Costs, break-even analysis and budgets

Last time

Before we start: last time, in Business finance, working capital and sources of finance, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Knowing the numbers

Managers need to know what things cost, when the business will break even, and whether it is spending as planned. This lesson covers types of cost, break-even analysis, and budgets with variance analysis. Plan first, then check the plan against what happened.

Types of cost

Fixed costs do not change with output; variable costs do; semi-variable costs have both parts, such as a phone bill. Direct costs can be traced to a product; indirect costs, or overheads, are shared. Average cost is total cost divided by output; marginal cost is the cost of one more unit.

Contribution and break-even

Contribution per unit is price minus variable cost per unit: 50 minus 30 is 20 dollars. Break-even output is fixed costs divided by contribution per unit: 60,000 divided by 20 is 3,000 units. At 4,000 units, the margin of safety is 1,000 units, and profit is 1,000 times 20: 20,000 dollars.

The break-even chart

Output in thousands of units, costs and revenue in thousands of dollars. Revenue rises at 50; total cost starts at 60 and rises at 30. They cross at 3 thousand units and 150 thousand dollars.

Is break-even essential?

For a new hotel, break-even shows how many room nights must be sold to cover high fixed costs, which helps planning and raising finance. But it assumes constant prices and costs and that all output is sold; hotels use dynamic pricing, so the figure is only a guide. So it is useful but not essential on its own; it should be combined with market research and cash flow forecasts.

Budgets

A budget is a financial plan for a future period: sales, costs and profit. Budgets set targets, allocate resources, coordinate departments, and allow control. Zero-based budgeting starts from nothing each year; incremental budgeting adjusts last year's figures.

Variance analysis

A variance is the difference between budgeted and actual figures. Sales of 12,000 against a budget of 10,000 is a favourable variance of 2,000. Costs of 9,000 against a budget of 8,000 is an adverse variance of 1,000. Managers investigate large variances to find causes and take action.

Budgets for big projects

For a large construction project, budgets control spending across many contractors and stages, and warn early of overruns. But estimates can be wrong, and rigid budgets may prevent necessary changes. Their importance depends on how realistic they are and how well they are monitored.

Variances

How to label variances.

Mistakes that lose marks

Mistake one: dividing fixed costs by price instead of contribution. Mistake two: calling higher costs than budget a favourable variance. Mistake three: treating break-even as certain, ignoring its assumptions. The fix: correct formula, correct labels, and limits.

The full-marks tip

The full-marks tip: show break-even working: contribution first, then fixed costs divided by it. Label variances by their effect on profit: helps profit is favourable.

On one card

So, on one card: costs and budgets. Keep it for revision.