BREAK EVEN ANALYSIS

Break even analysis is the analysis of the relationship of cost, volume ,profit revenue, volume of sale for a particular product of a company.Break even analysis is usually done with the help of a break even chart. Break even chart is a graphical representation of various components like Fixed cost, Variable cost, Total cost, Quantity of production/sales, sales revenue, profit/lose and margin of safety. The chart has Quantity of production/sales on X axis and cost/sales revenue in Rupees on Y axis. It is assumed that the quantities of production and sales are same

COMPONENTS OF BREAK EVEN CHART

1. FIXED COSTFixed cost is the costs that remain constant irrespective of Quantity of production . It includes

Salary Administrative expenses Rent and other establishment charges Depreciation

Fixed cost is represented by a line parallel to X axis.

2. VARIABLE COSTVariable cost is the sum of costs that vary directly with the volume of production / sales. It includes

Direct labor costs consisting of wages and other benefit paid to direct workmen

Direct material cost Other semi-variable costs like fund, electricity, maintenance, transport etc

Variable cost at any quantity of production/sale = variable cost per piece X QuantityVariable cost is represented by inclined line starting from (0,0)

3. TOTAL COSTTotal cost of any point represents the sum of fixed cost and variable cost at that quantity.Total cost = Fixed cost + variable costTotal cost is represented by an inclined line starting from cost in Y axis (0.FC)

4. SALES REVENUESales revenue is represented by an inclined line starting from (0,0)

ANALYSIS OF BREAK EVEN CHART

1 BREAK EVEN POINT (BEP)Break even point is the point in BE chart where Sales Revenue = Total cost. It is represented a point where the Total cost line crossed the Sales Revenue line. At BEP, there is no loss and no profit.

2 BREAK EVEN QUANTITY (BEQ)The quantity of production/sales at BEP is termed as Break even Quantity

3 BREAK EVEN COST/REVENUEThe sales revenue or total cost at BEP is termed as BE Revenue or BE cost

4 PROFITProfit at a particular Quantity is Profit = Sales revenue – Total cost for that Quantity. It represents the area between the sales revenue line and total cost line after BEP in the BE chart

5 LOSSIf sales revenue is less than total cost, the product is making a loss

Loss= Total cost – sales revenue for that quantityIt is represented by the area between the two lines before BEP in the BE chart

6 ANGLE OF INCIDENCEIt is the angle between sales revenue line and the total cost line. Large angle indicate higher rate of profit, means higher profits for small increase in sales.

7 MARGIN OF SAFETY

QUANTITYMargin of safety (Quantity) = Present Quantity of Sale – BE QuantityThe importance of margin of safety is that it shows graphically the vulnerability of company’s profit due to changes in Quantity of Production/sale. If the distance or difference is large, even if there is a serious drop in production/sales, the profit will not be affected much. If the distance is short, a small drop in production /sale will lead to loss for the company. Margin of safety can be expressed in absolute values or as %age of the current level of production/sale.

MARGIN OF SAFETY (Rs)= Present sales value –BE Revenue

example= total sale – BEP Sale=sale Rs 5,00,000, BEP sale = 3,00,000Margin of Safety 500000-300000 = 200000 It can be represented as 40% (200000/500000 x 100 )

CONTRIBUTIONContribution is the difference between the sale price / unit and the marginal cost (variable cost) per unitSuppose the selling price is Rs 10/ unitVariable cost is Rs 7/ unitFixed cost Rs 30,000Contribution is Rs 3

ADVANTAGES OF BREAK EVEN ANALYSIS

1 Calculation of profit of different sales volume2 Calculation of sales volume to produce desired profit.3 Calculation of selling price per unit for a particular break even point4 Calculation of sales volume required to meet proposed expenditure5 Determination of sales required to offset price reduction6 Measurement of effect of changes in profit factors7 Choosing the most profitable alternatives8 Determining the optimum sales mix9 Deciding on changes in capacity

LIMITATIONS OF BE ANALYSISThe break even analysis is based on a number of assumptions which are rarely found in real life. Hence its managerial utility becomes limited. Its main limitations are as follows

1 Both cost and revenue should be taken into account to determine the break even point. The one without the other has no meaning. But this analysis pre suppose that prices do not change while in actual life, price do changes as a result of several factors eg-change in demand, fashion, styles etc

2 It assumes that all costs can be divided into fixed and variable costs, that they vary in linear fashion and that the principle of cost variability applies to them. All these assumptions do not hold true

3 This analysis ignores the time lag between production and sales. The production quantity may be kept constant, but the sales are bound to vary from period to period. This feature of sales reduces the significance of BE analysis as a management guide.

4 Factors like plant size, technology and methodology of production have to be kept constant in order to draw an effective break even chart. But it is not found in actual life.

5 The analysis does not take into account the capital employed in the production and its cost which is an important consideration in profitability decisions.

MATHEMATICAL CALCULATION OF BEP

Contribution Selling price-variable cost An exampleCalculate BEP from the following informationTotal cost = Rs 55000Fixed cost = Rs 20000Sale(7000 units) = 70000VC=55000-20000 = 35000 OR Rs 5Contribution per unit =10-5 = Rs 5BEP in Units = 20000/5=40000 u

BEP in value= FC+VC20000+20000 = Rs 40000

ProfitFixed costcontribution

Contribution-fixed costContribution – profitFixed cost+profit

PV Ratio(Profi volume ratio)

Contribution per unitSelling price per unit

Contribution x 100 sales

BEP (output)Fixed cost

BEP (Rs)Fixed cost x selling price/unit

Contribution per unit Contribution / unit orFixed cost x Total salesTotal contributionor Total fixed cost1- variable cost per unit selling price per unitorfixed costP/V Ratio

A factory making sewing m/c has capacity to produce 500 m/cs per annum. The variable cost of each m/c is Rs 200 and each m/c is sold for Rs 250. Fixed expense are Rs 1200 pm. Calculate the BEP for output and sales.

12000/50=240 m/cs

240x250 = Rs60000/=

1200x250/50=Rs 60000/=or12000 x 125000/25000=Rs 60,000/=Or 12000

1- 200/250=12000 1/5= Rs 60,000/=or12000/20% = Rs60,000/=

NE – PV RATIO=

Cntribution x 100Sales

25000/125000 x 100 = 20%

Margin of Safety

= total current sales-BE Sales

FormulaNet profitP/V RatioNB- margin of safety can be expressed as percentage of salesMargin of safety x 100Total salesOrSales-BE sales x100 Sales

ExampleTotal sale= Rs 1,50,000Variable cost = Rs 75,000Fixed cost = 50,000

Margin of safety=BE Sales = fixed cost P/V Ratio = 50,000/50% = Rs 1,00,000

net profit = contribution minus fixed cost = 75000-50000=25000margin of safety= Rs 1,50,000-1,00,000 Rs 50,000Or = net profit P/V Ratio = 25000/50%= Rs 5000o/=

Calculation of sales to get desired profit

Sales in unitsFC+desired profitP/V Ratio Sales in Rs

FC+desired profitP/V Ratio