BREAK-EVEN ANALYSIS

tool used for decision making

shows effect of changes in costs or volumes on profits

shows impact of operating leverage

also called Break-Even Analysis or Cost-Volume-Profit Analysis or CVP Analysis

Vocabulary

fixed costs : costs that remain constant regardless of number of units produced

variable costs: unit production costs of product

total variable cost: function of volume and unit variable cost

total cost: total fixed costs plus total variable cost

profit: difference between total revenue and total cost

Assumptions of Break-Even Analysis:

1. one product is involved

2. everything produced can be sold

3. variable cost per unit is the same regardless of volume

4. fixed costs do not change with volume

5. revenue per unit is constant with volume

6. revenue per unit exceeds variable cost per unit

Contribution margin:

total contribution margin: the total sales revenue minus total variable costs

unit contribution margin: the difference between sales price and variable cost per unit

The Model

P= SPx – VCx – FC

=CMx – FC

where

P= profit

SP= unit selling price

VC= unit variable cost

FC= total fixed costs

x= sales volume in units

CM= unit contribution margin=unit SP – unit VC

Example

sales= 10 000 units

selling price 20 per unit

variable cost 7 per unit

fixed costs 124 800

Sales (10 000 units) | 200 000 |

-variable costs | 70 000 |

CM | 130 000 |

-fixed costs | 124 800 |

Profit | 5200 |

The Break-Even Point (BE): Fixed expenses/unit contribution margin

P=(SP-VC)x-FC

0=(20-7)x-124800

x=9600 uninits

Target sales volume: Fixed expenses + Target profit/unit contribution margin

=FC + Desired profit/CM= 10667 units

Margin of Safety

Difference between the budgeted sales revenue (or units) and the break-even sales revenue (or units)

e.g 10000 units sold

BE = 9600 units

margin safety is 400 units or 400/10000= 4% margin of safety or

5200/130 000= 4 % margin of safety

CVP Graph

shows how costs, revenues and profits change as sales volume changes

CVP Analysis with multiple Products

weighted average unit contribution margin

BE = Fixed expenses/Weighted average unit contribution margin

Break-Even Analysis: Possible Uses

Sensitivity Analysis

Goal Seeking Approaches

What-If Analysis

Operating Leverage

The extent to which an organization uses fixed costs in its cost structure.

Measuring operating leverage:

contribution margin/profit before tax