Accounting Business Reporting for Decision Making

424 Accounting: Business Reporting for Decision Making

An understanding of fixed and variable costs is necessary in order to explore break-even analysis.

REALITY CHECK

Mixed costs in practice

Communication and utility costs are good examples of a mixed cost. Telephone and internet costs are

usually a mix of a fixed component (e.g. rental or access charges) and a variable component (e.g. usage

relating to calls or levels of internet traffic). Cost of utilities (e.g. gas and electricity) will include a supply

charge, which is fixed, and a variable component based on usage.

10.2 Break-even analysis

LEARNING OBJECTIVE 10.2 Prepare a break-even analysis for single-product and multi-product
entities.

Break-even analysis relates to the calculation of the necessary level of activity required in order to

break even in a given period. Break-even occurs when total revenue and total costs are equal, resulting

in zero profit. There are a number of ways in which the break-even calculation can be made. (Illustrative

example 10.1 explores the more popular of these.)

Break-even analysis draws on the traditional understanding of fixed and variable costs to introduce

the concept of the contribution margin. The contribution margin is calculated by deducting total vari-

able costs from the total revenue. To determine contribution margin per unit the variable cost per

unit is deducted from the revenue per unit. We can think of the contribution margin as that amount of

revenue that contributes in the first instance towards fixed costs with any excess contributing to profit.

Alternatively, if the contribution margin does not cover fixed costs, then the entity is in a loss-making

situation. At break-even point, the total contribution margin is equal to the fixed costs.

We will now calculate break-even for single-product and multi-product entities and highlight the dif-

ferences in calculations for each.

Break-even analysis is an important tool for entities such as airlines to understand the financial impact

of changing cost structures.

In the following reality check ‘Altering margins to drive volume’ we have given two examples where

organisations have tried to drive revenue by reducing prices, therefore reducing contribution margin, or

offering free services, thereby increasing variable costs.

REALITY CHECK

Altering margins to drive volume

Organisations are constantly trying to find ways to improve financial performance, often altering the mix

between sales volume, price and cost. Two recent examples include the following.

1. A reduction in food and drink prices at sporting events at the Melbourne Cricket Ground. While the
   focus may be on the affordability of food and drink for sporting fans, food and drink vendors will hope
   that the volume of sales will increase to offset the price reductions.


2. Virgin Australia introduced free beer, wine and snacks on specific routes to try to capture more of the
   business market, particularly between Sydney and Canberra. While this may increase the variable cost
   and reduce the contribution margin, Virgin will hope that a rise in the volume of passengers will drive
   profitability.
   Source: Jefferson, A 2015, ‘MCG slashes the price of popular food items including hot dog and pie’, Herald Sun,
   2 March, http://www.heraldsun.com.au/news/victoria/mcg-slashes-the-price-of-popular-food-items-including-hot-dog-and-pie/
   story-fni0fit3-1227244436025; Creedy, S 2011, ‘Virgin Australia to offer free drink and nibbles to business fliers’,
   The Australian, 16 August, http://www.theaustralian.com.au.