Unit 5: Operations Management – 5.5 Break-Even Analysis
Introduction to Break-Even Analysis
Break-even analysis is a financial assessment used to determine the point at which total costs and total revenues are equal, meaning the business makes neither a profit nor a loss. This point is known as the break-even point (BEP).
Why is it important?
- Helps managers plan output and pricing.
- Assists in investment decisions.
- Indicates the minimum sales needed to avoid losses.
- Helps managers plan output and pricing.
- Assists in investment decisions.
- Indicates the minimum sales needed to avoid losses.
Break-Even Chart
A break-even chart visually represents the relationship between sales volume, costs, and revenues. The chart typically shows:
- Total cost line (fixed + variable costs)
- Total revenue line
- Break-even point (where revenue and cost lines meet)
Break-Even Point Formula:
Break\text{-}even\ Point = \frac{Fixed\ Costs}{Selling\ Price\ per\ Unit - Variable\ Cost\ per\ Unit}
Break\text{-}even\ Point = \frac{Fixed\ Costs}{Selling\ Price\ per\ Unit - Variable\ Cost\ per\ Unit}
Profit/Loss Formula:
Profit\ or\ Loss = Total\ Revenue - Total\ Costs
Profit\ or\ Loss = Total\ Revenue - Total\ Costs
Total Contribution vs Contribution Per Unit
| Definition | Formula | |
|---|---|---|
| Contribution Per Unit | Amount each unit contributes towards covering fixed costs and profit | Contribution\ per\ unit = Selling\ Price\ per\ Unit - Variable\ Cost\ per\ Unit |
| Total Contribution | Total amount contributed by all sold units |
Total\ Contribution = Contribution\ per\ unit \times Number\ of\ Units\ Sold
or Total\ Contribution = Total\ Revenue - Total\ Variable\ Costs |
Interpretation: If Total\ Contribution > Fixed\ Costs, the business is profitable.
Worked Example
Example: A company makes a product with:
- Fixed Costs: \${10,000}
- Selling Price per unit: \${50}
- Variable Cost per unit: \${30}
- Fixed Costs: \${10,000}
- Selling Price per unit: \${50}
- Variable Cost per unit: \${30}
- Contribution Per Unit: {50} - {30} = {\$20}
- Break-even Point: \frac{10,000}{20} = 500 \ units
- If 700 units are sold:
- Total Contribution: 700 \times 20 = {\$14,000}
- Profit: 14,000 - 10,000 = {\$4,000}
Strengths & Limitations of Break-Even Analysis
| Strengths | Limitations |
|---|---|
|
- Simple to use and understand - Helps with decision-making - Good for "what if" scenario analysis |
- Assumes costs and revenues are linear - Ignores qualitative factors - Forecasts may not match reality if assumptions change |
Conclusion
Break-even analysis gives managers a powerful tool for planning and financial control. Understanding contribution and break-even helps in pricing, cost management, and making informed production decisions.