Using Break-Even Analysis to Make Decisions (Cambridge International IGCSE Business)

Break-even analysis and decision-making

Spec point — "use break-even analysis to help make decisions: effect of changes in price, changes in fixed costs, changes in variable cost per unit"

Break-even analysis and decision-making

• Break-even calculations are a useful tool for a business to use in deciding how much to produce and calculating estimated levels of profit

• It is particularly useful for communicating with stakeholders, including investors or lenders

  • Knowing when the business will break-even or how much profit it is expected to make may attract or deter shareholders *from investing in the business

• Break-even analysis provides a basis for informed decision-making

  • It helps the business to assess the costs and expected returns of new projects and expansion plans

    • By considering the break-even point, businesses can assess the potential risks and rewards associated with different decisions

Ways break-even is used in decision-making

Changes to break-even variables

Spec point — "use break-even analysis to help make decisions: effect of changes in price, changes in fixed costs, changes in variable cost per unit"

Changes to break-even variables

• Changing any of the variables of break-even (selling price, variable cost per unit or total fixed costs) changes the break-even point and level of profit it can expect to achieve

Increased selling price

• An increase in the selling price reduces the break-even point

• An increase in the selling price increases revenue at each level of output from R₁ to R₂
• The break-even point falls from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is increased

Decreased selling price

• A decrease in the selling price increases the break-even point

• A decrease in the selling price reduces revenue at each level of output from R₁ to R₂
• The break-even point rises from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is decreased

Increased variable costs

• An increase in variable costs increases the break-even point

• An increase in variable costs increases total costs at each level of output from TC₁ to TC₂
• The break-even point increases from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is decreased

Decreased variable costs

• A decrease in variable costs decreases the break-even point

• A decrease in variable costs decreases total costs at each level of output from TC₁ to TC₂
• The break-even point falls from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is increased

Increased fixed costs

• An increase in fixed costs increases the break-even point

• An increase in fixed costs increases total costs at each level of output from TC₁ to TC₂
• The break-even point increases from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is decreased

Decreased fixed costs

• A decrease in fixed costs decreases the break-even point

• A decrease in fixed costs reduces total costs at each level of output from TC₁ to TC₂
• The break-even point falls from BEP₁ to BEP₂
• Profit on each unit of output greater than the break-even point is increased

Exam Hint Strengthen your answers by linking changes in price, costs or sales volume to shifts in the break-even point and margin of safety – this application gains higher marks

Limitations of break-even analysis

• Break-even analysis provides valuable insights into the financial viability and performance of a business
• The sooner a business can reach break-even point, the more likely it is to survive and make a profit
• However, there are several limitations to the use of break-even analysis

Limitations of break-even analysis include the assumption that all output is sold and its limited usefulness for multi-product businesses

1. Limited use for multi-product businesses

• Break-even analysis works best for businesses that sell one product
• If a business sells many products with different prices and profit margins, it is difficult to calculate a single break-even point that applies to all of them

2. Relies on quality costs and revenue data

• The results are only accurate if the data used is correct
• If the business uses outdated or incorrect cost or revenue figures, the break-even point will be misleading

3. Assumes all output is sold

• Break-even analysis assumes that everything produced is sold with no leftover stock
• In reality, some products may not sell, which can make the analysis too optimistic

4. Revenue and costs are not always directly linked to output

• The model assumes that costs and revenue change in a straight line as output increases
• However, in real life, discounts, bulk purchasing or changing raw material costs can affect this relationship.

5. Requires skill to calculate and interpret correctly

• To get useful results, the business must understand how to calculate and read break-even charts and data
• If the analysis is done poorly, it can lead to wrong decisions