What is the break even point and the shut down point? Explain the significance of these points in relation to the output decisions of a competitive firm.
The break even point is the point at which a company's revenues equal its expenses for a certain time period. To calculate the break even point for sales, you need to know the fixed costs (costs that don't change depending on the volume of sales, such as the cost of renting the factory in which the product is manufactured or the cost of paying salaries and taxes); variable costs (costs that change depending on the sales volume, including the cost of producing each unit); and the sales price of the product. To find the break even point, you divide the fixed costs by the quantity represented by the price minus the variable costs. That will provide the break even point in units sold. The break even point helps managers determine the output they will need to start earning a profit at a particular price. If, for example, they are worried about selling a particular number of units to turn a profit, they will have to price each one higher to turn a profit, given their fixed costs.
The shut down point is the lowest price a company can use for a product to justify continuing to produce that product in the short term. In the short term, the cost per unit must be greater than the variable costs for a product, or the company must discontinue producing it. A company's fixed costs remain the same no matter the output of the company. If a company can earn more than the shut down point, it can use the revenue to contribute to paying its fixed costs. The shut down point helps companies determine the minimum output at a certain price that they need to pay their variable costs.
The break-even point refers to the point at which total cost and total revenue are equal. At the break-even point, a business has neither gained a net profit, nor suffered a net loss. In relation to the output decisions of a competitive firm, the break-even point is a reliable indication of the amount of output needed before a business can begin to make a net profit. If a business cannot meet this demand, then it is unlikely that they will be able to continue functioning since the break-even point is the bare minimum level to which sales revenue must aspire.
On the other hand, the shut-down point is the point at which total revenue is equal to variable cost. At this point, there is neither incentive to continue production, nor incentive to limit it. In relation to the output decisions of a competitive firm, the shut-down point is a reliable indication of the point at which a business should consider shutting down production. If a business cannot even meet the demands of its variable costs, then the business is operating with costs that are greater than the benefits generated by those operations, even if costs remain fixed.
'Break-even point' and 'shut-down point' appear to sound as similar concepts, but these are concepts from two different topics. Break-even point is a concept for companies to take business decision based on relationship between product cost, price and volume. The concept of competition has no role to play in break-even analysis. Concept of shut-down point is from the field of economics. It is used to understanding the way companies decide on the level of their sales and production volume taking into consideration between production cost, sales price and customer demand under competitive conditions.
Break-even point is defined the level of production and sales of product by a firm at which the sales revenue generated is exactly equal to the cost of production. The term break-even is used to mean that the company makes no profit and on loss - it breaks even.
Typically the production cost for any product can be be divided in two components, a fixed cost component and a variable cost components. The same fixed cost is incurred by the company irrespective of the level of production. For example if a production facility is set up some costs will be incurred for the things like rent, depreciation and interest charges which are fixed for a period irrespective of production volume. The variable cost is directly proportional to the volume of production, and is incurred on things like raw material used, piece rate wages paid and other expenses related directly to the production. The company must typically fix a selling price that is more than the variable cost per piece. Unless this is so, more a company produces, more losses it will make. The excess of selling price over the variable cost is called "contribution to fixed cost and profits" or simply contribution. This total amount of contribution can be represented bu the following equation.
Total contribution = Sales volume x (Selling price - variable cost)
And profit of the company = Total contribution - fixed cost
At zero volume the company, the contribution is zero, and the company makes a loss equal to the fixed cost. AS the sales increases the contribution increase in direct proportion. As one point of sales volume called break-even point the contribution is exactly equal to fixed cost. At this point company makes no profit and no loss. Company makes losses below the break-even point, and profit above this point.
The break-even analysis is generally used by the companies to take decision on new investments.
Shut-down point is the minimum market price at which a company would prefer to close down its operation rather than manufacture anything. In determining the shut-down price it is assumed that the variable cost per unit decreases with increasing volume up to a point. After this the the variable cost rises. As a result when a curve of quantity on x-axis and and average variable cost on y-axis is drawn it is a u-shaped curve. The shut down point for the company is the lowest point on this curve.
The concept of shut-down point is used to understand and analyse and understand the way companies take decision on the product level under competitive conditions. It is not used by the companies themselves for their decision making.