Break Even
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The break-even point for a product is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). [1]A break-even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break-Even Analysis can also be used to analyse the potential profitability of an expenditure in a sales-based business.
Contents [hide] • • • • • • •
1 Margin of Safety 2 In unit sales 3 In Capital budgeting 4 Internet research 5 Limitations 6 References 7 Bibliography
•
8 External links
[edit] Margin of Safety In break-even analysis, margin of safety is how much output or sales level can fall before a business reaches its break-even point (BEP).[2] Margin of safety = ((Budgeted sales - break-even sales) /Budgeted sales) x 100%
[edit] In unit sales If the product can be sold in a larger quantity that occurs at the break even point,then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by: Total fixed costs / (selling price - average variable costs). Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold. This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. Therefore, Profit = (selling price*quantity)-(average variable costs*quantity+total fixed costs). Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product. An example: • • • •
Assume we are selling a product for $2 each. Assume that the variable cost associated with producing and selling the product is 60 cents. Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000. In this example, the firm would have to sell (1000/(2.00 - 0.60) = 715) 715 units to break even. in that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining loss.
Break Even = FC / (SP − VC) where FC is Fixed Cost, SP is selling Price and VC is Variable Cost
[edit] In Capital budgeting Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables at which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time. The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur. In using Break even analysis, it is important to remember the problem associated with Sensitivity analysis as well as some extension specific to the method: • • •
•
Variables are often interdependent, which makes examining them each individually unrealistic. Often the assumptions upon which the analysis is based are made by using past experience/data which may not hold in the future. Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid. Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis.
[edit] Internet research By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.
To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal, axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.
[edit] Limitations * == Break-even analysis is only a supply side (ie.: costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. • • •
•
It assumes that fixed costs (FC) are constant It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant
When dealing with a make vs. buy decision, there are four numbers you need to know: 1. Your volume 2. The fixed costs associated with making (e.g., the tooling that must be bought)
3. The per-unit direct costs of making 4. The per-unit landed cost from a supplier So, you plug these numbers into a couple of formulas: CTB = V * LC
and
CTM = FC + (PUDC * V)
Where, CTB = Cost To Buy V = Volume LC = Supplier's Per Unit Landed Cost CTM = Cost To Make FC = Fixed Costs (of making) PUDC = Per Unit Direct Cost (of making) If CTM exceeds CTB, then it is more financially desirable to buy. If CTB exceeds CTM, the opposite is true. Practice by using the Excel template at http://www.NextLevelPurchasing.com/make.xls . Make/buy decisions aren’t just about numbers, though. Questions you absolutely must consider include: •
Is this the organization’s core competency?
•
Could we be harmed by disclosing proprietary information?
•
What will be the impact on quality or delivery?
•
What additional risks would we be facing?
•
How irreversible is the decision?
When dealing with a make vs. buy decision, there are four numbers you need to know: 1. Your volume 2. The fixed costs associated with making (e.g., the tooling that must be bought) 3. The per-unit direct costs of making 4. The per-unit landed cost from a supplier So, you plug these numbers into a couple of formulas: CTB = V * LC
and
CTM = FC + (PUDC * V)
Where, CTB = Cost To Buy V = Volume LC = Supplier's Per Unit Landed Cost CTM = Cost To Make FC = Fixed Costs (of making) PUDC = Per Unit Direct Cost (of making) If CTM exceeds CTB, then it is more financially desirable to buy. If CTB exceeds CTM, the opposite is true. Practice by using the Excel template at http://www.NextLevelPurchasing.com/make.xls . Make/buy decisions aren’t just about numbers, though. Questions you absolutely must consider include: •
Is this the organization’s core competency?
•
Could we be harmed by disclosing proprietary information?
•
What will be the impact on quality or delivery?
•
What additional risks would we be facing?
•
How irreversible is the decision?
PLANT LOCATION Qualitative Factors 1. Local infrastructure 2. Worker education and skills 3. Product content requirements 4. Political and economic stability Quantitative Factors 1. Labor cost
2. Distribution 3. Facility costs 4. Exchange rates Plant Location Methods A. Center of Gravity Method
Retail Store
Number of containers shipped/month
Cincinnati
400
Knoxville
300
Chicago
200
Pittsburgh
100
New York
300
Atlanta
100
Formula:
B. Factor Rating 1. Develop a list of relevant factors 2. Assign a weight to each factor to reflect its relative importance 3. Develop scale
4. Have management score each location 5. Multiply score by weight and total 6. Make recommendation, considering results of qualitative approaches also.
After location is selected, the layout has to be determined. Process(job-shop) - similar equipment or functions are grouped together Product (flow-shop) - one in which equipment or work processes are arranged according to progressive steps by which product is made. PLANT LOCATION Qualitative Factors 1. Local infrastructure 2. Worker education and skills 3. Product content requirements 4. Political and economic stability Quantitative Factors 1. Labor cost 2. Distribution 3. Facility costs 4. Exchange rates Plant Location Methods A. Center of Gravity Method
Retail Store
Number of containers shipped/month
Cincinnati
400
Knoxville
300
Chicago
200
Pittsburgh
100
New York
300
Atlanta
100
Formula:
B. Factor Rating 1. Develop a list of relevant factors 2. Assign a weight to each factor to reflect its relative importance 3. Develop scale 4. Have management score each location 5. Multiply score by weight and total 6. Make recommendation, considering results of qualitative approaches also.
After location is selected, the layout has to be determined.
Process(job-shop) - similar equipment or functions are grouped together Product (flow-shop) - one in which equipment or work processes are arranged according to progressive steps by which product is made.
Contents [hide] • • • • • • •
1 Margin of Safety 2 In unit sales 3 In Capital budgeting 4 Internet research 5 Limitations 6 References 7 Bibliography
•
8 External links
[edit] Margin of Safety In break-even analysis, margin of safety is how much output or sales level can fall before a business reaches its break-even point (BEP).[2] Margin of safety = ((Budgeted sales - break-even sales) /Budgeted sales) x 100%
[edit] In unit sales If the product can be sold in a larger quantity that occurs at the break even point,then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by: Total fixed costs / (selling price - average variable costs). Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold. This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs. Therefore, Profit = (selling price*quantity)-(average variable costs*quantity+total fixed costs). Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product. An example: • • • •
Assume we are selling a product for $2 each. Assume that the variable cost associated with producing and selling the product is 60 cents. Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000. In this example, the firm would have to sell (1000/(2.00 - 0.60) = 715) 715 units to break even. in that case the margin of safety value of NIL and the value of BEP is not profitable or not gaining loss.
Break Even = FC / (SP − VC) where FC is Fixed Cost, SP is selling Price and VC is Variable Cost
[edit] In Capital budgeting Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables at which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time. The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur. In using Break even analysis, it is important to remember the problem associated with Sensitivity analysis as well as some extension specific to the method: • • •
•
Variables are often interdependent, which makes examining them each individually unrealistic. Often the assumptions upon which the analysis is based are made by using past experience/data which may not hold in the future. Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid. Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis.
[edit] Internet research By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.
To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal, axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.
[edit] Limitations * == Break-even analysis is only a supply side (ie.: costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. • • •
•
It assumes that fixed costs (FC) are constant It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant
When dealing with a make vs. buy decision, there are four numbers you need to know: 1. Your volume 2. The fixed costs associated with making (e.g., the tooling that must be bought)
3. The per-unit direct costs of making 4. The per-unit landed cost from a supplier So, you plug these numbers into a couple of formulas: CTB = V * LC
and
CTM = FC + (PUDC * V)
Where, CTB = Cost To Buy V = Volume LC = Supplier's Per Unit Landed Cost CTM = Cost To Make FC = Fixed Costs (of making) PUDC = Per Unit Direct Cost (of making) If CTM exceeds CTB, then it is more financially desirable to buy. If CTB exceeds CTM, the opposite is true. Practice by using the Excel template at http://www.NextLevelPurchasing.com/make.xls . Make/buy decisions aren’t just about numbers, though. Questions you absolutely must consider include: •
Is this the organization’s core competency?
•
Could we be harmed by disclosing proprietary information?
•
What will be the impact on quality or delivery?
•
What additional risks would we be facing?
•
How irreversible is the decision?
When dealing with a make vs. buy decision, there are four numbers you need to know: 1. Your volume 2. The fixed costs associated with making (e.g., the tooling that must be bought) 3. The per-unit direct costs of making 4. The per-unit landed cost from a supplier So, you plug these numbers into a couple of formulas: CTB = V * LC
and
CTM = FC + (PUDC * V)
Where, CTB = Cost To Buy V = Volume LC = Supplier's Per Unit Landed Cost CTM = Cost To Make FC = Fixed Costs (of making) PUDC = Per Unit Direct Cost (of making) If CTM exceeds CTB, then it is more financially desirable to buy. If CTB exceeds CTM, the opposite is true. Practice by using the Excel template at http://www.NextLevelPurchasing.com/make.xls . Make/buy decisions aren’t just about numbers, though. Questions you absolutely must consider include: •
Is this the organization’s core competency?
•
Could we be harmed by disclosing proprietary information?
•
What will be the impact on quality or delivery?
•
What additional risks would we be facing?
•
How irreversible is the decision?
PLANT LOCATION Qualitative Factors 1. Local infrastructure 2. Worker education and skills 3. Product content requirements 4. Political and economic stability Quantitative Factors 1. Labor cost
2. Distribution 3. Facility costs 4. Exchange rates Plant Location Methods A. Center of Gravity Method
Retail Store
Number of containers shipped/month
Cincinnati
400
Knoxville
300
Chicago
200
Pittsburgh
100
New York
300
Atlanta
100
Formula:
B. Factor Rating 1. Develop a list of relevant factors 2. Assign a weight to each factor to reflect its relative importance 3. Develop scale
4. Have management score each location 5. Multiply score by weight and total 6. Make recommendation, considering results of qualitative approaches also.
After location is selected, the layout has to be determined. Process(job-shop) - similar equipment or functions are grouped together Product (flow-shop) - one in which equipment or work processes are arranged according to progressive steps by which product is made. PLANT LOCATION Qualitative Factors 1. Local infrastructure 2. Worker education and skills 3. Product content requirements 4. Political and economic stability Quantitative Factors 1. Labor cost 2. Distribution 3. Facility costs 4. Exchange rates Plant Location Methods A. Center of Gravity Method
Retail Store
Number of containers shipped/month
Cincinnati
400
Knoxville
300
Chicago
200
Pittsburgh
100
New York
300
Atlanta
100
Formula:
B. Factor Rating 1. Develop a list of relevant factors 2. Assign a weight to each factor to reflect its relative importance 3. Develop scale 4. Have management score each location 5. Multiply score by weight and total 6. Make recommendation, considering results of qualitative approaches also.
After location is selected, the layout has to be determined.
Process(job-shop) - similar equipment or functions are grouped together Product (flow-shop) - one in which equipment or work processes are arranged according to progressive steps by which product is made.
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