Break-even - CCEA

Key facts about break-even

Break-even calculation: Break-even is when revenue equals total costs, calculated as fixed costs divided by (selling price - variable costs). This tells a business how many products it needs to sell to break even.

Break-even graph: A graph showing revenue, costs, and the break-even point (BEP). It helps businesses visualise when they will start making a profit.

Margin of safety: The difference between actual sales and break-even sales, indicating how much sales can drop before the business stops making a profit.

Impact of changes: Increases in revenue or decreases in costs are positive, improving profit margins. Conversely, decreases in revenue or increases in costs are negative, potentially leading to losses.

How do you calculate the break-even level of output?

Break-even is the point at which a business is not making a profit or a loss. Businesses calculate their break-even point and are able to plot this information on a break-even graph.

Break-even is the point at which revenue and total costs are the same, meaning the business is making neither a profit nor a loss. The break-even level of output informs a business of how many products it needs to sell to reach the break-even point (BEP).

Break-even is calculated as follows:

Break-even = fixed costs ÷ (selling price − variable costs)

The result of this calculation is always how many products a business needs to sell in order to break even. The calculation in brackets must be completed first.

Example

A business that sells T-shirts wants to find out what its BEP is.

Its fixed costs are £400.

The selling price (per unit) is £10.

The variable costs (per unit) are £6.

Therefore:

Break-even = £400 ÷ (£10 − £6)

= £400 ÷ £4

= 100

So this business breaks even when it sells 100 T-shirts.

Sometimes the result is a little more complex, as the BEP may not be a whole number (eg 100.12). In such cases, the business would always need to sell an additional item in order to break even. An example of this is shown below:

Break-even = £401 ÷ (£10 − £6)

= £401 ÷ £4

= 100.25 T-shirts

In this case, the business would need to sell 101 T-shirts to break even.

A break-even graph shows a break-even point (BEP) visually. A break-even graph shows the revenue, costs, number of products sold and BEP. An example is below:

Creating a break-even graph

Assume a firm has the following costs:

• fixed costs: £400

• selling price: £10 per unit

• variable costs: £6 per unit

To calculate the variable cost, multiply variable cost per unit by number of units. In this example, assume that the variable cost per unit is £6 and there are 200 units, so the variable cost is £1,200.

Construct a chart with output (units) on the horizontal (X) axis, and costs and revenue on the vertical (Y) axis. Onto this, plot a horizontal fixed costs line - it is horizontal because fixed costs don’t change with output.

Then plot a line to represent variable cost starting at the same point as the fixed costs line. Because the variable costs line is drawn above the fixed costs line, it becomes the total costs line. This is because the fixed cost added to the variable cost gives the total cost.

Now plot the revenue line. To do this, multiply sales price by number of units sold (output).

If the sales price is £10 and 200 items are planned to be sold, the calculation is:

£10 × 200 = £2,000 total revenue

Where the revenue line crosses the total cost line is the break-even point -costs and revenue are the same. Everything shown below this point is loss, and everything above it is profit.

The margin of safety is the amount sales can fall before the break-even point (BEP) is reached and the business makes no profit. This calculation also tells a business how many sales it has made over its BEP.

The margin of safety is calculated as follows:

Margin of safety = actual sales − break-even sales

For example, a business has a BEP of 100 products and has made 150 sales. Therefore:

Margin of safety = 150 – 100

= 50 products

This means the business is making profit on 50 of its items sold, and its sales could fall by 50 items before the BEP were reached.

A company can use its margin of safety to see whether a product is worth selling or not. For example, if the BEP is 3,800 items and projected sales are 4,000 items, the business may decide not to sell the product as it would only be making profit on 200 items, making it high risk.

The below example demonstrates a BEP of 100. With sales at 200, this represents a margin of safety of 100 units (ie 200 − 100).

Changes in revenue

An increase in revenue is always a positive thing for a business, because if revenue increases then profits are also likely to increase. Increasing revenue also allows a business to get past its break-even point (BEP) and increase its margin of safety by selling more products. However, this only applies if costs stay the same or decrease. If costs increase, the increase in revenue may have no impact.

A decrease in revenue is bad for a business. If revenue is decreasing, a business is at risk of not breaking even or having very low margins of safety and levels of profit. The only scenario where a decrease in revenue is not damaging to a business is when costs are also decreasing. If costs are also decreasing, the business may be in the same overall financial position. Sometimes, if revenue decreases, a business may try to reduce its costs, for example by sourcing cheaper materials or employing fewer staff.

Changes in costs

Increasing costs usually have a negative impact on a business. They are likely to increase the BEP or reduce the business’ profit. With increasing costs, a business would have to sell more products in order to break even or make a profit. When costs increase, businesses often have to make the choice of absorbing increased costs or passing them on to customers by increasing prices. As a result, the business will be more likely to make a loss.

Decreasing costs are a positive thing for a business, as long as the quality of its product or service remains the same. Decreased costs are likely to lower the BEP and give a business access to more profit, as it will need to sell fewer products to break even. A business may decide to keep the savings as profit or pass them on to customers as a price decrease. If customers are aware that the business’ costs have decreased (eg if electricity bills are reduced by 50% for everyone in the UK), they may expect a price decrease to be passed on to them.

Final checks