Fixed costs are expenses that do not change in response to changing demand or output. Fixed costs have to be paid whether or not the business is trading; examples include rent, business rates and interest charges. On the other hand variable costs will alter as demand and output adjust. An increase in output will require greater supplies of fuel and labour, for example, and the costs of these items will rise. A doubling in demand will double variable costs.
The break-even output level can be calculated by the formula:
Break-even output = Fixed costs / (selling price per unit – variable cost per unit)
A break-even chart is a graph showing a business’s revenues and costs at all possible levels of demand or output.
The break-even chart is constructed on a graph by first drawing the horizontal axis to represent the output of goods or services for the business in question. The vertical axis should represent costs and sales values in pounds. The horizontal axis shows output per time period – usually output per month of year. A break-even chart looks like this:
The Value of Break-Even Analysis
Break-even analysis is simple to understand, and useful particularly for small and newly established businesses, where the managers may not be able to employ more sophisticated techniques. Businesses can use break-even to:
- estimate the future level of output they will need to produce and sell in order to meet given objectives in terms of profit.
- assess the impact of planned price changes upon profit, and the level of output needed to break even.
- assess how changes in fixed and/or variable costs may affect profits, and the level of output necessary to break even.
- take decisions on whether to produce their own products or components, or whether to purchase from external sources.
- support applications for loans from banks and other financial institutions – the use of the technique may indicate good business sense as well as provide a forecast of profitability.
- The model assumes that costs increase constantly and that firms do not benefit from bulk buying. If, for example a firm negotiates lower prices for purchasing larger quantities of raw materials then its total costs line will no longer be straight. It will in fact level out at higher outputs.
- Similarly, break-even analysis assumes the firm sells all its output at a single price when in reality, firms frequently offer discounts for bulk/wholesale purchases.
- A big flaw in the technique is that it assumes that all output is sold. This may well not be true and, if so, would result in an accurate break-even estimate. In times of low demand, a firm may have difficulty in selling all that it produces.
- Break-even analysis is only as good as the data on which it is based: poor-quality data can result in inaccurate conclusions being drawn.
Variable costs – the costs which vary directly with the level of output. They represent payments made for the use of inputs such as raw materials, packaging and piece-rate labour.
Margin of safety – the amount by which current output exceeds the level of output necessary to break-even.
Fixed costs – any costs which do not vary directly with the level of output such as rents and interest rates.
Contribution – total revenue – variable costs. The calculation of contribution is useful for businesses which are responsible for a range of products.
Break-even chart – a line graph showing total revenue and total costs at all possible levels of output or demand from zero to maximum capacity.