Break Even Analysis

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 COST Fixed 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 COST Variable 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 Quantity Variable cost is represented by inclined line starting from (0,0) 3. TOTAL COST Total cost of any point represents the sum of fixed cost and variable cost at that quantity. Total cost = Fixed cost + variable cost Total cost is represented by an inclined line starting from cost in Y axis (0.FC) 4. SALES REVENUE Sales 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/REVENUE The sales revenue or total cost at BEP is termed as BE Revenue or BE cost 4 PROFIT Profit 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 LOSS If sales revenue is less than total cost, the product is making a loss Loss= Total cost – sales revenue for that quantity It is represented by the area between the two lines before BEP in the BE chart 6 ANGLE OF INCIDENCE It 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

QUANTITY Margin of safety (Quantity) = Present Quantity of Sale – BE Quantity The 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 = 3,00,000 Margin of Safety 500000-300000 = 200000 It can be represented as 40% (200000/500000 x 100 ) CONTRIBUTION Contribution is the difference between the sale price / unit and the marginal cost (variable cost) per unit Suppose the selling price is Rs 10/ unit Variable cost is Rs 7/ unit Fixed cost Rs 30,000 Contribution is Rs 3

ADVANTAGES OF BREAK EVEN ANALYSIS 1 2 3 4 5 6 7 8 9

Calculation of profit of different sales volume Calculation of sales volume to produce desired profit. Calculation of selling price per unit for a particular break even point Calculation of sales volume required to meet proposed expenditure Determination of sales required to offset price reduction Measurement of effect of changes in profit factors Choosing the most profitable alternatives Determining the optimum sales mix Deciding on changes in capacity

LIMITATIONS OF BE ANALYSIS The 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

2 3 4 5

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 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 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. 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. 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 example Calculate BEP from the following information Total cost = Rs 55000 Fixed cost = Rs 20000 Sale(7000 units) = 70000 VC=55000-20000 = 35000 OR Rs 5 Contribution per unit = 10-5 = Rs 5 BEP in Units = 20000/5=40000 u BEP in value= FC+VC 20000+20000 = Rs 40000

Profit Fixed cost contribution PV Ratio (Profi volume ratio)

Contribution-fixed cost Contribution – profit Fixed cost+profit Contribution per unit Selling price per unit Contribution x 100 sales

BEP (output)

BEP (Rs) Fixed cost Contribution per unit

Fixed cost x selling price/unit Contribution / unit

or

Fixed cost x Total sales Total contribution

or 1-

Total fixed cost variable cost per unit selling price per unit

or fixed cost P/V Ratio A factory making 12000/50=240 m/cs sewing m/c has capacity to produce 240x250 = Rs60000/= 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.

1200x250/50=Rs 60000/= or 12000 x 125000/25000= Rs 60,000/= Or 12000 1- 200/250=12000 1/5 = Rs 60,000/= or 12000/20% = Rs60,000/= NE – PV RATIO= Cntribution x 100 Sales 25000/125000 x 100 = 20%

Margin of Safety

Example Total sale= Rs 1,50,000 = total current Variable cost = Rs 75,000 sales-BE Sales Fixed cost = 50,000 Margin of safety= Formula BE Sales = fixed cost Net profit P/V Ratio P/V Ratio = 50,000/50% NB- margin of = Rs 1,00,000 safety can be expressed as net profit = contribution percentage of sales minus fixed cost Margin of safety x 100 = 75000-50000=25000 Total sales margin of safety= Or Rs 1,50,000-1,00,000 Sales-BE sales x100 Rs 50,000 Sales Or = net profit P/V Ratio = 25000/50%= Rs 5000o/= Calculation of Sales in units sales to get desired FC+desired profit profit P/V Ratio Sales in Rs FC+desired profit P/V Ratio