IB Docs (2) Team
Limitations of break-even analysis
The limitations of break-even analysis as a decision-making tool include the following points:
Prices are assumed to be constant (the linear Total Revenue line is shown to have a constant gradient) but in reality many businesses offer price discounts to loyal customers and those who buy large quantities.
Costs are assumed to be constant (the Total Cost line is shwon to be upwards sloping with a constant gradient) but in reality businesses are unlikely to experience constant average costs as its output or sales level increases. Instead, economies of scale (see Unit 1.5) enable firms to benefit from lower average costs as output increases, so the Total Cost line is highly unlikely to be linear in reality.
Changes in the external business environment (see BMT 3 - STEEPLE analysis) will also have a direct impact on costs and revenues. For example, inflation will increase production costs and wages, whereas a fall in interest rates will reduce the costs of borrowing. These factors are not easy to consider in a break-even analysis.
Break-even analysis is ideal for businesses that sell a single good or service. It can be difficult to calculate break-even for businesses that sell a large range of goods and services, as prices and production costs differ.
As with all quantitative tools, the effectiveness of break-even analysis relies on the accuracy of the cost and revenue data used to make the predictions. Any inaccuracies and/or deliberate bias in the use of the quantitative data will invalidate the results of the break-even analysis.
As a decision-making tool, break-even analysis ignores qualitative considerations, such as the impact on employees who may need to work overtime in order to reach break-even. In reality, managers are likely to consider both quantitative and qualitative factors when making decisions.
Review your understanding of break-even analysis by watching this video, which focuses on the construction of break-even diagrams:
This is also a student-friendly video that will help you review the topic of break-even analysis, including numerous examples and quantitative questions:
Business Management Toolkit
Discuss how knowledge of contribution costing can support break-even analysis for multi-product businesses.
To test your understanding of the contents of break-even analysis, have a go at these revision questions.
Which of the following is the correct formula for calculating contribution per unit?
Contribution per unit refers to the difference between the selling price of a product and its variable cost per unit. Hence, Price per unit – variable cost per unit is the correct answer. Total revenue – total variable cost refers to total contribution. Total revenue – total cost refers to profit. Price per unit + variable cost per unit is incorrect since unit contribution requires variable cost per unit be subtracted from price per unit, not added.
The point at which the level of sales of a business exactly equals its costs is known as the...
The break-even point can be found at the point where total costs are equal to total revenue. Hence, Break-even point is the correct answer. Profit point, start-up stage and insolvency point are not terms used on a break-even chart.
Mr Icy is a popular shop in a busy town, selling tubs of frozen yoghurt. Each tub has a variable cost of
The formula for contribution per unit is selling price minus variable cost per unit. In this case, the selling price is
Mr Icy is a popular shop in a busy city, selling tubs of frozen yoghurt. Each tub has a variable cost of
The formula for break-even quantity is fixed costs divided by unit contribution. Therefore, fixed costs of
Mr Icy is a popular shop in a small town, selling tubs of frozen yoghurt. Mr Icy needs to sell 8,000 tubs of frozen yoghurt each month to break-even. Last month Mr Icy sold 9,500 tubs. Using this information, calculate Mr Icy’s margin of safety.
The margin of safety is calculated by finding the difference between actual sales and the number of units required to break-even. In this case, 9,500 units were sold minus 8,000 required to break-even. Therefore, the margin of safety is 1,500 tubs of frozen yoghurt, so the correct answer is 1,500.
The difference between actual sales and the number of units needed to break- even is known as the...
Margin of safety shows the difference between actual demand and the number of units required to break-even, so margin of safety is the correct answer. Margin of error, standard cost and opportunity cost are not found in a break-even analysis.
On a break-even chart, what does the horizontal axis measure?
On a break-even chart, the horizontal axis (x-axis) denotes the output or units of production. Hence, outputs or units of production is the correct answer. Costs and revenues are measured on the vertical axis (y-axis), i.e. output or units of production. Opportunity cost does not appear in a break-even chart. Profit or loss may be labelled on the vertical axis.
On a break-even chart the vertical axis measures the...
Costs and revenues are measured on the vertical axis (y-axis) using a unit of currency, such as the US dollar. Hence the correct answer is costs and revenues. Opportunity cost and unit contribution, do not appear in a break-even chart. The output or units of production is shown on the horizontal axis.
On a break-even chart, what are fixed costs represented by?
Fixed costs are costs which do not directly change with the level of production. Therefore, the fixed costs line will be horizontal, starting at the value of fixed costs on the y-axis. Therefore, a continuous horizontal line is the correct answer. A line beginning from the origin (zero) describes the total revenue line. The point where the total cost line intersects with the total revenue line refers to the break-even point. A line parallel to the variable cost line describes the total cost line (which is parallel to the variable cost line).
Which of the following is the formula for calculating break-even?
Break-even can be calculated by dividing fixed costs by contribution per unit. Hence Fixed costs divided by contribution per unit is correct answer.
Which of the following is the formula for calculating target profit output?
Option A is correct as the formula for calculating target profit output is: (fixed costs + target profit) divided by contribution per unit. (Variable costs + target profit) divided by contribution per unit and target profit divided by contribution per unit are incorrect since fixed costs must be considered to calculate profit. Fixed costs divided by contribution per unit is incorrect as this is the formula for break-even, not target profit.
Which of the following is a limitation of break-even analysis?
A limitation of break-even analysis is the assumption that the figures for fixed costs and variable costs will not change. Hence, it not allowing for possible changes in costs over time is the correct answer.
Which of the following is a not a limitation of break-even analysis?
It is relatively simple to calculate and analyse is the correct answer as once the figures for fixed costs, variable costs and selling price are provided, a break-even calculation can easily be made. A strength of break-even analysis is its ease of calculation and the visual representation makes it easy to interpret. All other options all describe limitations of conducting a break-even analysis.
Boards R Us is a surfboard shop in a famous beachside town. Each surfboard has a variable cost of
The formula for break-even is fixed costs divided by unit contribution. The formula for contribution per unit is selling price minus variable cost per unit. Therefore, fixed costs of
Boards R Us is a surfboard shop in a famous beachside town. The fixed costs for Boards R Us are
The formula for calculating target profit output is: (fixed costs + target profit) divided by contribution per unit. In this case, fixed costs (
Have a go at more Unit 5.5 break-even analysis questions from the InThinking Business Management Question Bank here.
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