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In this article we will discuss about:- 1. Definition of Break-Even Point 2. Determination of the Break-Even Point 3. Charts 4. Assumptions 5. Managerial Uses 6. Limitations.
Contents:
- Definition of Break-Even Point
- Determination of the Break-Even Point
- Break-Even Point Charts
- Assumptions Underlying Break-Even Point
- Managerial Uses of Break-Even Point
- Limitations of Break-Even Point
1. Definition of Break-Even Point:
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Break-even analysis involves the study of revenues and costs of a firm in relation to its volume of sales and specifically the determination of that volume at which the firm’s costs and revenues will be equal. The break-even point (BEP) maybe defined as that level of sales at which total revenues equal total costs and the net income is equal to zero. This is also known as no-profit no-loss point.
The main objective of the break-even analysis is not simply to spot the BEP, but to develop an understanding of the relationship of cost, price, and volume within a company’s practical range of operations. The break-even chart is an “excellent instrument panel for your guidance in controlling your business.”
2. Determination of the Break-Even Point
:
Break-even point may be determined either in terms of physical units or in money terms, i.e., sales value in rupees.
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1. Break-Even Point in Terms of Physical Units:
This method is convenient for the single-product firm. The break-even volume is the number of units of the product which must be sold to earn enough revenue just to cover all expenses—both fixed and variable. The selling price of a unit covers not only its variable cost but also leaves a margin (contribution margin) to contribute toward the fixed costs (costs remaining fixed irrespective of the volume).
The breakeven point is reached when sufficient numbers of units have been sold so that the total contribution margin of the units sold is equal to the fixed costs. The formula for calculating the break-even point is as follows –
BEP = Fixed cost/Contribution margin per unit
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Where the contribution margin is selling price-variable costs per unit.
2. Break-Even Point in Terms of Sales Value:
Multi-product firms are not in a position to measure the break-even point in terms of any common unit of product. They find it convenient to determine their breakeven point in terms of total rupee sales. Here, again, the break-even point would be the point where the contribution margin (Sales value – Variable costs) would equal the fixed costs. The contribution margin, however, is expressed as a ratio to sales. For example, if the sales are Rs.200 and the variable cost of these sales is Rs.140, the contribution margin ratio is (200 –140)/200, i.e., 0.3.
BEP = Fixed cost/Contribution ratio
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3. Break-Even Charts
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Break-even analysis is very commonly presented by means of break-even charts, also known as profit-graphs. A break-even chart prepared on the basis of Example I is represented in Fig. 3.19. Units of product are shown on the horizontal axis OX, and revenues and costs are shown on the vertical axis OY. The fixed costs are shown on the vertical axis OY. The fixed costs of Rs.10,000 are represented by a straight line parallel to the horizontal axis.
Variable costs are then plotted over and above the fixed costs. The resultant line is the total cost line, combining both variable cost lines in the graph; variable costs are represented by the vertical distance between the fixed cost and the total cost lines. The total cost at any point is the sum of Rs.10,000 plus Rs.2.00 per unit of variable cost multiplied by the number of units sold at that point.
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Total revenue at any point is the unit price of Rs.4.00 multiplied by the number of units sold. The break-even point corresponds to the point of intersection of the total revenue and the total cost lines.
Projecting a perpendicular from the BEP to the horizontal axis shows the break-even point in units of the product. Dropping a perpendicular from BEP (or to the left of it), total costs are more than total revenue and the firm would suffer a loss. Above BEP (or to its right), total revenue exceeds total costs and the firm would be making profits. Since profit or loss occurs between costs and revenue lines, the space between them is known as the profit zone (to the right of the BEP) and the loss zone (to the left of the BEP).
Where the BEP is measured in terms of sales rupee value rather than in physical units, the break-even chart remains basically the same as in Fig. 3.20. The only difference is that the volume on the X-axis is measured in terms of sales value. In that case, a perpendicular from the point BEP to either axis would show the break-even rupee sales value. The same type of chart can be used to depict the BEP in relation to full capacity: in this case, the horizontal axis would represent the percentage of full capacity, instead of physical units or the sale value.
The adjoining chart is a variation of the traditional break-even graph. This graph is prepared with the variable cost line (instead of fixed cost line) starting at the zero axis. It is superimposed the total cost line which includes the fixed cost and is, therefore, parallel to the variable cost line. This graph is more useful as much as the contribution to fixed cost and profit is more clearly shown.
4. Assumptions Underlying Break-Even Point
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1. All costs are either perfectly variable or absolutely fixed over the entire range of the volume of production. In practice, however, this assumption may not hold true over the entire range of production.
2. All revenue is perfectly variable with the physical volume of production. This assumption may not be valid in all cases, e.g., lower prices may be charged to large customers.
3. The volume of sales and the volume of production are equal. Everything produced is sold and there is no change in the closing inventory. In practice, sales and production volumes may differ significantly.
4. However, these assumptions are not so unrealistic as to impair the validity of the break-even analysis.
5. In the case of multi-product firms, the product-mix should be stable. For a multi-product firm, the BEP is determined by dividing total fixed costs by an average ratio of variable profit (contribution) to sales. If each product has the same contribution ratio, the BEP is unaffected by changes in the product-mix.
However, if different products have different contribution ratios, a shift in the product-mix may cause a shift in the break-even point. In real life, the assumption of stable product-mix is somewhat unrealistic.
5. Managerial Uses of Break-Even Point
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To the management, the utility of break-even analysis lies in the fact that it presents a microscopic picture of the profit structure of a business enterprise. Break-even analysis not only highlights the areas of economic strength and weaknesses in the firm but also sharpens the focus on certain leverages which can be operated upon to enhance its profitability.
Ever changing contributions are characteristics of modern business life, and through break-even analysis, it is possible for the management to examine the profit vulnerability of a business firm to the possible changes in business conditions, for example, sales prospects, changes in cost structure, etc. Through break-even analysis, it is possible to devise managerial actions to maintain and enhance profitability of the firm.
The break-even analysis can be used for the following purposes:
1. Margin of Safety:
The break-even chart can help the management to know at a glance the profits generated at the various levels of sales. But while deciding upon the volume at which the firm would operate, apart from the demand, the management should consider the “safety margin” associated with the proposed volume. The safety margin refers to the extent to which the firm can afford a decline in sales before it starts incurring losses. The formula to determine the safety margin is –
Margin of safety = [(Actual Sales – BEP)/Actual sales] x 100
Margin of safety = [(8,000 – 80,000)/8,000] x 100 = 37.5%
That is, we can afford to lose sales up to 37.5 per cent of the present level before incurring a loss. If the safety margin is dropping over a period of time, it would mean that the firm’s resistance capacity to avoid losses has become poorer. A margin of safety can be negative as well. In that case, it reveals the percentage increase in sales necessary to reach the BEP so as to avoid losses at least.
Thus, it reveals the minimum extent of sales effort expected of the management. Suppose in our example, sales are as low as 4,000 units. The safety margin would be –
Margin of safety = (4000 – 5,000)/4,000 = – 25%
In other words, the management must strive to increase sales at least by 25 per cent to avoid losses.
2. Drop and/or Add Decision:
A business manager is often confronted with the following questions:
(a) Should a new product be added in view of its estimated revenue and cost?
(b) Should a particular item be dropped from the product line and what would be its consequent effects on revenue and cost?
Break-even analysis is quite useful in deciding the question of product planning.
3. Make or Buy Decision:
Many business firms often have the option of making certain components or ingredients, which are part of their finished products, or purchasing them from outside suppliers. For instance, an automobile manufacturer can make spark plugs or buy them. Break-even analysis can enable the manufacturer to decide whether to make or buy.
4. Choosing Promotion-Mix:
Sellers often use several modes of sales promotion, e.g., personal selling, advertising, and the like. However, the proportion of various modes in the promotion-mix varies from seller to seller. A retail shop may have to consider whether to employ a certain number, say five, of additional salesmen.
A manufacturer may have to decide if he should spend an additional sum of Rs.20,000 on advertising his product. Break-even analysis enables him to take appropriate decisions by showing how these additional fixed costs would influence the break-even points.
6. Limitations
of Break-Even Point:
We may now mention certain important limitations which ought to be kept in mind while using break-even analysis:
1. When break-even analysis is based on accounting data, as it usually happens, it may suffer from various limitations of such data. For example, neglect of imputed costs, arbitrary depreciation estimates, and inappropriate allocation of overhead costs. Break-even analysis, therefore, can be sound and useful only if the firm in question maintains a good accounting system and uses proper managerial accounting techniques and procedures. The figures must be adequate and sound. If break-even analysis is based on past data, the same should be adjusted for changes in wages and price of raw materials.
2. Break-even analysis is static in character. It is based on the assumption of given relationship between costs and revenues, on the one hand, and input, on the other. However, costs and revenues may change over time making the projection based on past data wrong. As such, break-even analysis is more useful in situations relatively stable and slow-moving rather than extremely volatile, erratic, and widely changing ones.
3. Costs in a particular period may not be caused entirely by the output in that period. For example, maintenance expenses may be the result of past output or a preparation for future output; it may, therefore, be difficult to attribute them to a particular period.
4. Selling costs are especially difficult to handle in break-even analysis. This is because changes in selling costs are a cause and not a result of changes in output and sales. Besides, the relationship between output and selling expenses is unstable over time, rendering the projection of past relationship into future inaccurate.
5. A straight-line total revenue curve presumes that any quantity might be sold at that one price. This implies a horizontal demand curve and can be true only under conditions approximating perfect competition. Hence, to be realistic, calculations are often made at several price levels.
Several total revenue curves are required instead of just one, because, in real world, perfect competition is rare; or else demand and demand schedules will not get the weight and respect due to them.
6. A basic assumption in break-even analysis is that the cost-revenue-volume relationship is linear. This is realistic only over narrow ranges of output. For example, this type of analysis is worthwhile in deciding whether- (a) selling price should be 50 or 60 paise, (b) volume should be attempted at 80 per cent of capacity rather than 85 per cent, (c) advertising expenditure should total Rs.1,00,000 or Rs.1,15,000, or (d) the product should be put in a package costing 70 paise rather than 90 paise.
7. Break-even analysis is not an effective tool for long-range use and its use should be restricted to the short run only. The break-even analysis should better be limited to the budget period of the firm which is usually the calendar year.
8. The area included in the break-even analysis should be limited. If too many products, too many departments, or too many plants are lumped together and graphed on a single break-even chart, both good and bad performances can easily be buried in the total picture of the group. While the above limitation is valid, the job of getting data by product or by brand (and this is often what management requires) can be quite difficult.
9. Break-even analysis assumes that profits are a function of output ignoring the parent fact that they are also caused by other factors such as technological change, improved management, changes in the scale of the fixed factors of production, and so on.
In view of the limitations, doubts have sometimes been raised about the utility of break-even analysis unless it is made complex. The truth, however, remains that break-even analysis is a device, simple, easy to understand, and inexpensive and hence quite useful to management whose primary concern is to cut through the complexity of real world and focus attention on basic relationships.
Of course, its usefulness buries from industry. Industries suffering from frequent, volatile changes in input prices, rapid technological changes, and constant shifts in product-mix will not benefit much from break-even analysis. Finally, break-even analysis should be viewed as a guide to decision making and not as a substitute for judgment, logical thinking, or commonsense.
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