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Rural entrepreneurship in Wales
Rural entrepreneurship in Wales

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5.3.1 Profit, costs and break-even

Any profit-making organisation should, by definition, make a profit. A not-for-profit organisation should not run up a deficit, and may well be required to produce a surplus (‘profit’ in commercial terms). A crucial function of the profit-and-loss account (which could be a surplus and deficit account in non-commercial terms) is to forecast in advance the likely profit or loss at any stage in the future. This will indicate whether the operation is viable. Costs are split into two basic types: those that are related to the level of product or service being produced, and those that exist whatever level of a product or service is being produced.

Those that exist irrespective of the level of product or service production are called fixed costs (or overheads). They include items such as office and administration expenses, owners’ and directors’ salaries, management salaries, rent and rates. These must obviously be paid or the company cannot continue. The level of fixed costs stays static for a range of production or service provision. Of course, if there is a vast increase in production or service provision then larger offices and more managers may be needed, raising fixed costs.

Those costs that are directly related to the level of production of goods or delivery of services are called variable costs and include cost of materials and services, cost of utilities directly related to production or service provision, wages of employees only concerned with production or service provision, and other items directly concerned with production or service provision. These variable costs will rise as production or service provision increases, and decrease as production or service provision decreases. The increase and decrease can be smooth and directly related to volume – so in the case of Catterline, an increase in production would lead to a similar increase in the variable cost represented by the circuit boards. It can also be ‘stepped’ so the labour costs of the assemblers would remain static until the volume required another assembler when the variable costs would jump by the wages for an extra assembler.

Task 38: Fixed and variable costs

Think back to the information you suggested Gwyneth should collect. Which of these would you consider ‘fixed’ and which ‘variable’ costs?

The cost of ingredients may vary throughout the year and petrol prices may go up and down each month. Equipment required to prepare the products will be a fixed cost.

The majority of these costs are variable.

These two types of cost are used to estimate break-even sales. As sales increase, the contribution (the difference between sales or service value and variable costs) will also increase. When the level of income from sales exactly covers the fixed costs is the break-even. Sales above break-even will contribute to the net profit of the business; they will not necessarily mean that a business has the necessary cash to pay its debts. That must be determined by the cash flow.

Case study: Catterline break-even

Hannah’s operation is almost at break-even at the end of 18 months. In other words, it is at the point where it is neither making a profit nor a loss. At break-even, the sales exactly cover the total costs. The point of knowing that she is at break-even is that a reduction in costs or increase in sales will produce a profit – she has covered her total operating costs.

In general, organisations try to identify the break-even point in order to indicate to themselves, banks and investors that they have reached the point where they should be a viable organisation.