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CHAPTER 21
BREAKEVEN ANALYSIS AND SHORT-TERM DECISION MAKING
Fixed and variable costs
A variable cost is one which ………………………….. with changes in the level of
activity, over a defined period of time
A fixed cost is one which is …………………………….. by changes in the level of
activity, over a defined period of time
Cost related to activity level
The economist’s view
Total cost varying with activity: the economist’s view
Revenue and costs: the economist’s view
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.1
The accountant's view
Variable cost
Fixed cost
Table of data showing variable and fixed costs
Activity level
Variable cost
Fixed cost
Total cost
0 units
£
0
20
20
100 units
£
10
20
30
200 units
£
20
20
40
300 units
£
30
20
50
Total cost
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.2
Total cost and total sales
The breakeven point is that point of activity (measured as sales volume) where
…………………………… and …………………….. are equal, so that there is
……………………………………..
The margin of safety is the difference between the ……………………………… and
the …………………………………….. (measured in units or in £s of sales).
Breakeven chart
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.3
Breakeven analysis
Case study: Market trader
A market trader rents a stall at a fixed price of £200 for a day and sells souvenirs.
These cost the trader 50 pence each to buy and have a selling price of 90 pence each.
How many souvenirs must be sold to break even?
Algebraic method
The equation for the breakeven point is:
……………..
=
……………….costs + …………….. costs
If the number of souvenirs sold at the breakeven point is n, then the total sales
revenue is 0.9n and the total variable cost is 0.5n.
………
……….
=
=
………
………..
+ ……………..
Solving the equation, n = …………….. souvenirs to be sold to break even.
Formula method
Contribution per unit is the ………………………………… minus the
…………………………………….. It measures the contribution made by each item
of output to ……………………………….. and ………………………. of the
organisation.
Breakeven point
=
………………..
…………………………………..
Contribution is ………………… per souvenir (selling price 90 pence minus variable
cost 50 pence) and the fixed costs are £200.
Breakeven point
=
……….
=
500 units
……….
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.4
Graphical method
Sales of 900 souvenirs at 90 pence each
= £……………
The sales line will therefore join the points (…………….) and (……………..)
Variable cost of 900 souvenirs at 50 pence each
= £………..
Fixed cost
= …………
Total cost
£…………
The total cost line joins (………………) and (…………………..).
Breakeven chart
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.5
Profit–volume graph
Profit/volume ratio =
………………………………  100
……………………………..
Profit–volume chart
Illustration
When sales are zero, there will be a loss equal to the fixed cost, which gives the first
point to plot at (…………………..).
When 900 units are sold the sales are £810 and the profit is £160, giving the second
point to plot at (……………………….).
Profit-volume chart using data from the case study 'Market trader'
The breakeven point of …………… profit or loss is at a sales level of £……………...
The graph rises by £…… of profit for every £…………… increase in sales activity,
giving a slope of ……………..%.
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.6
The profit/volume ratio is calculated by formula as:
……………………..
=
……………………….
……………
= 44.4%
……………..
Using breakeven analysis
Breakeven analysis may be used to answer questions such as:

What level of …………………. is necessary to cover ………………… and make
a specified ……………..?

What is the effect of contribution per unit ……………………………………?

What happens to the breakeven point when the ………………………. changes?

What happens to the breakeven point when the …………………………………
changes?

What happens to the breakeven point when the ………………….. change?
Covering fixed costs and making a profit
Data
Selling price per unit
Variable cost per unit
Fixed cost
Desired level of profit
80 pence
30 pence
£300
£400
The contribution per unit is ………………… pence (80 pence  30 pence). To find
the breakeven point, the ………………………….. are divided by the
………………………………… to obtain a breakeven point of ………………..
To meet fixed costs of ………………… and desired profit of ………………..
requires the contribution to cover …………………. in all.
Volume of sales required =
………..
= …………….. units
………..
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.7
Beyond the breakeven point
A dry-cleaning shop takes two types of clothing. Jackets cost £6 to clean and the
customer is charged £9 per garment. Coats cost £10 to clean and the customer is
charged £12 per garment. The monthly fixed costs are £600 for each garment
(representing the rental costs of two different types of machine). The shop expects to
take in 500 jackets and 500 coats in the month.
Calculation of breakeven point and of sales beyond the breakeven point
Selling price
Variable cost
Contribution per item
Fixed costs
Breakeven point
Profit for sales of 500 units
Jackets
£
9
6
3
£600
Coats
£
12
10
2
£600
…… units
……. units
£……..
£………
The calculations show that, although both products have the same ………………., the
jackets have a lower ……………….. because they make a ……………….
contribution per unit. Beyond the breakeven point they continue to contribute
……………………. The profits at any given level of activity are therefore
…………………… for jackets.
Change in selling price
If the selling price per unit …………….. and costs remain ……………………., then
the contribution per unit will …………….and the breakeven volume will be ………...
Take as an example the dry-cleaning business of the previous illustration. If the
selling price of cleaning a coat rises to £15 then the contribution per unit will rise to
£……. That will require cleaning only ………. coats to break even. The ……….. of
raising the price is that customers may move elsewhere so that while it may not be
difficult to exceed the breakeven point at a selling price of £12 it may be extremely
difficult at a selling price of £15.
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.8
Change in variable cost
If the variable cost increases then the contribution per unit will ……………., with the
result that ………… items will have to be sold in order to reach the breakeven point.
If it is possible to ……. variable costs then the contribution per unit will ………. The
enterprise will reach the breakeven point at a ………………….. level of activity and
will then be earning profits at a faster rate.
Change in fixed costs
If fixed costs increase then ………………. units have to be sold in order to reach the
breakeven point. Where the fixed costs of an operation are relatively high, there is a
perception of greater …………. because a cut-back in activity for any reason is more
likely to risk leading to a loss. Where an organisation has relatively low fixed costs,
there may be ……………. concern about margins of safety because the breakeven
point is correspondingly ………………….
Limitations of breakeven analysis

The breakeven graphs assume that cost and revenue behaviour patterns are
…………. and change on a ……………………….. basis as activity levels
change.

It may not always be feasible to split costs neatly into variable and fixed
categories. Some costs show …………………. behaviour.

The breakeven graphs assume that fixed costs remain ………………. over the
volume range under consideration. If that is not the case then the graph of total
costs will have a ………… in it where the fixed costs are expected to increase.

Breakeven analysis, as described so far in this text, assumes input and output
volumes are ………………, so that there is no build-up of stocks and work-inprogress.

Breakeven charts and simple analyses can only deal with ……………… at a time.

It is assumed that cost behaviour depends entirely on ……………..
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.9
Applications of contribution analysis




Accepting a special order to use up spare capacity.
Abandoning a line of business.
The existence of a limiting factor.
Carrying out an activity in-house rather than buy in a service under contract.
Special order to use up spare capacity
The special order is acceptable provided the sales price per item covers the
…………………. costs per item, and there is ……………………………………. for
the spare capacity which could give a higher contribution per item.
Abandonment of a line of business
In the short term it is worth continuing if the business makes a ………………………
to fixed costs. If the line of business is abandoned and nothing better takes its place,
then that ………………………………………. but the fixed costs run on regardless.
Existence of a limiting factor
This means shortage of ………………………., or ………………………………..
Contribution analysis shows that maximisation of profit will occur if the activity is
chosen which gives the highest contribution ……………………………………..
In-house activity versus bought-in contract
The decision should be based on …………………. of variable costs per unit, relating
this to the …………………….. in fixed costs between the options.
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.10
Pricing decisions
Economic factors affecting pricing




Monopoly position will be able to dictate its own price but may attract new
entrants.
Market leader may be able to set its price by reference to covering its full costs
and making a satisfactory profit.
A few large sellers may compete with each other on price.
In the perfectly competitive market optimal price will be achieved where
………………………..…. equals ………………………………………..



Pricing policy depends primarily on the circumstances of the business.
Pressure from customers may force business to reduce selling price.
There are some situations in which a cost-based pricing formula may be
appropriate.
Cost-based pricing



The most readily available cost-based approach to pricing is to calculate the total
cost per unit of output and add a percentage to that cost called the ………………
A ‘normal’ mark-up may be characteristic.
Cost-plus pricing may not take into account the demand for the product.
Financial and Management Accounting, Third Edition
P Weetman and P Gordon. Copyright © Pearson Education Limited 2003
Student notes 21.11