# Relationship Between Revenue and Costs

## Break even analysis

A business’s break even point is where its total costs equal the total of its sales income.

The break even point is the minimum point at which the business can survive – it is neither making a profit nor a loss, it is simply covering its costs (i.e. breaking even). If it can sell more goods than its break even level then the business will be making a profit. If sales are below the break even level, then the business will be making a loss.

Importance:

• Shows the amount of goods which need to be sold in order to make a profit.

• Level of costs which can be survived.

• Price which needs to be charged for goods.

• How price change would affect profits (‘WHAT IF’ ANALYSIS).

A break even chart will show how the costs and revenues of a business change with sales. They show the level of sales a business must make in order to break even.

In order to draw a break even chart – you always need to know the following information:

• SELLING PRICE OF THE ITEM

• FIXED COSTS

• VARIABLE COSTS PER ITEM

• PRODUCTION CAPACITY

On the graph, total costs are shown as a diagonal line. But notice that the total cost line ALWAYS starts at the level of the fixed costs. This is because even at the point of no production, the business has still had to pay its fixed costs. Thus the total costs equal the fixed costs at this point. Always give your chart a title and label the axis!

In the exam you’d never be expected to take a graph as it takes too long. It’s more likely to appear as a 4 mark calculate question - thus learning the following formula is essential…

Break Even = Fixed Costs / (Selling Price p/unit - Variable Costs p/unit)

Margin of Safety

A businesses margin of safety is the output levels which exist beyond the break even point. These are levels of output that a business can operate at before a loss is made.

• Managers can read the expected profit/loss to be made at any output level

• Impact on profits of certain business decisions can be shown by redrawing your graph

• Break even chart can show the margin of safety

• They assume all goods produced are actually sold

• Fixed costs remain constant whereas, in reality, scaling of production increases overheads

• Only displays BEP; doesn’t illustrate wastage, sales etc (simplistic in nature)

• Assumes that costs and revenues are constants

Practical use

Namib tyre Ltd produce motorcycle tyres. The following information has been obtained:

• Fixed costs are \$30,000 per year.

• Variable costs are \$5 p.u.

• Each tyre is sold for \$10

• Maximum output is 10,000 tyres per year.