An enterprise, whether or not a profit maximizer, often finds it useful to know what price (or output level) must be for total revenue just equal total cost. This can be done with a breakeven analysis. Strictly speaking, this analysis is to determine the minimum level of output that allows the firm to break even, but it could be used for some other tasks.
Break-even analysis is based on two types of costs: fixed costs and variable costs. Fixed costs are overhead-type expenses that are constant and do not change as the level of output changes. Variable expenses are not constant and do change with the level of output. Because of this, variable expenses are often stated on a per unit basis.
Definition
Break-even point analysis is a measurement system that calculates the margin of safety by comparing the amount of revenues or units that must be sold to cover fixed and variable costs associated with making the sales.
A break-even analysis is a calculation of the point at which revenues equal expenses. In securities trading, the break-even point is the point at which gains equal losses.
The break-even point in any business is that point at which the volume of sales or revenues exactly equals total expenses -- the point at which there is neither a profit nor loss -- under varying levels of activity. The break-even point tells the manager what level of output or activity is required before the firm can make a profit; reflects the relationship between costs, volume and profits.
Break even Analysis is defined as the point that determines whether the business is making a profit or a loss. To be specific a profit in relation to break even analysis is zero and can be simplified but total costs (expenses) and total sales (revenue) are equivalent to one another.
Types Of Break Even AnalysisAmong many types of break even analysis there are three common measures a. Accounting break-even – sales volume where net income = 0 b. Cash break-even – sales volume where operating cash flow = 0 c. Financial break-even – sales volume where net present value = 0
Assumptions of Break-Even Analysis:
The break-even analysis is based on certain assumptions, which are
1. All costs can be separated into fixed and variable components,
2. Fixed costs will remain constant at all volumes of output,
3. Variable costs will fluctuate in direct proportion to volume of output,
4. Selling price will remain constant,
5. Product-mix will remain unchanged,
6. The number of units of sales will coincide with the units produced so that there is no opening or closing stock,
7. Productivity per worker will remain unchanged,
8. There will be no change in the general price level
Formula for break-even analysis
The basic formula for break-even analysis, sometimes abbreviated as BEA, is as follows:
Contribution margin
= selling price per unit–variable cost per unit
Break-even point (unit)
= FC / (CM)
FC = Total fixed costs
CM= Contribution margin
Break-even point (sales)
=FC / (CM) x SP
FC = Total fixed costs
CM= Contribution margin
SP= selling price
Break-even point (unit) To achieve a target profit
=FC + TP / (CM)
=FC + TP / (CM)
FC = Total fixed costs
CM= Contribution margin
TP= Target profit
Break-even point (sales) To achieve a target profit
=FC + TP / (CM) x SP
=FC + TP / (CM) x SP
FC = Total fixed costs
CM= Contribution margin
TP= Target profit
SP= selling price
Break-even point (tax)
= FC +TP
1-TR
CM
FC = Total fixed costs
CM= Contribution margin
TP= Target profit
1=constant
TR=Tax rate
Margin of Safety(unit) = Budgeted Sales − Break-even Sales
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Margin of safety(sales) =
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Budgeted Sales − Break-even Sales
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Budgeted Sales
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Advantages Break-Even Analysis:
1. It helps in the determination of selling price which will give the desired profits.
2. It helps in the fixation of sales volume to cover a given return on capital employed.
3. It helps in forecasting costs and profit as a result of change in volume.
4. It gives suggestions for shift in sales mix.
5. It helps in making inter-firm comparison of profitability.
6. It helps in determination of costs and revenue at various levels of output.
7. It is an aid in management decision-making (e.g., make or buy, introducing a product etc.), forecasting, long-term planning and maintaining profitability.
8. It reveals business strength and profit earning capacity of a concern without much difficulty and effort.
Disadvantages of Break-Even Analysis:
1. Break-even analysis is based on the assumption that all costs and expenses can be clearly separated into fixed and variable components. In practice, however, it may not be possible to achieve a clear-cut division of costs into fixed and variable types.
2. It assumes that fixed costs remain constant at all levels of activity. It should be noted that fixed costs tend to vary beyond a certain level of activity.
3. It assumes that variable costs vary proportionately with the volume of output. In practice, they move, no doubt, in sympathy with volume of output, but not necessarily in direct proportions.
4. The assumption that selling price remains unchanged gives a straight revenue line which may not be true. Selling price of a product depends upon certain factors like market demand and supply, competition etc., so it, too, hardly remains constant.
5. The assumption that only one product is produced or that product mix will remain unchanged is difficult to find in practice.
6. Apportionment of fixed cost over a variety of products poses a problem.
7. It assumes that the business conditions may not change which is not true.
8. It assumes that production and sales quantities are equal and there will be no change in opening and closing stock of finished product, these do not hold good in practice.