You are on page 1of 6

BREAK EVEN ANALYSIS Breakeven analysis is a powerful management tool, and one that is critical in planning, decision-making, and

expense control. Breakeven analysis can be invaluable in determining whether to buy or lease, expand into a new area, build a new plant, and many other such considerations. Breakeven analysis can also show the impact on your business of changing your price structure. As the price goes down (and so your gross margin goes down), breakeven shoots up - usually very rapidly. Breakeven analysis will not force a decision, of course, but it will provide you with additional insights into the effects of important business decisions on your bottom line. Break-even analysis will provide a sales objective that can be expressed in either dollars or units of production or sales, or whatever else is relevant. If the breakeven point is known, it can be a definite target to be reached and exceeded by carefully reasoned steps. Once you know the level of sales you have to reach before making a profit, you can evaluate the reasonableness of this target. What are the odds of reaching this breakeven sales level? One way to test this is to convert the gross pound sales needed for breakeven into some other unit which can then be compared against the capacity of the business or the size of the market. If the breakeven occurs at or near the capacity of the business, or if your analysis shows that you must capture all (or more than all) of the available target market, the feasibility of your concept is suspect, and the odds of business success are loaded against you. Another way to use breakeven analysis is to change the variables in the equation. If fixed or variable expenses can be reduced, the breakeven point will go down. If prices can be increased without hurting sales (and without increasing costs), the breakeven point will go down. This is an excellent way to experiment with different alternatives. Clearly, this is a subjective process - but then, so is the rest of business analysis. The purpose is to make your business decision making as reasonable as possible. Costing Systems and techniques for engineering companies There are three major types of costing they include; 9. Absorption Costing 10. Marginal Costing 11. Activity based costing Absorption Costing; In product/service costing, an absorption costing system allocates or apportions a share of all costs incurred by a business to each of its products/services. In this way, it can be established whether, in the long run, each product/service makes a profit. This can only be a guide. Arbitrary assumptions have to be made about the apportionment of many of the costs which, given that some costs will tend to remain fixed during a period, will also be dependent on the level of activity. An absorption costing system traditionally classifies costs by function. Sales less

production costs (of sales) measures the gross profit (manufacturing profit) earned. Gross profit less costs incurred in other business functions establishes the net profit (operating profit) earned. Using an absorption costing system, the profit reported for a manufacturing business for a period will be influenced by the level of production as well as by the level of sales. This is because of the absorption of fixed manufacturing overheads into the value of work-inprogress and finished goods stocks. If stocks remain at the end of an accounting period, then the fixed manufacturing overhead costs included within the stock valuation will be transferred to the following period One method of determining the total cost of a given product or service is that of adding the costs of overheads to the direct costs by a process of allocation, appointment and absorption. Since overheads (or indirect costs) can be allocated as whole items to production departments, it is possible to arrive at a normal amount that must be added to the cost of each product in order to cover the production overheads. Advantages 12. We cannot realistically produce unless fixed. 13. Costs are paid; therefore, they should be included in the production costs. Selling can be set. 14. Prices are based on total costs and in times of uncertain demand, it is better to consider final profit and not just contribution. Disadvantages of Absorption Costing The following are the criticisms against absorption costing: 15. You might have observed that in absorption costing, a portion of fixed cost is carried over to the subsequent accounting period as part of closing stock. This is an unsound practice because costs pertaining to a period should not be allowed to be vitiated by the inclusion of costs pertaining to the previous period and vice versa. 16. Absorption costing makes no distinction between fixed and variable costs thus is not suited for (Cost-volume-profit) CVP analysis. 17. Further, absorption costing is dependent on the levels of output which may vary from period to period, and consequently cost per unit changes due to the existence of fixed overhead. Unless fixed overhead rate is based on normal capacity, such changed costs are not helpful for the purposes of comparison and control. Marginal Costing; In product/service costing, a marginal costing system emphasises the behavioural, rather than the functional, characteristics of costs. The focus is on separating costs into variable elements (where the cost per unit remains the same with total cost varying in proportion to activity) and fixed elements (where the total cost remains the same in each period regardless of the level of activity). Whilst this is not easily achieved with accuracy, and is an oversimplification of reality, marginal costing information can be very useful for short-term planning, control and decision-making, especially in a multi-product business.

In a marginal costing system, sales less variable costs (regardless of function) measures the contribution that individual products/services make towards the total fixed costs incurred by the business. The fixed costs (regardless of function) are treated as period costs and, as such, are simply deducted from contribution in the period incurred to arrive at net profit. The principles of marginal costing The principles of marginal costing are as follows. For any given period of time, fixed costs will be the same, for any volume of sales and production (provided that the level of activity is within the relevant range). Therefore, by selling an extra item of product or service the following will happen. 18. Revenue will increase by the sales value of the item sold. 19. Costs will increase by the variable cost per unit. 20. Profit will increase by the amount of contribution earned from the extra item. 21. Similarly, if the volume of sales falls by one item, the profit will fall by the amount of contribution earned from the item. Profit measurement should therefore be based on an analysis of total contribution. Since fixed costs relate to a period of time, and do not change with increases or decreases in sales volume, it is misleading to charge units of sale with a share of fixed costs. When a unit of product is made, the extra costs incurred in its manufacture are the variable production costs. Fixed costs are unaffected, and no extra fixed costs are incurred when output is increased. Features of Marginal Costing The main features of marginal costing are as follows: Cost Classification The marginal costing technique makes a sharp distinction between variable costs and fixed costs. It is the variable cost on the basis of which production and sales policies are designed by a firm following the marginal costing technique. Stock/Inventory Valuation Under marginal costing, inventory/stock for profit measurement is valued at marginal cost. It is in sharp contrast to the total unit cost under absorption costing method. Marginal Contribution Marginal costing technique makes use of marginal contribution for marking various decisions. Marginal contribution is the difference between sales and marginal cost. It forms the basis for judging the profitability of different products or departments. Advantages of Marginal Costing Technique 22. Marginal costing is simple to understand. 23. By not charging fixed overhead to cost of production, the effect of varying charges per unit is avoided. 24. It prevents the illogical carry forward in stock valuation of some proportion of current years fixed overhead.

25. The effects of alternative sales or production policies can be more readily available and assessed, and decisions taken would yield the maximum return to business. 26. It eliminates large balances left in overhead control accounts which indicate the difficulty of ascertaining an accurate overhead recovery rate. 27. Practical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed overhead, efforts can be concentrated on maintaining a uniform and consistent marginal cost. It is useful to various levels of management. 28. It helps in short-term profit planning by breakeven and profitability analysis, both in terms of quantity and graphs. Comparative profitability and performance between two or more products and divisions can easily be assessed and brought to the notice of management for decision making. Disadvantages 29. The separation of costs into fixed and variable is difficult and sometimes gives misleading results. 30. Normal costing systems also apply overhead under normal operating volume and this shows that no advantage is gained by marginal costing. 31. Under marginal costing, stocks and work in progress are understated. The exclusion of fixed costs from inventories affect profit, and true and fair view of financial affairs of an organization may not be clearly transparent. 32. Volume variance in standard costing also discloses the effect of fluctuating output on fixed overhead. Marginal cost data becomes unrealistic in case of highly fluctuating levels of production, e.g., in case of seasonal factories. 33. Application of fixed overhead depends on estimates and not on the actual figures and as such there may be under or over absorption of the same. 34. Control affected by means of budgetary control is also accepted by many. In order to know the net profit, we should not be satisfied with contribution and hence, fixed overhead is also a valuable item. A system which ignores fixed costs is less effective since a major portion of fixed cost is not taken care of under marginal costing. 35. In practice, sales price, fixed cost and variable cost per unit may vary. Thus, the assumptions underlying the theory of marginal costing sometimes becomes unrealistic. For long term profit planning, absorption costing is the only answer. 36. Marginal costing is not a method of costing but a technique of presentation of sales and cost data with a view to guide management in decision-making. 37. The traditional technique popularly known as total cost or absorption costing technique does not make any difference between variable and fixed cost in the calculation of profits. But marginal cost statement very clearly indicates this difference in arriving at the net operational results of a firm. Following presentation of two Performa shows the difference between the presentation of information according to absorption and marginal costing techniques: Marginal Costing versus Absorption Costing After knowing the two techniques of marginal costing and absorption costing, we have

seen that the net profits are not the same because of the following reasons: Over and Under Absorbed Overheads In absorption costing, fixed overheads can never be absorbed exactly because of difficulty in forecasting costs and volume of output. If these balances of under or over absorbed/recovery are not written off to costing profit and loss account, the actual amount incurred is not shown in it. In marginal costing, however, the actual fixed overhead incurred is wholly charged against contribution and hence, there will be some difference in net profits. CONCLUSION Marginal cost is the cost management technique for the analysis of cost and revenue information and for the guidance of management. The presentation of information through marginal costing statement is easily understood by all managers, even those who do not have preliminary knowledge and implications of the subjects of cost and management accounting. Activity Based Costing Activity Based Costing is an accounting system that assigns costs to products based on the resources they consume. The costs of all activities are traced to the product for which they are performed. Overhead costs are also traced to a particular product rather than spread arbitrarily across all product lines. The true cost of a product can be determined with much more fidelity than was previously available with a traditional accounting system. An ABC system gives visibility to how effectively resources are being used and how all activities contribute to the cost of a product. 38. More accurate costing of products/services 39. Better understanding overhead 40. Easier to understand for everyone 41. Utilizes unit cost rather than just total cost 42. Makes visible waste and non-value added 43. Supports performance management and scorecards 44. Enables costing of processes, supply chains, and value streams 45. Activity Based Costing mirrors way work is done 46. Facilitates benchmarking Activity Based Costing Disadvantages

More time consuming to collect data Cost of buying, implementing and maintaining activity based system

Makes waste visible which some executives and managers don't want their boss to see..

CONCLUSION Absorption costing and marginal costing are two different techniques of cost accounting. Absorption costing is widely used for cost control purpose whereas marginal costing is used for managerial decision-making and control. For this reason, absorption costing and ABC are appropriate costing techniques for engineering companies. However, ABC is the most appropriate as provides managers with useful information they need regarding the contribution that each customer makes to overall profitability. Also, ABC allows managers to see how to maximise performance and implement sound profit-growth strategies. Also, ABC also makes it very clear that integrated costs associated with the services that the customer demands play a crucial role in determining each customer's contribution to net profit. ABC is nevertheless a form of absorption costing and the point of absorption costing is simply to make sure that all costs are covered. It is also a way of obtaining an accurate comparison with outside alternative suppliers.

You might also like