of the Faculty of Business Administration,
the requirements for the successful completion of
“Break-even point.” That’s the magic number that tells you when your revenue will cover your expenses, which is being used by experts for over 25 years. Although entrepreneurs often fail to realize the significance of recognizing and reaching the break-even point in the financial cycle, understanding what it takes to break even is critical to making any business profitable (Thompson, 1 and 4).
Break even directly relates to marketing because marketing managers are accountable for the impact of their actions on profits. Therefore, a working knowledge of basic accounting and finance is important to make decisions among various alternatives (Kerin and Peterson, 33). Several decisions are aided by this technique of analysis, such as those related to pricing and machinery or equipment purchasing, etc. because costs are incurred by all the activities that a business undertakes (Amos, 1)
Therefore, in business planning one might ask questions, such as, ‘How much do I have to sell to reach my profit goal?’, ‘How will a change in my costs affect my income?’ or ‘What prices should I charge to allow for a planned amount of profit?’. Hence, all these questions can be answered by the simple use of contribution analysis. As defined by Kerin and Peterson, contribution analysis is defined as ‘the difference between total sales revenue and total variable costs, or, on a per-unit basis, the difference between unit selling price and unit variable cost.
The simplest and easiest application of contribution analysis is the break-even analysis that helps access relationships among costs, prices, and volumes of products and services (Kerin and Peterson, 37). The fundamental definition of Break-even Analysis suggests that it is ‘a method of determining the relationship between total costs and total revenues at various levels of production or sales activity’ (Dubrin, 154).
The principle idea behind break-even analysis is that all costs are variable, fixed or a combination of both. Break-even point at which the firm makes no profit or sustains no loss can be computed or it can be determined from a graphical representation of the relationship between revenue, cost and volume of productive capacity (Amos, 1).
1.Fixed Costs: Fixed costs are those costs that over a given period of time, are unaffected by changes in output (Hammond, 365). For example, a factory capable of producing 100 thousand engineering parts in a certain period of time might have fixed costs in terms of rent, heating, lighting and cost of machinery of $100 thousand for that period. Furthermore, even if the factory produces 80 thousand parts, it would still have to meet the same costs – the fixed costs.
2.Variable Costs: An increase in output will tend to lead to an increase in the amount of raw materials being used, an increase in power consumed and an increase in certain types of labor. These costs are known as variable costs because they vary with output (Hammond, 365). The simplest example of variable cost assumes that the cost of raw materials, labor and power will be the same for each unit produced, regardless of the level of output.
3.Total Variable Costs: Total variable costs (TVC) are defined by ‘output in a given period of time multiplied by the costs of labor and materials directly concerned with that output (Hammond, 365).
4.Total Costs: This figure is calculated by adding the total fixed costs (TFC) and the total variable costs (TVC) (Hammond, 365).
5.Revenue: The money received by a business from the sale of goods and services produced is termed as ‘revenue’. It is calculated by multiplying the selling price of each unit by the level of output (Hammond, 365).
The basic formula for the calculation of the break-even point is as follows:
Break-Even Point = Total Fixed Cost
Price – Average Variable Cost
A break–even analysis graph represents the profit, loss, the various costs, the revenue, and the point where the firm covers all expenses, but not necessarily makes profits (Dubrin, 155).
On a recent vacation trip to Juarez, Mexico, Mr. XYZ noticed small stores and street vendors selling original art. The prices ranged from $2 to $20 (U.S). A flash of inspiration hit him and he decided to sell Mexican art back in the States using a van as his exhibition store. Every three months he would have to drive the 350 miles to Mexico and load up on art. He anticipates receiving generous large-quantity discounts.
HE would park his van on busy streets and nearby parks, wherever he could obtain a permit. Typically he would display the art outside the van, but on a rainy day people could step inside. Mr. XYZ’s intention is to operate his travelling art sale about 12 hours per week. If he could make enough money from his business, he could attend classes full-time during the day. He intends to sell the original paintings at an average of $12 a unit.
Based on preliminary analysis, he discovered that his primary fixed costs per month would be: $450 for payments on a van, $75 for gas and maintenance, $50 for insurance, and $45 for a street vendors permit. He will also be driving down to Mexico every three months at $300 per trip, resulting in a $100 per month travel cost. His variable costs would be an average of $3 per painting and 25cents for wrapping each painting in brown paper.
1.The number of paintings he would have to sell each month before he starts to make a profit:
Break Even Formula = Total Fixed Cost
Payments on a Van $ 450.00Gas and Maintenance $ 75.00Insurance $ 50.00Street Vendor’s Permit $ 45.00Travel cost $ 100.00
Total Fixed Cost Per Month $ 720.00
Costs per painting $ 3.00Wrapping Costs $ 0.25
Total Variable Cost Per Painting $ 3.25
Break Even Point = $ 720.00
$ 12.00 – $ 3.25
= $ 720.00
= 82.28571429 number of Paintings
He would have been to sell 83 paintings each month before he starts to make a profit
2.If the average cost of paintings rose to $5, the number of paintings to be sold each month if the price was still held at $12 per unit would vary. The following calculations explain how.
Payments on a Van $ 450.00Gas and Maintenance $ 75.00Insurance $ 50.00Street Vendor’s Permit $ 45.00Travel cost $ 100.00
Total Fixed Cost Per Month $ 720.00
Costs per painting $ 5.00Wrapping Costs $ 0.25
Total Variable Cost Per Painting $ 5.25
Break Even Point = $ 720.00
$ 12.00 – $ 5.25
= $ 720.00
= 106.6666667 units
If the average cost of the paintings rose to $ 5.00, Mr. XYZ would have to sell 107 paintings to start making a profit.
1.Break-Even analysis is a relatively simple and cheap technique that shows the relationship between the fixed costs, variable costs and revenue (Hammond, 366).
2.With the help of this specialized technique, marketing managers can decide whether to drop an existing product from the line, to replace equipments or to buy, rather than produce a part (Dubrin, 155).
3.It is a useful tool to approach a variety of decision problems such as costs in expansion, evaluation of sales or profit performance, setting price, etc. This technique can further aid management highlight problem areas and examine them in detail (Hammond, 367).
Disadvantages of Break-Even Analysis:
1.This technique requires estimated projections of expected sales, fixed costs, variable costs, etc. Such gathering and generating of data itself, generates further costs. Therefore, this analysis is only as good as the information on which it is based (Hammond, 367).
2.Both simple and complex models of Break-Even analysis are simply forecasting methods. A sudden change in the price of commodity in the market, a union agreement on pay, etc, would make the analysis out of date (Hammond, 367).
3.The third limitation is potentially more serious. The graphical representation indicates that the variable costs and sales increase together in a direct relationship. In reality, unit costs may decrease with increased volume or costs may increase with volume.
Therefore, in conclusion, break-even analysis is valuable as a preliminary decision-making tool, but care should be taken so that the management doesn’t reply solely on this technique. It doesn’t guarantee that the firm would make a profit; rather it is a great planning tool (Thompson, 8).
References
Dubrin, Andrew J. Specialized Techniques for Planning and Decision Making. Essentials of Management. 4th Edition. South-Western College Publishing – Ohio, 1997.
Hammond, Susan. Describing the Difference. Business Studies. 3rd Edition. Longman Publishers – United Kingdom, 1994
Kerin and Peterson. Financial Aspects of Marketing Management. Strategic Marketing Problems. 8th Edition. Prentice Hall – New Jersey.
Thompson, Kevin D. Business Management: Planning for Profit. Black Enterprise. April 1993. Online Library Database. Expanded Academic ASAP.
Amos, John M. Break-even Analysis for Management Decision Making. Center for Applied Engineering Management, University of Missouri – Rolla. October 2000. The Internet.
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