BREAK-EVEN ANALYSIS O. M. Break-even-at the level of output where total costs equal total revenue. CONTRIBUTION Unit contribution=price – average variable costs Any product that makes a positive contribution will help towards paying some of the fixed costs of the b. Contribution analysis suggests ways in which profits can be improved: -increase sales revenue, e. g. by using appropriate marketing strategies to attract more customer -reduce variable costs, e. g. by seeking cheaper production methods -reduce fixed costs
O. M BREAK-EVEN ANALYSIS Suppose that a jeans retailer has fixed costs of 2500 per month and that each pair of jeans sells for an average of 30. Variable costs are known to be 10 per pair of jeans. There are different ways to determine break-even point 1. Using the TC=TR rule Px. Q=TFC+TVC 30 x. Q=2, 500+10 Q 20 Q=2, 500 Q=125 units 2. Using the Unit Contribution rule: Break-even=Fixed Costs/Unit Contribution=P- AVC=30 -10=20 The break-even=2, 500/20=125 pairs of jeans This shows that the b. needs to sell 125 pairs of jeans each month in order for it to breakeven. Any sales beyond the break-even level of output will generate a surplus(or profits)wheras levels of sales below the break-even point mean that the firm will make a loss for that month
O. M. THE MARGIN OF SAFETY Measures the difference between a firm’s current sales quantity and the quantity needed to break-even, i. e. it shows how much demand exceeds the break-even quantity. The larger the positive difference between a firm’s sales output and its BEQ, the safer the firm will be in terms of earning profits, especially if there adverse changes in the marketplace. A positive margin of safety means that the firm makes a profit, wheras a negative m. of s. means the firm makes a loss. Safety margin=Level of demand – Break-even quantity E. g. , if the level of demand for the jeans retailer is 200 pairs per week, then the safety margin is 75 units(200 -125). This means that the b. can sell 75 pairs of jeans less than its current level and still not make a loss. Hence, the smaller the margin of safety, the more vulnerable a b. becomes to changes in the market. The margin of safety is calculated and shown on the xaxis of a break-even chart, i. e. the unit of measurement is the volume of output and not the value of that output
O. M. Break-even analysis can help firms in making certain decisions: -product portfolio management: assessing the expected BEQ prior to launch of a new product. this can help b. to manage a profitable product portfolio. however, it is important to remember that the analysis is really only useful for single-product firms -risk assessment: being able to accurately calculate a margin of safety can help a b. gauge the level of risk involved in a particular project -make-or-buy decisions: firm’s choice of whether to produce the product itself or to buy it from a supplier. -special order decisions: special orders are atypical and/or one-off orders for which a b. will charge a price that differs from the norm. For example, the demands placed on the firm by the customer are likely to raise their costs of production. Break-even analysis can help to assess whether the change in profits justifies taking on the offer
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