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Break-even analysis is of vital importance in determining the practical application of cost functions. It is a function of three factors, i.e. sales volume, cost and profit. It aims at classifying the
dynamic relationship existing between total cost and sale volume of a company.
Hence it is also known as cost-volume-profit analysis. It helps to know the operating condition
that exists when a company breaks-even, that is when sales reach a point equal to all expenses
incurred in attaining that level of sales. The break-even point may be defined as that level of
sales in which total revenues equal total costs and net income is equal to zero. This is also known
as no-profit no-loss point. This concept has been proved highly useful to the company executives
in profit forecasting and planning and also in examining the effect of alternative business
management decisions.
Contents
1. Break-Even Point
2. Determination of Break-even Point
3. Managerial Uses of Break-Even Analysis
1. Break-Even Point:
The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined in
terms of physical units, i.e., volume of output or it may be determined in terms of money value,
i.e., value of sales.
in terms of Physical Units:
This method is convenient for a firm producing a product. The is the number of units of a
product that should be sold to earn enough revenue just to cover all the expenses of production,
both fixed and variable. The firm does not earn any profit, nor does it incur any loss. It is the
meeting point of total revenue and total cost curve of the firm.
The break-even point is illustrated by means of Table 1:
Table 1: Total Revenue and Total Cost and
Output Total
in units Revenue
Total
Fixed
Cost
Total
Total Cost
Variable Cost
150
150
50
200
150
150
300
100
400
150
300
450
1150
600
150
450
600 BEP
200
800
150
600
750
250
1000
150
750
900
300
1200
150
900
1050
Some assumptions are made in illustrating the . The price of the commodity is kept constant
at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total revenue is increasing
proportionately to the output. All the units of the output are sold out. The total fixed cost is kept
constant at Rs. 150 at all levels of output.
The total variable cost is assumed to be increasing by a given amount throughout. From the Table
we can see that when the output is zero, the firm incurs only fixed cost. When the output is 50,
the total cost is Rs. 300. The total revenue is Rs. 200. The firm incurs a loss of Rs. 100.
Similarly when the output is 100 the firm incurs a loss of Rs. 50. At the level of output 150 units,
the total revenue is equal to the total cost. At this level, the firm is working at a point where there
is no profit or loss. From the level of output of 200, the firm is making profit
Break-Even Chart:
Break-Even charts are being used in recent years by the managerial economists, company executives and government agencies in order to find out the break-even point. In the break-even charts,
the concepts like total fixed cost, total variable cost, and the total cost and total revenue are
shown separately. The break even chart shows the extent of profit or loss to the firm at different
levels of activity. The following Fig. 1 illustrates the typical break-even chart.
In the preparation of the break-even chart we have to take the following considerations:
(a) Selection of the approach
(b) Output measurement
(c) Total cost curve
(d) Total revenue curve
(e) Break-even point and
(f) Margin of safety.
In the case of term loans, the financial institutions shall have to find out the probability of the
applicant being able to meet the interest and loan repayment schedule. It will be more interested
in knowing the level of break-even point where not only total costs are required but also the full
debt service.
The level of break-even is called the cash break-even. It is based on revenue and cost data
involving cash flows. The depreciation, investment allowance reserve and other provision of the
cost items should be excluded but at the same time the repayment of installment should be added
to fixed cost.
Cash Break-Even Point = Fixed Cost+ Loan installment Cash outflow/Contribution per unit
(ii) The Income Break-Even:
The various sources from which the industry is proposed to be financed such as the capital, long
term borrowing, deferred payments and other sources. If these sources are inadequate the
industry may approach the bank for under writing its shares. If the share market does not respond
positively, the equity risk falls on the underwriter.
As the share holder of the bank will expect a certain dividend just to cover the payment of
interest for the term loans. In order to calculate income break-even point the equity capital cash
earnings should be added. The income breakeven point can be calculated in the following
manner.
Income Break-Even Point = Fixed Cost + Earnings required for dividend/Contribution per unit
Multiple-product Firms and Break-Even Point:
The multiple products may differ in models, styles or sizes of their output. In the case of multiproduct firms the break-even point for each product can be calculated if the product mix is
known. The product mix is the full list of products offered for sale by a Company. It may range
from one or two product lines to a combination of several product lines or groups.
Suppose an industry is engaged in the production of three items, namely X, Y, and Z. The
contribution for items is as follows:
X = Rs. 6 per unit
Y = Rs. 4 per unit
Z = Rs. 2 per unit
The product-mix given by the manufacturer is as follows:
X = 40,000 units
Y = 2, 00,000 units
Z = 1, 60,000 units.
Then the product-mix proportions are 1:5:4. We can work out the weighted average
contribution in the following way:
Product Contribution x Unit Proportions Total Contributions
X6x16
Y 4 x 5 20
Z2x48
____ ____
10 34
Average Contribution per unit = 34/ 10 = Rs 3.4
BEP= Total Fixed Cost/ Average contribution per unit = 5, 10,000 / 3.4 = 1, 50,000 units
We will get the break-even output for all the three items by dividing the above figure in the same
proportion
X = 15,000
Y = 75,000
Z = 60,000
This reveals that the production manager has to ensure that production in the X line does not go
below 15,000 units, in the Y line 75,000 units and in the Z line 60,000 units. If not, he has to
sustain loss. The same method can be applied for computing the in cases of multiple
product industries producing any number of items.
Assumptions of Break-Even Analysis:
The break-even analysis is based on the following set of assumptions:
(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.
(ii) The cost and revenue functions remain linear.
(iii) The price of the product is assumed to be constant.
(iv) The volume of sales and volume of production are equal.
(v) The fixed costs remain constant over the volume under consideration.
(vi) It assumes constant rate of increase in variable cost.
(vii) It assumes constant technology and no improvement in labour efficiency.
(viii) The price of the product is assumed to be constant.
(ix) The factor price remains unaltered.
(x) Changes in input prices are ruled out.
(xi) In the case of multi-product firm, the product mix is stable.
Example:
The fixed cost of a firm increases from Rs. 5,000 to Rs. 6,000. The variable cost is Rs. 5 and the
sale price is Rs. 10 and the firm sells 1,000 units of the product
New Sales Volume = 1,000 + 6,000 5,000/ 10 5 =1,000 + 1,000/ 5 = 1,000 + 200=1,200 units
New Sale Price = 10 + 6,000 5,000/ 1,000 = 10 + 1,000/ 1,000= Rs.10 + Re1
= Rs. 11
(v) Decision on Choice of Technique of Production:
A firm has to decide about the most economical production process both at the planning and
expansion stages. There are many techniques available to produce a product. These techniques
will differ in terms of capacity and costs. The breakeven analysis is the most simple and helpful
in the case of decision on a choice of technique of production.
For example, for low levels of output, some conventional methods may be most probable as they
require minimum fixed cost. For high levels of output, only automatic machines may be most
profitable. By showing the cost of different alternative techniques at different levels of output,
the break-even analysis helps the decision of the choice among these techniques.
(vi) Make or Buy Decision:
Firms often have the option of making certain components or for purchasing them from outside
the concern. Break-even analysis can enable the firm to decide whether to make or buy.
Example:
A manufacturer of car buys a certain components at Rs. 20 each. In case he makes it himself, his
fixed and variable cost would be Rs. 24,000 and Rs.8 per component respectively.
BEP = Fixed Cost/ Purchase Price Variable Cost
= 24,000/ 20-8 = 24,000/ 12 = 2,000 units
From this, we can infer that the manufacturer can produce the parts himself if he needs more than
2,000 units per year. However, certain considerations need to be taken account of in a buying
decision, such as
(i) Is the required quality of the product available?
(ii) Is the supply from the market certain and timely?
(iii) Do the supplies of the components try to take any monopoly advantage?
If a product has outlive utility in the market immediately, the production must be abandoned by
the management and examined what would be its consequent effect on revenue and cost.
Alternatively, the management may like to add a product to its existing product line because it
expects the product as a potential profit spinner. The break-even analysis helps in such a
decision.
Example:
A fan manufacturer possesses the following data regarding his firm:
Total Fixed Cost = Rs. 1, 50,000
Volume of Sales = 5, 00,000 units
The manufacturer is considering whether or not to drop heaters from its product line and replace
it with a fancy kind of fan.
He knows that if he takes the decision of dropping heaters and replaces it with fancy fans
his output and cost data would be:
Total Fixed Cost = Rs. 1, 50,000
Likely Volume of Sales = Rs. 5, 00,000
To find out the impact of proposed change, we need to compare profits in the two situations.
Firstly, we have to find out the contribution ratio of each product.
Therefore, the contribution ratio of the entire product line = 0.167+ 0.12+ 0.08 = 0.367
Total Contribution = Rs.5, 00, 00 0.367 = Rs 1,83,500
Profit = Total Contribution Total Fixed Cost
= Rs. 1, 83,500 Rs. 33,500.
We have to follow the similar analysis for the second situation:
Contribution Ratio of Ordinary Fans = 360 240/ 360 50% = 0.167
Contribution Ratio of Exhaust Fans = 600 360/ 600 20% = 0.08
Contribution Ratio of Fancy Fans = 850 450/ 850 30% = 0.141
Thus the contribution ratio of the entire product line = 0.167+0.08+0.141 = 0.388.
Total Contribution =Rs. 5, 00,000 x 0.388=Rs. 1, 94,000
Profit= Rs. 1, 94,000 Rs. 1, 50,000=Rs 44,000
From the above analysis, we can infer that the manufacturer should drop heaters from his product
line and add fancy fens to his product line so as to earn more profit.
Limitations:
1. In the break-even analysis, we keep everything constant. The selling price is assumed to be
constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future with the
help of past functions. This is not correct.
3. The assumption that the cost-revenue-output relationship is linear is true only over a small
range of output. It is not an effective tool for long-range use.
4. Profits are a function of not only output, but also of other factors like technological change,
improvement in the art of management, etc., which have been overlooked in this analysis.
5. When break-even analysis is based on accounting data, as it usually happens, it may suffer
from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates
and inappropriate allocation of overheads. It can be sound and useful only if the firm in question
maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because changes in
selling costs are a cause and not a result of changes in output and sales.
7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate
income tax.
8. It usually assumes that the price of the output is given. In other words, it assumes a horizontal
demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a
particular period need not be the result of the output in that period.
10. Because of so many restrictive assumptions underlying the technique, computation of a
breakeven point is considered an approximation rather than a reality.