step 3

Add the total cost line to the graph

Total costs are fixed costs plus variable costs. The output of 0 shirts has an
actual cost of £400,000 (£400,000 fixed costs + £0 variable costs). One shirt
produced will have a total cost of £400,010 (£400,000 fixed cost + £10
variable cost of producing one shirt).

An output of 70,000 shirts (the maximum capacity) will cost £1,100,000

(£400,000 fixed cost + (£10x 70,000 shirts) ).

Step 4

Add the total revenue curve to the graph

The total revenue for one shirt is £20, two shirts £40 and for 70,000 shirts it is
£1,400,000 (70,000 shirts x £20 selling price per shirt).

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Step 5

Identify the break-even point (BEP) on the graph

The BEP is the level of output/sales when total revenue equals total cost.
Remember: it is the point of output when neither a profit nor a loss is made.
It tells the business how many shirts it must make before it will begin to earn
itself a profit. In the case of Dragon Shirts the BEP is …………….shirts

Step 5

Identify the margin of safety on the graph

Margin of safety = Current level of output – BEP level of sales

The margin of safety is the gap between the number of shirt being produced
and the number needed to break-even Dragon Shirts margin of safety is

…………….. shirts.

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Summary

The graphical method has several benefits:

It shows output decisions clearly and simply

Managers can use the technique to see the effect of variations in costs,
revenues and the volume of goods produced

It can be used to explain to workers why production targets must be met. It

can be used to motivate people to achieve targets as well as highlighting the
consequences of failing to meet targets.

It can also be used to answer ‘What if’ questions.

The following You Tube link provides a four minute summary of break-
even with a worked example:

http://www.youtube.com/watch?v=TLOo2mY6FIw

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Limitations of break-even

It assumes that a firm only produces one product at one price

It assumes cost and revenue lines are straight. In the ‘real world’ this is
seldom the case.

Calculating break-even point.

This is a quick method. It is also a more accurate way of analysing break-

even.

Break-even occurs when fixed costs are covered by the revenue from units
made or sold. This depends on how much is made on each unit made or sold.

Selling price per shirt £20

less Variable cost per shirt £ 10
= Contribution £ 10
Contribution is the difference between selling price and variable cost. Each
shirt produced/ sold contributes £10 towards paying the fixed costs of the
business. Once fixed costs are covered, then the business has reached
break-even point.

Therefore:

Total Fixed costs = Break-even point

Contribution per unit

£400,000 = 40,000 shirts

£10

If you have to draw a break-even diagram in the exam, using the contribution
method can reduce the potential for mistakes and ensure that the diagram is
drawn accurately

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Task 1

Dragon Shirts decides to reduce its selling price and use cheaper materials.

Selling price per shirt £15

less Variable cost per shirt £7
= Contribution £?

Each shirt produced/ sold contributes £…… towards paying the fixed costs of
the business.

Its fixed costs have also increased. The fixed costs of Dragon Shirts have
increased to £440,000.

Therefore:

Total Fixed costs = Break-even point

Contribution per unit

______________ = ……………. Shirts

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Task 2

Assume:

Fixed costs are £500,000

The variable cost per unit amounts to £1

The selling price is £5 per unit

Planned output is 200,000 units per year.

Calculate the:

o Break-even output

o Margin of safety

o Profits at planned output

Task 3

Ortho-beds Ltd produces a bed which is specially designed to give people

with bad backs a comfortable night’s sleep. The beds retail for £420. Variable
costs are £270 and fixed costs £150,000. How many beds do they need to
produce in order to break-even? The total market for this type of bed is 30,000
beds per year. If Ortho-beds gains 10% of the market, how much profit might
it expect to make?

Task 4

Pembridge Chocolates makes handmade chocolates which it sells in a

selection box priced at £6.50. The variables costs are £4.10. Fixed costs of
the workshop unit it rents are £3,600. The company produces 2000 boxes a
month. How much profit does it make?

Pembridge believes that cocoa prices are likely to rise sharply in the next six
months. It estimates that variable costs may rise by £0.40. How will this affect
the break-even point and profits?

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Task 5
Sgt. Pepper’s Lonely Heart Club Band
The album cover of Sgt. Pepper’s Lonely Heart Club Band was the
inspiration for Jane Griffiths. As part of her catering course she
designed a celebration cake which reproduced the classic album
cover. The distinctive feature was that a picture of the birthday boy
or girl was inserted into the crowd. By inserting a small chip similar
to ones used in birthday cards in the cake base, music could be
added. The cake proved an instant success. Jane found herself
with orders for dozens of cakes. Before long she had produced
designs for other cakes reproducing classic album covers. Even
before she finished her catering course, she was in business.

A local bakery allowed Jane to use their equipment in the

evenings. Working part-time after college, Jane was able to
produce 240 cakes a month. The selling price was set at £24. The
cost of materials was £14 for each cake. Overheads were £400
per month.

Questions

1. What is the contribution towards the fixed overheads made

by each cake?

2. Calculate the number of cakes which need to be sold each

month in order to break even (no profit, no loss)?

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Task 6

Carwyn Coats Ltd

Carwyn Coats Ltd manufacture waxed jackets in a small factory on the

outskirts of Cardiff. Their sole customer is a major UK chain store, which
purchases 1,000 jackets each month. The factory’s capacity is 1,250 per
month. The company charges the chain store £80 per jacket.

Fixed costs per month are: The manufacture of each

jacket costs
rent £4, 800 materials £24.00
rates £3, 600 labour £26.00
salaries £9 ,600
Total
Total

Questions:

1 Construct a break-even chart from the data given.

2.a) What is the present level of profit per month?

b) What is the break-even output?
c) What is the margin of safety at the present level of output?

3. Carwyn Coats’ management is anxious to make use of excess capacity,

which represents unnecessary fixed costs. The board decide to accept the
offer of a twenty per cent increase in order size, in return for a reduction in
selling price from £80 to £76 per jacket. Evaluate this decision with reference
to your break-even calculations.

4. Another major retailer will purchase 600

jackets per month on a regular basis at this new
price of £76. The firm has the opportunity to
rent additional factory space, and for an
increase in fixed costs to £36 000 per month,
capacity can be doubled to 2 500 jackets a
month. Assess the advantages and
disadvantages of this proposal, and
recommend a decision.

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