Break-even
From WikiTextbook
A business can only make a profit if the revenue from sales is greater than the cost of supplying the goods or service. Break-even is the point at which total revenue equals total costs. At levels of output below the break-even point the business will be making a loss. At levels of output above the break-even point the business will be making a profit. It is therefore very important that the business knows the amount of goods or services it has to produce in order to break-even.
The break-even point shows the business the minimum level of sales needed to make a profit. We can see the break-even point is where the total revenue line crosses the total costs line. Total revenue and costs are calculated as follows:
- Total Revenue = the total amount of money that the business receives from the sales of its goods or services. It is calculated using the following formula: number of goods sold x average selling price;
- Total Costs = Fixed Costs + Variable Costs.
At levels of output up to the break-even point the business will be making a loss and at higher levels of output the business will receive a profit. At the break-even point the business will be neither making nor losing money. The difference between the break-even and present output is known as the margin of safety, in other words the quantity sold can fall by that amount before the business will start to lose money.
Calculating break-even output is a relatively simple task, it equals:
Fixed costs รท (Selling price per unit minus Variable cost per unit)
Advantages and Disadvantages of Break-Even Analysis
Break-even is an excellent method of analysing a business. Its advantages are:
- It is cheap to carry out and it can show the profits/losses at varying levels of output.
- Due to its simplicity a new business will often have to present a break-even analysis to its bank in order to get a loan.
A break-even analysis can have some disadvantages:
- It assumes that everything produced is sold; often not all output will be sold.
- It assumes that all of the output is sold at the same price, often a business will have to lower its price in order to increase its sales.
Shifts in the Break-Even Point
There are a number of reasons that can lead to the break-even point shifting. We can split these reasons into internal and external factors. Internal factors are things the business can control and external factors are things that the business has no control over.
Internal factors (things businesses can control)
If the business moves to new offices that charge higher rent, it will increase the fixed costs and therefore the totals costs. When the total costs line shift upwards the break-even point will increase.
If the business increases it prices it will receive a higher revenue for each unit of output. This will shift the total revenue upwards and lower the break-even point.
External factors (things businesses can not control)
If a recession occurred the break-even point would be unaffected as the costs and revenue would stay the same. It is likely though that the level of demand would fall and this would reduce the margin of safety.
If a price war broke out the business would have to lower its prices. This would lead to the revenue being lower at each level of output. This would cause the break-even point to rise.
