CHAPTER 6

BREAK-EVEN ANALYSIS
1. Break-even analysis
One of the most common new years resolutions is to lose weight. Let’s say you have a
goal to lose 14 lbs, so you start by eating more healthily and exercising more. If you
burn more calories than you intake you lose weight and it goes towards your goal of
losing a stone. If you burn fewer calories than you intake you will gain weight and this
will take you further away from your goal. If you burn exactly the same amount of
calories as you intake you will neither gain nor lose weight, your weight will be in
stasis and you will neither be any closer or any further away from your goal.

So how does this relate to break-even analysis? Breaking even is when your costs
and revenues are equal, you are neither making a profit nor a loss. You could
argue that this is neither good nor bad. However, just as with the losing weight
example it is not moving you any closer to your goal.

Cost-volume-profit (CVP analysis)

This is a term used interchangeably with Break-even analysis and is arguably more
accurate. This is because the aim of break-even and CVP analysis tends to be to
uncover the effect of changes in cost and volume on future profit.

Under these umbrella terms we have various calculations and charts:

• Break-even point

• Margin of safety

• C/S ratio

• Break-even chart

• Profit/Volume chart
 Break-even analysis

Each of these areas will be looked at in the following chapter.

Now, a quick bit of revision before we start this next section.

Variable costs are the costs that vary with the level of activity. If we take the sales
value of a product and deduct its variable cost, we get the contribution.

Contribution = Sales value – Variable cost

It follows then, that contribution is the proportion of revenue per unit sold that
'contributes' towards fixed costs and profit.

So, imagine we are considering making a new product, which requires an initial
investment in machinery of £10,000 and has a contribution of £10 per unit sold. One
key question that the directors will ask is how many units will we need to sell, in
order to cover the investment?

In this case it’s 1,000 units (£10 x 1,000 = £10,000). This figure is known as the
break-even point, and is key for decision making, as the marketing team can
now assess likely demand to decide how much risk is being taken in producing
this product.

Formally, we define this as break-even analysis which is the study and

identification of the factors contributing to the break-even point (the point
where the level of cost and revenue matches), meaning that the company is not
making a loss or a profit.

The break-even point

Most (if not all!) business will need to, at the very least, break-even if they are to be
sustainable enterprises for the future. The break-even point is a simple calculation
that involves the fixed cost, variable cost and the selling price. The break-even point
is calculated by dividing the fixed cost by the contribution per unit (the selling
price minus the variable cost).

F
B =
P-V

B = Break-even point

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F = Fixed costs

P = Selling price

V = Variable cost

For example, a company has a product that has fixed costs of £30,000 and has
variable costs of £30 per unit. The company sells its products for £60. So the question
is: how many products will they need to sell to break-even?

To start with you need to calculate the contribution per unit, which is the
proportion of revenue per unit sold that 'contributes' towards fixed costs and
profit.

£60 – £30 = £30

Then divide the fixed costs by this number to get the break-even point:

£30,000
= 1,000
£30

Therefore the company will need to sell 1,000 units to cover its costs and break-even!

Margin of safety
The margin of safety is the difference between the number of units you predict
to sell and the number of units required to match your break-even point.

If, for example, you expect to sell 100 units and the break-even point is 80 units, then
the margin of safety is 20 units. This is called the margin of safety because it
details by how much you can afford to under-perform before you begin making
a loss. This figure is useful because a low margin of safety may identify a risk and
discovery of this will allow you to take appropriate action.

M = Ps – B

M = Margin of safety

Ps = Predicted sales

B = Break-even point

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This margin of safety can also be expressed as a percentage of sales, simply by

dividing the margin of safety by predicted sales:

Margin of safety as a M
=
percentage of predicted sales Ps

So, returning to our break-even example, let us assume that the company has
predicted to sell 2,000 units. We already know that their break-even point is 1,000
units, so by applying the above formula we can clearly see that their margin of safety
is 1,000 units or using the percentage formula:

1,000
= 50%
2,000

Essentially these figures mean that the company can suffer up to a 50% decline on
predicted sales before they suffer a loss, which is quite nice to know when going
down an uncertain path!

Contribution to sales
The contribution to sales ratio (C/S) illustrates how much contribution a product
generates for every pound or dollar of sales revenue generated.

The contribution to sales ratio is calculated by dividing the contribution price per
unit by the sales price per unit. Alternatively it can be calculated by dividing the
total contribution by total revenue. A product with a high contribution to sales
percentage will reach its break-even point quickly and once surpassed, will generate
profits at pace.

P-V
C/S =
P

C/S = Contribution to sales

P = Selling price

V = Variable cost

Returning once again to our previous example, we know the following information:

P = £60

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V = £30

So, the contribution to sales ratio is:

60 - 30
= 0.5 or 50%
60

Now that we have established that the C/S ratio is 50%, we can calculate the break-
even point in revenue by dividing fixed costs by the C/S ratio:

Fixed costs
Break-even revenue =
C/S ratio

So, if we input our figures into this formula then we get:

30,000
Break-even revenue = = £60,000
0.5

Note: that we now have two methods of working out the break-even revenue, as we
could have just taken the break-even point of 1,000 units calculated earlier and
multiplied it by the selling price of each unit, which was £60. Either is fine to use,
although it may well depend on what you are asked.

2. Break-even in action
The real business world is often faced with uncertainties. So far we’ve made
assumptions that the prices and costs are constant, but in the real world we face
competition and our prices are unlikely to remain the same as we change prices to
compete. Additionally, our suppliers are also in a competitive market and face their
own challenges, meaning our costs are unlikely to be always constant.

A common question might be something like: how much would prices have to fall by
before we start to make a loss?

Let’s work through an example:

Company X makes product Y and here are the relevant figures:

Selling price per unit = £10

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Variable cost per unit = £5

Fixed costs = £100,000

Forecast sales = 25,000 units

They want to know two things:

• By how much can fixed costs increase before they will be unable to break-
even?

• What would a 20% increase in price do to the margin of safety?

Question 1: fixed cost increase

To answer this question we must first work out our total revenue and variable costs.
We know the most they can sell is 25,000 units, the forecast sales, so their maximum
revenue is £250,000 (25,000 x £10).

The total variable cost is £5 x 25,000 which gives us £125,000. Add this to our fixed
costs and we get £225,000 (£125,000 + £100,000). This means that costs can only
increase by £25,000 before the company no longer makes a profit.

Alternatively, we can calculate this using the contribution. We take the selling price
and subtract the variable cost, which gives us the contribution, which we then
multiply by our sales. In our example, we would see that £10 - £5 = £5, and £5 x
25,000 = £125,000.

If we then deduct the fixed costs,(£125,000 - £100,000), this also gives us £25,000.
This £25,000 is the contribution being provided by these units above the value of the
fixed costs, and therefore represents the amount by which fixed costs could rise
before the company no longer makes a profit at this output level.

We can now calculate this figure as a percentage of our fixed costs:

£25,000
= 25%
£100,000

So there you have it, fixed costs would need to increase by at least 25% before they
inhibit the company’s ability to meet their break-even point.

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Question 2: 20% increase in price

Step 1: Margin of safety
The first step here is to calculate the current margin of safety, once again using the
method you learned earlier. So, first of all we need to calculate the break-even point,
by dividing the fixed costs by the contribution per unit:

£100,000
= 20,000 units
(£10 - £5)

Next we deduct the number of units required to break-even, from the predicted sales
volume:

25,000 – 20,000 = 5,000 units Margin of safety

Step 2: Calculate the change

Now we can take a look at what a 20% increase in the selling price would do to this.
At £10 a 20% increase would take the sales price of product Y to £12 per unit, which
is an increase of £2.

This £2 in turn boosts the contribution per unit to £7, giving us a revised break-even
point of:

£100,000
= 14,286 units
(£12 - £5)

And a revised margin of safety:

25,000 – 14,286 = 10,714 units

Step 3: Compare the before and after figures

Finally, the two margins of error can be compared to give us the increase or decrease:

10,714
= 2.143 = 214.3%
5,000

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As you can see, a 20% increase in the sales price (assuming all other variables remain
constant) will actually grant an enormous increase in company X’s margin of safety!

However, please note that an assumption has been made here that the level of
demand stays the same despite the increase in price. In the real world this is very
unlikely to be the case. In order to calculate an accurate margin of safety, the
company would need to take into account any potential resultant change in demand
alongside the change in price.

3. Drawing a break-even chart

The break-even information can be shown graphically in what is known as a break-

even chart. We will use the same figures that we have used for the above examples
for simplicity, when making our chart in the pages to follow.

Fixed costs = £20,000

Variable costs per unit = £35

Selling price per unit = £60

Predicted sales volume = 1,200

Break-even sales volume = 800

Step 1:
You need to draw your axis, with units on the X axis and values on the Y axis.

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Step 2: Add your fixed costs.

We know these to be £20,000 so we add a straight line across the graph from
£20,000, like so:

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Step 3:
We now need to add the variable costs. These will be represented by a diagonal
line, because unlike fixed costs they will increase as production increases. Usually the
variable costs start at (0, 0). The unit number needs to go on the X axis and the cost
on the Y axis, so if a unit costs £5 to produce this is plotted as (1,5) and then (2,10)
and so on.

Afterwards plot a parallel line (identical to the variable costs line and gradient)
beginning where the fixed costs intercept the Y axis and call this the Total
Costs, as it is the variable costs and the fixed costs put together:

Step 4: Add the predicted sales.

Adding the predicated sales is the final step. Like the variable and total costs, the
predicted sales will be dependent on sales volume. The unit number needs to go on
the X axis and the price (per unit) on the Y axis. Therefore, if a unit sells for £10 we
produce this line by plotting it as (1,10) and then (2,20) and so on. This will be
represented by a diagonal line:

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Now that the graph is complete we can now identify some of the elements and ratios
which we discussed earlier in the chapter:

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4. Multi-product break-even analysis

Suppose for example that, like most companies, our company sells a variety of
products and we want to perform a break-even analysis. It currently doesn’t look like
this will be worth us doing, because the break-even analysis, while being simple and
effective, can only be used to identify the break-even point of one specific product.
Therefore, if we wanted to identify the break-even point for all the products our
company offers this could actually turn into a fairly labour intensive process.

Now most of you are thinking: there must be a quicker way to do this, rather than
product by product, right?

Well you would be correct!

Thankfully there is a way for us to calculate the break-even point, even when we sell
several different products all with different costs and selling prices. So, what we want
to do in this situation is work out what is known as the weighted average
contribution. This is an average based on all the products, which we then use to
divide the fixed costs by.

So the formula for the break-even point now looks like this:

Fixed costs
Break-even point =
Weighted av. price – Weighted av. variable costs

Example
The following simple example should hopefully help clarify this further:

Product A B C

Selling price per unit (£) 1,000 500 2,000

Variable cost per unit (£) 750 250 1,000

Predicted sales 5,000 10,000 5,000

Fixed costs (£) 500,000 500,000 500,000

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Step 1: Percentage sales

Firstly we need to work out the percentage of sales each of the three products
will provide. The company predicts 20,000 sales with 10,000 coming from product B
and 5,000 from products A and C, so:

Product A = 25%

Product B = 50%

Product C = 25%

Step 2: Weighted average contribution per unit

Next we need to work out the weighted selling price and weighted variable
costs. This is done by multiplying the selling price or variable cost, by the predicted
sales percentage. This is done for each product and then they are all added together:

Weighted average selling price = Product A + Product B + Product C

= (£1,000 x 25%) + (£500 x 50%) + (£2,000 x 25%)

= £250 + £250 + £500

= £1,000

So, our weighted average selling price is £1,000. Now that we know this we need to
calculate the weighted average variable cost:

Weighted average variable cost = Product A + Product B + Product C

= (£750 x 25%) + (£250 x 50%) + (£1,000 x 25%)

= £188 + £125 + £250

= £563

Now that we know our weighted average variable cost is £563, we can subtract this
from our weighted average selling price, to give us our weighted average
contribution per unit!

Weighted average contribution per unit = £1,000 - £563

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= £437

Step 3: Break-even point

Finally we divide the fixed costs by the contribution:

£500,000
= 1,144
£437

This shows us that the company must sell 1,144 units to break-even. We can then
delve even further into this figure, by working out how many of each product must
be sold to reach the break-even point. This is done by multiplying our break-even
point with each product's sales percentage:

Product A (1,144 × 25%) = 286

Product B (1,144 × 50%) = 572

Product C (1,144 × 25%) = 286

Step 4: Break-even revenue

These figures then enable you to calculate the sales revenue required to make your
break-even target. This is done by multiplying the product’s break-even point by
its selling price per unit:

Product A (286 × £1,000) = £286,000

Product B (572 × £500) = £286,000

Product C (286 × £2,000) = £572,000

Break-even revenue = £1,144,000

5. Profit–volume chart

Introduction
So, now we know how to calculate the number of units we need to sell to break-even.
This is great and all, but don’t most companies operate with the intention of making
profit?

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Therefore, considering most companies operate with the intention of making a profit
and not simply breaking even, it is useful to know how changes in price and volume
can affect the amount of profit a company makes.

This is where the profit-volume chart comes into play, which is a simple and clear
way to illustrate profit and loss as well as being able to identify the impact of
changes to variables such as costs and selling prices.

How?
This might sound obvious to you, but to draw a profit volume chart you first need to
work out the profit! For starters, let’s take the break-even chart we created earlier.
Now, let’s take the sales revenue and the total costs, and work out the profit at
certain points on the graph. So we can see that at 0 units our profit/loss is at minus
£20,000.

We know the break-even point to be 800, thus the line will intercept the X axis at 800
and finally we know the profit at 1,200 units to be £10,000.

Knowing this we can now plot the following points on a graph:

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(0, -20000)

(800, 0)

(1,200, 10,000)

Giving us this line:

Using the profit-volume chart

As you can see, everything above the X axis represents a profit and everything
below it represents a loss.

An advantage of using a profit volume chart is how it can be used to calculate the
effect certain inputs will have on profit/loss.

As an example let’s say that all other variables remain constant but fixed costs are
reduced to £10,000. What effect will that have on profit/the break-even point?

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As you can see, a reduction in fixed costs has boosted profit and greatly reduced the
break-even point. Clear graphical representations like this are very useful for
businesses as a decision making tool!

6. Limitations of break-even analysis

As helpful as break-even analysis can be, there are several drawbacks and limitations
to it that ultimately affect its usefulness. These limitations chiefly revolve around
assumptions made about production and costs, here are a few them:

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Limitations
Break-even analysis assumes that a company either
makes only one product (single break-even chart) or
Product range sells several in a consistent ratio (multi-product). i.e. for
every 1 product A sold, 2 products B are sold. In reality it
is highly unlikely that sales would be this predictable.
The break-even chart assumes that fixed costs will
always remain the same regardless of activity (they
can be adjusted but the graph becomes messy if you do)
Assumptions over cost and that the variable cost per unit remains consistent
at any level of production, which will not always be the
case. In the real world suppliers tend to change their
prices regularly.
In reality the price a company sells a product for will
often change. For instance, in response to competitor
price changes or in a bid to increase profits.
Assumptions over price Consequently, the demand and profitability of a product
is always moving up and down. However, the break-even
chart assumes a constant and consistent price and
demand, which is relativistic!
The break-even chart assumes that production and
activity are the only factors that affect the cost and
External influences and ignore external factors like interest rates and inflation.
accounting practices Likewise it also fails to take into account that costs can
be affected by accounting practices such as activity
based costing or absorption costing.

So, now that you have learnt the limitations of break-even and CVP analysis you
might be thinking that they are a little bit pointless. In very fast changing industries,
this may very well be the case, but in industries where change is slow, competition is
limited and prices are consistent, then they can actually be very useful. They can both
also be useful for short term decision making in fast changing industries.

7. Limiting factor analysis

As the name would suggest, these are factors that ultimately limit the amount of
produce that can be made by a company within a certain period. For example, if you
wanted to make and sell 20,000 products a month but your machine capacity is

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currently 15,000 products, then in this instance, machine capacity is a ‘limiting factor’
in production.

Single limiting factor

This occurs when a company’s production is stifled and limited by a single factor.
The machine in the example above is an example of a single limiting factor. In this
case a decision then has to be made by the powers that be at the company on how
to mitigate the effects of this limitation by using it in the most efficient way.

Another great example of this would be raw materials; if a supplier can only grant
you a finite amount of material and that material is used in all the different
products you produce, you must figure out the most efficient and profit maximising
use for it. This is particularly relevant as this is often the example chosen to be tested
in exam questions.

For example a company produces products A, B and C and relies on a supplier to

provide materials X and Y to produce them. However, the supplier can only provide a
finite amount of X and Y. With the exception of external demand, the rest of the
company’s production is uninhibited by any other factors so this restriction on
supply is the ‘single limiting factor’.

The supplier can provide 2,000 tonnes of both products X and Y. Usage of this
material in each product can be seen below:

A B C

Quantity required X (Tonnes per

unit) 1 2 3

Quantity required Y (Tonnes per

unit) 6 5 4

Sales demand (Max.) 150 100 200

Contribution per unit £ 75 100 60

Step 1
See whether or not the amount of X and Y that can be obtained will be sufficient; it
could be that there is enough of one material for one period but not enough of the
other.

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A B C Total

Sales demand (Max.) 150 100 200

Material X per unit 1 2 3

Total material X 150 200 600 950

Material Y per unit 6 5 4

Total material Y 900 500 800 2,200

As you can see, there is more than enough of material X to fulfil the period’s
production but not enough of material Y. So the question now is where you
allocate the limited quantity of material Y in order to get the most efficient return?

Step 2
The next step is to take a look at the contribution per unit and contrast it against the
amount of material required for each product:

A B C

Contribution per unit £ 75 100 60

Quantity required Y (Tonnes) 6 5 4

Contribution per tonne £ 12.5 20 15

Now the contribution per tonne has been calculated we can rank the products by
their rate of return by usage of material Y, in this example from highest to lowest
would be B, C, A. Note what we’re doing here – we’re saying that per tonnes of this
limited material, on what do we get the best return.

Step 3: With this knowledge we can then allocate material Y accordingly, ensuring
that the maximum number of product B is produced before allocating any of our
material Y stock to product C and so on, ensuring the best possible return from the
limited amount of raw material:

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Product Recommended production (Units) Material Y used (Tonnes)

B 100 500

C 200 800

116 (700 ÷ 6)
A (Note the 700 is what is left after B and C 700
are completed)

Total 2,000

With material Y priority being given in accordance with contribution per tonne, the
company can make the best use out of its limiting factor.

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