Financial terms and calculations - AQABreak-even

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 the amount of products they need to sell in order to reach the break-even point (BEP). This information can be displayed on a chart, called a break-even graph.

Break-even analysis is an extremely useful tool for a business and has some significant advantages:

• it shows how many products they need to sell to ensure a profit
• it shows whether a product is worth selling or is too risky
• it shows the amount of revenue the business will make at each level of output
• it shows whether costs need to be reduced to lower the BEP
• it can be used to persuade investors or banks to finance a business
• it is quick and easy to analyse

However, break-even analysis does have some drawbacks:

• break-even assumes a business will sell all of the stock (of a particular product) at the same price
• businesses can be unrealistic in their calculations
• variable costs could change regularly, meaning the analysis could be inaccurate
• they can be time consuming to create

Break-even graph

A break-even graph shows a break-even point in a visual way. A break-even graph displays the revenue, costs, number of products sold and break-even point. An example of a break-even graph is below:

The graph above demonstrates a break-even point (BEP) of 100 units. The BEP is always displayed as the point at which the revenue and total costs lines cross.

Understanding a break-even graph:

• Loss is represented as anything below the break-even point, this is demonstrated by the space in between the revenue and total cost lines.
• Profit is represented as anything above the break-even point, this is demonstrated by the space in between the revenue and total cost lines.
• The break-even point is always the point at which the revenue and total costs lines cross.
• The fixed costs line is always demonstrated as a straight line across the graph, this represents that the costs remain the same at any level of output.
• The total costs line always starts on top of the fixed costs line. Adding the variable costs onto the fixed costs is why this becomes the total costs line.
• The revenue line always rises with the level of output, this represents an increase in revenue.
• Break-even graphs are drawn with reasonable estimated maximum total costs and sales on each axis, so the break-even point is clearly visible

Margin of safety

The margin of safety is the amount sales can fall before the break-even point is reached and the business makes no profit. This calculation also tells a business how many sales they have made over their break-even point (BEP). The larger the margin of safety, the lower the risk for a business.

The margin of safety is calculated through the following calculation:

Margin of safety = actual sales - break-even sales

For example:

A business has a break-even point of 100 products and has sold 150.

Margin of safety = actual sales – break-even sales = 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 break-even point is reached.

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

The example below demonstrates a break-even point (BEP) of 100. If the output soldare is 200, this represents a margin of safety of 200 – 100 = 100 units.