BREAK EVEN ANLAYISIS

MANAGEMENT ACCOUNTING AND CONTROL

BY LOGO

Rupesh Kumar Kanaujiya Sanjeev Acharya Satya Prakash Rao Shubham Aggrawal Shweta Dariyal

CONTENTS
Introduction to Break-Even-Point
Algebraic Break Even Point

Cash and Composite Break-Even Charts

Graphical Method: Break Even

Margin of Safety

Managerial Usage of Break Even Analysis

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Cost-volume-profit analysis

It is a management accounting tool. In cost-volume-profit analysis an attempt is made to analyse the relationship between variation in cost with variation in volume. The widely used technique to used cost volume profit analysis is Break Even Analysis
3

Continued

Cost-volume-profit relationship is of immense utility management, it can be used to answer question such as-

to

How much sales should be made to avoid losses? How much should be the sales to earn a desired profit? What will be the effect of change in prices, costs and volume on profits? Which product or product mix is most profitable? Should we manufacture or buy some product or component?
4

Break Even Analysis

The Break even analysis shows the relationship between costs and profits with the sales volume.

The term Break even analysis is used in two senses Broad sense- Relation between costs, volume and profit at different levels of sales or production Narrow sense- Refers to a technique of determining that level of operations where total revenue equal total expense, i.e., the point of no profit, no loss.

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Assumptions of Break-Even analysis

All elements of cost can be segregated into fixed and variable components. Fixed cost remain constant at all volume of output. Variable cost remains constant per unit of output, fluctuates directly in proportion to changes in level of output. Selling price per unit remains unchanged. Volume of production is only factor that influences cost. There will be no change in general price level.
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Applications of BEP Analysis

Break even analysis is more applicable to determine the level of sales of a new product that must be attained to put the firm in profit. If any firm attempts to introduce a new product, then certainly it has to forecasts its possible sales volume resulting from demand analysis of the product. Now, with the application of break even analysis, a firm can determine the profitability of new products from perceived sales level.

New Product Development

Expansion Decisions:
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Break even analysis is equally applicable to know the effect of the expansion of the firms existing operations. In any expansion program the firm proceeds to add additional capacity so that additional fixed cost is incurred. Now, it can determine how profitable the expansion decision is in relation to perceived sales volume, variable cost and selling price per unit. This information enables the manager to decide upon whether the selling price per unit has to be increased or decreased.

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Limitations of Break Even Analysis

Multiple Products

Mostly the break even analysis is applicable to single product firm. When a firm works on multiple products, then the task of cost allocation becomes difficult for each product in the group of multiple products.

Non Linear Relationships

The basic assumption of break even analysis is that the variable cost per unit and selling price per unity remains unchanged. But in reality these changes with output because of intensification of competition and economies of scale. Therefore break even analysis may mislead in profit planning and control process

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Break even point

Break even point

Point of sales volume at which total revenue is equal to total cost.

It is the point of no profit, no loss.

At this point, contribution, i.e., sales minus marginal cost, equals the fixed costs. This point is often called as Critical Point or Equilibrium point or Balancing point.
1 0

Computation of the break even point

Break even point can be computed by the following two methods: 1 2

The Algebraic Formula method

Graphic or Chart method

1 1

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Algebraic Formula Method

The break-even point can be computed in terms of:

1. Budget total or in terms of money value 3. As a percentage of estimated capacity

1 2

2.Units of sales volume

(a) Break-Even points in units

At the point of break-even, total contribution equal the total fixed costs. FormulaBreak-Even point = fixed cost
selling price per unit-variable cost per unit

fixed cost contribution per unit

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Example 1

Calculate the break-even point in units: Output = 3,000 units Selling price per unit = Rs. 30 Variable cost per unit = Rs. 20 Total fixed cost = Rs. 20,000
Break-even points (in units) = fixed cost selling price per unit- variable cost = 20,000 = 20,000 30-20 10 = 2,000 units

1 4

(b) Break even point in terms of budget-total or money value

At break-even point: Total sales= Total fixed cost + Total variable cost S= F+V (where S= sales, F= fixed cost & V=variable cost) Or S-V = F Or S-V F (dividing both sides by S-V) = S-V S-V Or F 1 = S-V Or Fx S (multiplying both sides by S) Sx1 = S-V
1 5

Continued

Hence, break-even sales =

fixed cost sales-variable cost

x sales

Fixed cost With the use of P/V ratio, B.E.P. = P/V ratio as contribution = P/V ratio sales

1 6

Example 2
Calculate the break-even point in Sales Value: Output = 3,000 units Selling price per unit = Rs. 30 Variable cost per unit = Rs. 20 Total fixed cost = Rs. 20,000
Break-even point (in sales value) fixed cost sales variable cost Hence, B.E.P. (in sales value) = = = = = = 1 7 fixed cost X sales sales- variable cost Rs. 20,000 (given) 3,000 x 30 = Rs. 90,000 3,000 x 20 = Rs. 60,000 20,000 x 90,000 90,000- 60,000 20,000 x 90,000 = Rs. 60,000 30,000

P/V Ratio

The P/V ratio shows the relationships of contribution to the sales volume.

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Applications of P/V Ratio

Determinants of BEP (BEP=FC/P-V ratio) Determinants of profits at given/budgeted sales volume.

Profit= (Actual sales-BEP Sales) X P/V Ratio Determinants of Sales volume to earn budgeted profits Sales=(FC + Desired Profit)/P-V Ratio Determinants of the percentage of net profit with the help of Margin of Safety ratio % of Net Profit =(P/V Ratio X MS Ratio)
1 9
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Example 3:

From the following data, calculate: (a) P/V ratio (b) Break-even sales with the help of P/V ratio (c) Sales required to earn a profit of Rs. 4,50,000 Fixed expenses Variable cost per unit: Direct material Direct labor Direct overhead Selling price per unit = Rs. 90,000 = = = = Rs. 5 Rs. 2 100% of direct labour Rs. 12

2 0

Solution:
Selling price per unit = Less:
Direct material Direct labor Direct overhead

12
Rs. 5 Rs. 2 Rs. 2

Rs 12

Rs. 9

Contribution per unit = (12 9) (a) P/V ratio = =

Rs. 3 contribution X 100 sales 3 X 100 = 25% 12

21

Continued

(b) Break-even sales

= Fixed expense P/V ratio = 90,000 = 90,000 x100 25 25 100 = Rs. 3,60,000

22

Continued

(c) Sales required to earn a profit of Rs. 4,50,000 = fixed expense + desired profit P/V ratio = 90,000 + 4,50,000 = 5,40,000 25% 25 100 = 5,40,000 x 100 = Rs. 21,60,000 25

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(c) Break-even point as a Percentage of estimated capacity

Break even point (as a percentage of estimated capacity or sales)

break even sales = estimated sales For example: if estimated capacity = 1,00,000 units & break even sales = 50,000 units then B.E.P. = 50% of estimated capacity And if total contribution at full capacity is available then B.E.P. = fixed cost total contribution

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LOGO

LOGO

CASH BREAK-EVEN POINT

The

cash break-even point may be defined as that point of sales volume at which total revenue is equal to total cash cost. At this point, cash contribution equals the cash fixed cost.

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CONTD..

This

point enables the management to determine the level of activity below which the liquidity position of the firm would be adversely affected.
Break-Even Point (in units) = Cash Fixed Cost Cash Contribution per unit

Cash

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ILLUSTRATION

From the following information, calculate the cash break-even point.

Selling Price per unit Variable cost per unit Depreciation included in above per unit Fixed Cost Depreciation included in fixed cost Rs. 40 30 5 1,00,000 25,000

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SOLUTION

= Rs. 1,00,000 25,000 = Rs. 75,000 Cash contribution per unit = Rs. 40 (30-5) = Rs. 15 Cash Break-Even Point = Cash Fixed Cost Cash Contribution per unit = 75,000 = 5,000 units 15 Cash Break-Even Point in sales value = Rs. 5,000 x 40 = Rs. 2,00,000 Cash Fixed Cost

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COMPOSITE B-E POINT

We can also calculate the composite break-even point for a firm producing several products, as below:
Composite Break-Even Point (in Sales value) = Total Fixed Cost Composite P/V Ratio And, Composite P/V Ratio = Total Contribution x 100 Total Sales

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ILLUSTRATION

From the following information of a company producing three products, you are required to compute (a) Composite P/V Ratio, and (b) Composite Break-Even Point.
Product X Y Z Sales Revenue Rs. 20,000 40,000 60,000 Variable Cost Rs. 10,000 14,000 36,000

Fixed costs : Rs. 50,000.

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SOLUTION

Product

Sales Revenue (Rs.)

Variable Cost

Contribution (S V) (Rs.)

P/V Ratio

(Rs.)

X Y Z Total

20,000 40,000 60,000 1,20,000

10,000 14,000 36,000 60,000

10,000 26,000 24,000 60,000

50% 65% 40% 50%

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CONTD..

(a) Composite P/V Ratio = Total Contribution x 100 Total Sales = 60,000 x 100 = 50% 1,20,000 (b) Composite Break-Even Point (in Sales value) = Total Fixed Cost Composite P/V Ratio = 50,000 = Rs. 1,00,000 50%
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Management Accounting and Control

LOGO

GRAPHIC METHOD
The

break-even point can also be computed graphically with the help of Break-Even Charts. is a graphical representation of

A break-even chart

marginal costing.
The

break-even chart portrays a pictorial view of the relationship between costs, volume and profits.

It shows the break-even point and also indicates the estimated profit or loss at various levels of output.
break-even point is the point (in the chart) at which the total cost line and the total sales line intersect.
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The

ILLUSTRATION
Plot the following data on a graph (break-even chart) and determine (a) break-even point (b) profit if the output is 25,000 units.
Output Variable Cost (units) (per unit) Rs. 0 5 5,000 5 10,000 5 15,000 5 20,000 5 25,000 5 30,000 5 Total VC Fixed Total Cost SP Expenses (per unit) Rs. Rs. Rs. 75,000 75,000 10 75,000 1,00,000 10 75,000 1,25,000 10 75,000 1,50,000 10 75,000 1,75,000 10 75,000 2,00,000 10 75,000 2,25,000 10
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Rs. 0 25,000 50,000 75,000 1,00,000 1,25,000 1,50,000

Total Sales Rs. 0 50,000 1,00,000 1,50,000 2,00,000 2,50,000 3,00,000

SOLUTION

FIRST METHOD:

Under this method following steps are taken to draw the break-even chart :
1.

Volume of production/output or sales is plotted on horizontal axis i.e., X-axis. The volume of sales or production may be expressed in terms of rupees, units as a percentage of capacity.
Costs and sales revenue are represented on vertical axis, i.e. Y-axis.
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2.

CONTD..
3.

Fixed cost line is drawn parallel to X-axis. The line indicates that fixed expenses remain constant at all levels of activity. Sales values at various levels of output are plotted and a line is drawn joining these plotted points. This line is called the sales (revenue) line. The point of intersection of total cost line and sales (revenue) line is called the break-even point.

4.

5.

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350 300
Cost and Revenues 250 (Rs, `000) Profit
Profit Area

200 150 100 50

Loss Area

BEP
Margin of safety

Variable Expenses

Fixed cost line

Fixed Expenses

5000

10000

15000 20000 25000

Output in units

30000

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CONTD..
6.

The number of units to be produced at break-even point can be determined by drawing a perpendicular to the Xaxis from the point of intersection of cost and sales line. The sales revenue at break-even point can be determined by drawing a perpendicular to the X-axis from the point of intersection of cost and sales line. The area below the break-even point represents the loss area as the total sales is less than the total cost and the area above the break-even point indicates the area of profit as the sales revenue exceeds the total cost.
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7.

8.

GRAPHIC METHOD

SECOND METHOD: The break-even chart can also be drawn by another method which is a variation of the first method.

Under this method, the variable cost line is drawn first and then total cost line is drawn over and parallel to the variable cost line

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350 300
Cost and Revenues 200 (Rs, `000) Profit

250
BEP
Margin of safety

Profit Area

Fixed Cost

150 100 50
Loss Area

Variable Cost

5000

10000 15000 20000

Output in units

25000

30000

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CONTD..

This method is useful to the management for decision making because it reveals additional information:

(a) The

variable costs are shown directly for various levels of output/sales. (b) Marginal contribution at various levels of sales is indicated clearly by the difference between sales line and variable cost line. (c) It indicates the recovery of fixed costs at various levels of production.

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CONTRIBUTION B-E CHART

THIRD METHOD: This is a modified form of a simple break-even chart as shown in the first two methods.

Under this method, total cost line is not drawn, rather another line called contribution line is drawn from the origin and this line goes up with the increase in the level of output.
The fixed cost line is drawn parallel to the X-axis as in the first method. The sales line is also drawn as usual.
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350 300
Cost and 250 Revenues Variable Cost

200
(Rs, `000)

150 100 50
Fixed cost line

Profit BEP

Fixed Cost

5000

10000

15000 20000 25000

Output in units

30000

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CONTD..

In this method, the question of intersection of sales line with the total cost line does not arise because there is no cost line. The break even point is that point where the contribution line crosses the fixed cost line. At this point, total contribution is equal to the total fixed cost and hence there is no profit or loss.

As the contribution increases more than the fixed cost, profit shall arise to the organisation and as contribution decreases from the fixed cost, there shall be loss to the organisation.
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CONTD..

The contribution break-even chart shows clearly the contribution at different levels of activity and indicates that all levels below the break-even point are unable to cover the fixed costs.

Note : In the above example, at level of output/sales of 25,000 units, there is a profit of Rs. 50,000 as indicated by break-even charts under the three methods.

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MARGIN OF SAFETY

The excess of actual or budgeted sales over the breakeven is known as margin of safety. It is the difference between actual sales minus the sales at break-even point. It represents the amount by which sales revenue can fall before a loss is incurred

As at break-even point there is no profit no loss, sales beyond the break-even point represent margin of safety because any sales above the break-even point will give some profit.
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CONTD..
Margin of Safety = Total Sales Sales at Break-Even Point
Margin of Safety calculated in % terms is known as Margin of safety Ratio and can be expressed as:

Margin of Safety Ratio = Margin of safety x 100 Sales = Actual Sales Sales at B.E.P. x 100 Sales

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CONTD..

Margin of safety can also be calculated with the help of the following formula : Profit P/V Ratio

Margin of Safety (M.S.) =

This is so because margin of safety is the volume of sales beyond break-even point and all sales above the break-even point give some profit which can be calculated as : Profit = Margin of Safety x P/V Ratio

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CONTD..

The size of margin of safety is an important indicator of the strength of a business. The large margin of safety indicates that the business is sound and even if there is a substantial fall in sales, there will still be some profit. On the other hand, small margin of safety indicates that position of the business is comparatively weak and even a small decline in sales would adversely affect the profit of the business and may result into losses.

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CONTD..

The margin of safety can be improved by taking the following steps :

By increasing the level of production. By increasing the selling price. c) By reducing the fixed costs. d) By reducing the variable cost. e) By substituting unprofitable products with profitable f) products. g) By increasing contribution by changing the sales mix.
a) b)

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ANGLE OF INCIDENCE

The angle of incidence is the angle between the sales line and the total cost line formed at the break-even point where the sales line and the total cost line intersect each other. The angle of incidence indicates the profit earning capacity of a business. A large angle of incidence indicates a high rate of profit and, on the other hand, a small angle of incidence indicates a low rate of profit.

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CONTD..

Usually, the angle of incidence and margin of safety are considered together to indicate the soundness of a business. A large angle of incidence with a high margin of safety indicates the most favourable position of a business.

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Managerial Usage of Break Even Analysis

Curvilinear Break-Even Analysis Interpretation of CVP Graphs

CVP Graph: Cost-wise

Changes in Fixed and variable costs

Changes in sales and sales mix

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Curvilinear B-E Analysis

The marginal costing approach is based upon the basic assumption that selling price and variable cost per unit will remain constant at all levels of activity or in other words the cost-volume-profit relationship is linear. However, in actual practice, the selling prices do not remain the same forever and for all levels of output due to competition and changes in general price level etc.

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Contd..

Further, it may not be possible to increase the sales volume without offering concessions in price to the customers. In the same manner, variable cost per unit may also increase with the increase in level of production due to operating inefficiencies and the law of diminishing returns. Thus, profit can be increased only upto a certain point and then it will decrease until it is converted into a loss.

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Contd..

The break-even chart will then become curvilinear instead of linear. It might show more than one break-even point, one at a lower level of output and another at a higher level of output. In such a case, increasing output/sales volume beyond the first break-even point will increase profit but increase in volume beyond the second break-even point will result in loss.

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Contd..

The optimum level of output shall be reached at the point where difference between the total revenue and the total cost is the highest.

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CBE Graph

Total Costs

BEP2

Loss

Costs/Revenue
Profit Area Loss BEP1 Total Revenue

Output/Sales
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Interpretation of CVP Graphs

Like the algebraic break-even applications, the CVP graph can be used to analyse the cost-volume-profit planning. CVP graphs can also be used to interpret the following: Distribution of various costs and taxes. Change in fixed costs Change in variable costs Change in selling price, and so on.

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Contd..

The following example illustrates the interpretation of Break-even chart (CVP graph). The data of ABC Ltd. is given below:
Selling price per unit: Fixed Costs: Variable costs per unit: Rs. 10 Rs. 60,000 Rs. 5

Relevant Range (units): lower limit

: upper limit

6,000
20,000

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Contd..

Break up of variable costs per unit:

Direct Material: Direct Labour: Direct Expenses: Selling Expenses: Tax Rate:

Rs. 2 Rs. 1.50 Rs. 1 Rs. 0.50 50%

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CVP Graph, cost-wise

Lets calculate the various costs and selling price for 20000 units.

Selling price per unit = Rs. 10 selling price for 20000 units = Rs. 200,000 Variable cost per unit = Rs. 5 variable cost for 20000 units = Rs. 100,000
direct material cost @ Rs. 2 = 40,000 direct labour @ Rs. 1.50 = 30,000 direct expenses @ Rs. 1 = 20,000 selling expenses @ Rs. 0.50 = 10,000

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Contd..

Fixed cost = Rs. 60,000 So, Total cost for 20,000 units = Variable cost + Fixed cost = 100,000 + 60,000 = 160, 000 The graph shows the various costs separately. Break even point = Rs. 120,000 for 20,000 units. Taxes = 50% of total income = 20,000 Net Income (profit) = Rs. 20,000 Margin of Safety = 200,000FMS-BHU 120,000 = 80,000

CVP Graph

28 0 24 0 20 Cost and 0 Revenues 16 0 (Rs, `000) 12 0 80 40

BEP

Fixed cost line

Sales Volume Sales Revenue

0 20,000 0 200,000

4,000 24,000 40,000 240,000

8,000

12,000

16,000

80,000

120,000
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160,000

Cost-wise CVP graph

28 0 24 0 20 Cost and 0 Revenues 16 0 (Rs, `000) 12 0 80 40

BEP1

Net Income Taxes Total cost Selling line Direct Exp Expenses Direct Labour Direct
Fixed cost line

Material

Sales Volume Sales Revenue

0 20,000 0 200,000

4,000 24,000 40,000 240,000

8,000

12,000

16,000

80,000

120,000
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160,000

Change in fixed costs

Changing the fixed cost by Rs. 10,000.

All values are corresponding to 20,000 units (in Rs.)
Actual values Decreasing fixed cost by 10,000 10 200,000 50,000 5 100,000 100,000 100,000 Increasing fixed cost by 10,000 10 200,000 70,000 5 100,000 170,000 140,000

Various parameters

a b c d e f g

Selling price / unit Total selling price Fixed cost Variable cost / unit Variable cost Total cost (c + e) Break even point

10 200,000 60,000 5 100,000 160,000 120,000

h
i

Margin of safety (b - g)
Operating profit (b - f)

80,000
40,000

60,000
50,000

60,000
30,000
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Change in fixed cost: CVP graph

28 0 24 0 20 Cost and 0 Revenues 16 0 (Rs, `000) 12 0 80 40

Sales Volume Sales Revenue

B BEP2 BEP1 Fixed cost lines

0 20,000 0 200,000

4,000 24,000 40,000 240,000

8,000

12,000

16,000

80,000

120,000
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160,000

Change in variable costs

Changing the variable cost by 10%.

All values are corresponding to 20,000 units (in Rs.)
Actual values Decreasing fixed cost by 10% 10 200,000 60,000 4 Increasing fixed cost by 10% 10 200,000 60,000 6

Various parameters

a b c d

Selling price / unit Total selling price Fixed cost Variable cost / unit

10 200,000 60,000 5

e
f g h i

Variable cost
Total cost (c + e) Break even point Margin of safety (b g) Operating profit (b f)

100,000
160,000 120,000 80,000 40,000

80,000
140,000 100,000 100,000 60,000

120,000
180,000 150,000 50,000 20,000
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CVP Graph: Change in variable cost

28 0 24 0 20 Cost and 0 Revenues 16 0 (Rs, `000) 12 0 80 40

Sales Volume Sales Revenue

BEP2

BEP1 Fixed cost line

0 20,000 0 200,000

4,000 24,000 40,000 240,000

8,000

12,000

16,000

80,000

120,000
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160,000

Change in selling price

Changing the selling price per unit by 25%. The impact of change in sales price is reflected indirectly in the variable cost line.

There is only one sales line in the CVP graph.

The following steps are followed:

Changing sales price per unit by 25%.

Sales price/ unit = Rs. 10 Increasing sales price by 25% = Rs. 12.5 Decreasing sales price by 25% = Rs. 7.5 Variable cost/ unit = Rs. 5
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Contd..

Changing the selling price per unit by 25%. The impact of change in sales price is reflected indirectly in the variable cost line.

There is only one sales line in the CVP graph.

The following steps are followed:

Changing sales price per unit by 25%.

Sales price/ unit = Rs. 10 Increasing sales price by 25% = Rs. 12.5 Decreasing sales price by 25% = Rs. 7.5 Variable cost/ unit = Rs. 5
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Contd..

Changing the sales price to Rs. 10 per unit and reflecting the corresponding change in variable costs:
Actual Values Selling price/ unit Variable cost/ unit Variable cost 12.5 5 100,000 7.5 5 100,000

Changed Values Selling price/ unit Variable cost/ unit Variable cost 10 4 80,000 10 6.67 133,333.33

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Contd..

Changing the selling price by 25%.

All values are corresponding to 20,000 units (in Rs.)
Actual values Change corresponding to sales price of Rs. 12.5 10 200,000 60,000 4 80,000 140,000 100,000 100,000 60,000 Change corresponding to sales price of Rs. 7.5 10 200,000 60,000 6.67 133,333.33 193,333.33 180,000 20,000 6666.67
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Various parameters

a b c d e f g h i

Selling price / unit Total selling price Fixed cost Variable cost / unit Total variable cost Total cost Break even point Margin of safety Operating profit

10 200,000 60,000 5 100,000 160,000 120,000 80,000 40,000

CVP Graph: Change In Selling Price

280
240
Cost and Revenues 200 (Rs, `000) 160
BEP2

120 80 40
Sales Volume Sales Revenue

BEP1 Fixed cost line

0 0

4,000 8,000 12,000 6,000 20,000 24,000 40,000 80,000 120,000 160,000 200,000 240,000
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Change in Sales mix

Many manufacturers make more than one kinds of products. The relative proportion of each product sold in the aggregate sales is known as the sales mix. A change in the mix of products sold affects the Break even point.

So the optimal strategy of the manufacturer is to chose the mix of products in a way so as to lower down the total costs and hence BEP.

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CVP Graph: Change in sales mix

BEP1

Costs/Revenue
BEP2 BEP3 Fixed cost line

Output/Sales
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References

Management Accounting by MY Khan, PK Jain Management Accounting by Shashi K. Gupta, R.K. Sharma

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Management Accounting and Control

LOGO

Management Accounting and Control

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