- Break-even analysis is a widely used tool in business decision-making, and it helps in calculating the minimum amount of sales required to cover total costs.
- It is an essential tool for managers to understand the relationship between costs, volume, and profits.
Features of break-even charts:
- A break-even chart is a graphical representation of the break-even analysis.
- It is also known as a cost-volume-profit chart.
- It shows the relationship between costs, volume, and profits, which helps managers to understand the financial situation of the business.
- It indicates the point at which total revenue equals total cost, and the business neither makes a profit nor a loss.
- It shows the contribution margin, which is the difference between sales revenue and variable costs.
- It illustrates the fixed cost line, variable cost line, and total cost line.
Margin of safety
- Margin of safety refers to the excess of expected or actual sales over the break-even sales.
- It is the cushion or buffer zone between the break-even point and the actual sales.
- It indicates the level of sales a business can absorb without incurring losses.
- Margin of safety is calculated by subtracting the break-even point from the actual sales.
- A higher margin of safety means the business is less vulnerable to unexpected changes in sales volume.
- A lower margin of safety indicates greater risk and lower profitability.
Total Revenue Line
- The total revenue line is a graphical representation of the total revenue earned at different levels of output.
- It is a straight line that starts from the origin and slopes upwards at the unit selling price of the product.
- The equation for the total revenue line is TR = P x Q, where TR is total revenue, P is unit selling price, and Q is quantity or output.
- As output increases, the total revenue line also increases, but at a decreasing rate due to the law of diminishing marginal returns.
- The point where the total revenue line intersects with the total cost line represents the breakeven point, where total revenue equals total cost.
Total Variable Costs Line
- It represents the total variable costs incurred by a business at different levels of production.
- It starts from the origin (zero output) because there are no variable costs at zero output.
- It slopes upward because variable costs increase with higher levels of production.
- The slope of the line represents the variable cost per unit of output.
- The shape of the line depends on the nature of the variable costs. If variable costs are constant per unit, the line will be linear. However, if variable costs increase or decrease as production levels change, the line will be curved.
Fixed Costs Line
Steps to follow when drawing a break-even chart:
- Identify fixed costs and variable costs.
- Calculate the contribution margin per unit.
- Determine the break-even point in units and dollars.
- Plot the total cost line, variable cost line, and fixed cost line on the chart.
- Plot the sales revenue line and the total cost line intersection point to indicate the break-even point.
Fixed Cost Line
- The fixed cost line on a break-even chart represents the total fixed costs that a business incurs, regardless of the level of output.
- This line is a horizontal straight line that intersects the vertical axis at the total fixed cost point.
- The fixed cost line does not change with changes in the level of output, as the fixed costs remain constant.
- The distance between the fixed cost line and the total revenue line represents the profit or loss that the business makes at different levels of output.
Loss Area and Profit Area
- The loss area is the region below the break-even point on the chart and represents the level of output where total costs exceed total revenue, resulting in a loss.
- The profit area is the region above the break-even point on the chart and represents the level of output where total revenue exceeds total costs, resulting in a profit.
Total Cost Line
- The total cost line represents the sum of fixed and variable costs incurred in producing a certain quantity of goods or services.
- It is a straight line that starts at the fixed cost level and increases proportionally with the increase in production.
- The total cost line intersects with the total revenue line at the break-even point, indicating the production level at which the company neither makes a profit nor incurs a loss.
- The area below the total cost line and above the total revenue line represents the loss area, where the company incurs losses.
- The area above the total cost line and below the total revenue line represents the profit area, where the company earns profits.
Uses/Benefits of break-even charts:
- Helps managers to set pricing strategies for their products or services.
- Helps in evaluating the impact of changes in cost or volume on the profits of the business.
- Helps in making decisions about whether to enter a new market or launch a new product.
- Helps in setting sales targets and forecasting profits.
- Helps in identifying the margin of safety, which is the difference between actual sales and the break-even point.
Drawbacks of break-even charts:
- The break-even analysis assumes that all units produced are sold, and it does not consider the impact of fluctuations in demand or production.
- It assumes that fixed and variable costs are known and constant, which may not be the case in reality.
- It does not consider the time value of money, and it assumes that costs and revenues occur at the same time.
- It may not be suitable for businesses with multiple products or services.
- It does not consider non-monetary factors such as quality, customer service, and brand image, which may influence demand and affect the break-even point.
