Costs, Profits and Break-even Analysis.

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Costs, Profits and Break-even Analysis

Alas, this means coming to terms with numbers, something that seems to frighten a large proportion of Business Studies students. Before reaching the stage of actually drawing a break-even diagram we need to think what actually goes into one. First, we need to look at costs. They can be referred to in terms of output, time or product. When we speak of costs in terms of output and time we mean FIXED and VARIABLE costs. Remember fixed costs do not vary with output, whilst variable do. The TOTAL costs of a firm are its fixed and variable costs added together. We also need to remember that we borrow something from economists when we introduce time to the calculation. By this I mean the dreaded long and short run. Remember that in the short run the scale of the operation cannot be changed and any expansion in output has to come from what spare capacity may be available. In the long run the entire scale of the operation can be altered. Quite literally the company can open a new factory to meet the increase in demand for its products.

When looking at the actual product we need to remember that the costs we must now calculate are the DIRECT and INDIRECT costs. Some people prefer to call indirect costs overheads. Direct costs involve all the costs that can be directly related to the product or service. An example of this would be the materials needed to make a specific product. Indirect costs are those which cannot be directly allocated to a specific product or service. This might be the postage or telephone costs, which cannot normally be allocated to just one product or service. When we add the direct and indirect costs together we get what are known as the Total costs for the product or service. We also need to make certain that we understand what is meant by the term profit. What comes into the business via sales is the revenue and what goes out are the costs. So, the costs taken away from the revenue gives us our gross profit or surplus. When thinking about how we construct a break-even diagram we also need to look at CONTRIBUTION. This means how much the sale of one product puts towards the fixed costs of the company. Once the firm has met its fixed costs, the revenue that then comes in contributes to profit. So contribution per unit of output is equal to: the selling price -the direct costs of producing each unit of product. We calculate this by either;

a. the contribution per unit x the number sold

b. total sales revenue - total direct costs

So, what will the examiners be looking for?

. They might ask you to provide reasons, implications, the reasons for a change in the outcome or what can be drawn from your calculations. Remember to think how, what, why, how and who when addressing a piece of analysis.

2. They may ask you to draw conclusions from what you have calculated. This might involve you in commenting on how a changing set of circumstances might influence the numbers, or what other factors would you want to see before offering advice on the calculations, or assessing the usefulness of what has been calculated, or whether you think the numbers can be maintained given the information you have and how do your numbers compare with previous figures available.

It's worth remembering that in many questions it's what you say, that is the quality of your comments that actually earn you the majority of marks.

Let's now turn our attention to break-even analysis.

In short we are trying to establish the minimum amount we need to make in order for our sales revenues to cover our costs. Before we actually start to make our product or service we will incur high levels of fixed costs and no revenue will be flowing to offset these. As output expands so we receive revenue, however we also start to incur variable costs. Remember that price - direct costs shows us the contribution per unit of output As we sell, so we generate revenues that allow us to cover our fixed costs and eventually start to move into a profit-making situation. When calculating the break-even point we have to make certain assumptions. These are:

* the selling price remains the same whatever amount is sold

* fixed costs also remain the same regardless of output

* variable costs vary in direct proportion to output

To calculate the break-even point the formula is: fixed costs / contribution per unit

To put this on a graph we need to look at Sales Revenue - this is plotted against units sold. The higher the price the steeper the gradient line. The lower the price the less steep is the gradient line. This is the line marked sales revenue in the diagram below.

Before commencing production a firm must buy what are known as its FIXED ASSETS. These are the profit generating parts of the business and form the fixed costs. As such they have to be paid for regardless of output. Let's say that in our example the fixed costs are £10,000 whether we fully produce or make a complete zero amount of whatever it is we are producing. We can see in the diagram below that the fixed costs line is horizontal.

Next we need to look at our variable costs, which do vary with changes in output. Therefore the line on the diagram is upward-sloping. At zero production we will not incur any variable costs but as we expand by production by each successive unit made so we incur costs. If we decide on £3 per unit produced then we can start to make our calculations. When we add the fixed costs to the variable costs we arrive at the total costs. With fixed costs needing to be paid for regardless of sales we can predict that in most companies low levels of sales will not result in profits. However, as sales increase so the fixed costs are being spread over a larger output and will reduce per unit sold. To put this in more technical language the average fixed cost will start to fall. So, if for example output is 100 units, fixed costs are £100 per unit produced, then if output rises to 2000 units the average fixed cost will be £5 per unit produced. The output required to break even is 2000 units (as marked break-even on the diagram above), at which level the total sales revenue and costs equate at £16000. It is always sensible to leave some room for change and so we introduce the concept of margin of safety. This is the difference between the actual output and the break-even output. So, if this company could produce 3000 items its margin of safety is 1000 units. A company which has a small margin of error has little room for errors or cost problems.

What then can examiners ask you to do with any numbers you manage to calculate? Well, they might ask you to:

* simply state the break-even output and the margin of error

* look at the contribution being made per unit of output to the covering of fixed costs

* compare targets with probable outcomes

* predict the possible success of a new firm which is considering entering a market

* use the graph to comment on prices, variable cost control problems and how to influence fixed costs

Whenever you are using a break-even analysis remember that they do have problems or disadvantages. These include:

* your calculations are only as good as the figures you are given

* sales may not be the same as output

* all of your workings are static

* the analysis takes no account of economies of scale

Examiners might also ask you to:

* comment on how useful a break-even chart is

* make an assessment of whether the firm should/should not produce or continue to produce

* move into a dynamic situation, where values are changing and you need to look carefully at the outcome and comment on the changes and the decisions they may affect

Good luck with the revision and don't let numbers get you down.

People in Organisations

When revising this essential area of any of the syllabuses/specifications you need to make certain that you have covered:

Motivation

When you think about this area, the main aim is that firms are trying to improve efficiency, productivity and quality. So, how do we make people more aware of how they work and what they produce? You will normally be given a context in which the question is set. Think carefully about this before starting your answer. Remember part of the mark scheme will be directed at how well you adapt your knowledge to meet the circumstances in which the question is set.
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So, let's make certain that you know the basic theory. A little hint for your examination technique - the bigger the triangle normally the weaker the answer. In case you have not guessed I am talking about Maslow's triangle!

Theories

* Maslow:

According to Maslow human needs are split into five types - a hierarchy of needs. These are represented as a triangle with the highest level needs at the top. Behind each are some examples of how they might appear in a modern business context.

. Physiological- wage, salaries and working conditions ...

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