3.3 Cost and break-even analys

Costs of production

To generate revenue cost incurs in production process.

·        Fixed cost

Costs remaining fixed or constant irrespective to the level of output produced. Also known as indirect cost. E.g. salaries, rent, rate, loan repayment, etc.

·        Variable cost

Costs varying respective to the level of output produced. Also known as direct cost. E.g. raw materials, power, wages, utilities, etc.

·        Total cost

Sum of fixed costs and variable costs.

Formula:

Total cost = Fixed cost + Variable cost

·        Average cost

Production cost per unit of output. Also known as unit cost.

Formula:

Average cost = Total cost / Total output

Break-even analysis

An analysis to determine the point at which total revenue equalizes total costs. Break-even analysis is done so that information regarding costs along with sales revenue can be projected in order to find out whether the product is going to make profit or not. Most importantly, it helps to know how many units the company needs to sell to break even.

·         Total revenue > Total cost (Product is making a profit)

·         Total revenue < Total cost (Product is making a loss)

·         Total revenue = Total cost (Product is at break-even point)

Break-even point (BEP)

The point at which forecasted revenue is exactly the same as estimated costs, therefore at break-even point it neither incurs profit nor loss.

Formula:

Break-even point = Fixed cost / Contribution per unit

Contribution

Contribution is the amount generated from selling a commodity by subtracting all the variable costs from revenue.

Formula:

Contribution per unit = Selling price per unit – Variable cost per unit

Margin of safety (MOS)

Margin of safety is the benchmark within which sales above break-even causes profit and beyond causes decreasing profit or ultimately loss.

 Formula:

  Margin of safety = Current output – Break-even output

Given,

Selling price = £ 25

Variable cost = £ 5

Fixed cost = £ 20,000

Current output = 2,000 units

·         Contribution per unit = Selling price per unit – Variable cost per unit

                                          = £ 25 – £ 5

                                        = £ 20

·         Break-even point = Fixed cost / Contribution per unit

                                  = £ 20,000 / £ 20

                                  = 1,000 units

·         Margin of safety = Current out – Break-even output

                                    = 2,000 units– 1,000 units

                                  = 1,000 units

·         At BEP,

                    i.            Total revenue = £ 25,000

                  ii.            Total cost       = £ 25,000

Advantages of a break-even chart

1.      Helps to know how much output business has to produce in order to break even

2.      Estimates the cost, revenue and profit at different  levels of output

3.      Helps to know the margin of safety

Disadvantages of a break-even chart

1.      The TC and TR are shown as straight lines. In practice they may not be straight lines and fluctuates due to various reasons.

2.      It is assumed that all the outputs are sold and there is no unsold goods. Many businesses hold stock of finished goods to meet future demand at higher selling price.

3.      Inaccurate data collection and analysis may lead to error.

N.B“project break-even point first,

then go for production”