Break-even analysis entails the calculation and examination of the margin of safety for an entity based on the revenues collected and associated costs. Analyzing different price levels relating to various levels of demand a business uses break-even analysis to determine what level of sales is necessary to cover the company’s total fixed costs. A demand-side analysis would give a seller significant insight regarding selling capabilities.
Some of the popular definitions of break-even analysis are as follows:
According to Matz, Curry and Frank, “a break-even analysis indicates at what level, cost and revenue are in equilibrium.”
According to Keller and Ferrara, “the break-even point of a unit of a company is the level of sales income which will equal the sum of its fixed costs and its variable costs.”
According to Charles T. Homogreen, “the break-even point of activity (sales volume) is where total revenue and total expenses are equal. It is the point of zero profit and zero loss.”
The important aspect of understanding break-even analysis is the break-even point at which there is no net loss or gain for an organization as expenses equal revenue.
Mathematically, relationships can be expressed as follows:
Break-even-point = Fixed costs/ Contribution per unit
Contribution = Sale price per unit—variable costs per unit
The margin of safety = Total sale proceeds—sales at B.E.P
Profit = Sales—Total costs (fixed + variable) or
= Total Contributions-Fixed Costs
Break-Even Chart
The Break-even chart shows the profitability (or otherwise) of an undertaking at various levels of activity and as a result,,,,,,,,, indicates the point at which there will be neither a profit nor loss. The break-even chart is a graphic chart that ‘presents the varying costs along with the changing sales revenue, indicates the sales volume at which costs are fully covered by revenue, and reveals the estimated profits or loss which will be realised at different levels of activity.
The Break-even point refers to the point on the break-even chart at which cost is equal to the sales revenue. It is also known as the point of ‘no profit no loss. This is clearly illustrated in the diagram on the next page.
In the following diagram sales volume is shown on the x-axis and cost and revenue are shown on the y-axis. The fixed costs are represented by a horizontal line. The total cost of sales is represented by the fixed cost line. It moves upward proportionately with the volume.
The sales revenue is represented by the line moving upward uniformly from the origin of the axes. The point of interaction of the total cost line with the revenue line is the breakeven point.
The main advantage of break-even analysis is that it tells about the probable levels of profits at different levels of output. It clearly indicates the inter-relationship between revenue, cost and profit in graphic form which is easily understood. It also reflects the comparative significance of fixed and variable costs.
The main limitation of this method is that it takes into consideration fixed and variable costs but the semi-variable cost and their impact are not considered at all. The scope of break-even analysis is limited to cost-volume and profits but it ignores other considerations such as capital amount, marketing aspects and effects of government policy etc., which are necessary for decision-making and price determination.
It is assumed under this method that fixed costs remain unchanged, but in reality,,, they do not remain the same in the long run and changes take place in response to technological developments, the size of the concern and other factors.
Methods of Break-Even Analysis
Graphical Method
When the price of a product remains the same, the organization expands its production, thus, total revenue is linear to the output.
As shown in Fig. TFC is equal to FE, which is a fixed cost line. The vertical distance between TC and TFC line equals TVC. As the number of output increases, the vertical distance between TC and TFC increases. This implies that TVC increases with changes in TC and TFC.
Until Qb of the quantity is produced, the total cost exceeds the total revenue, which implies that an organization will suffer losses if it produces less than Qb. At the Qb output level, total revenue equals total cost. At this point, an organization never makes a profit or loss implying that it is a break-even point. Thus, Qb is a break-even level of output. Producing more than Qb will be profitable for organizations as TR is greater than TC.
Algebraic Method
Helps in decision-making problems of the organization. We know that profit is equal to the difference between total revenue and total cost.
π = TR – TC
TR = P*Q
TC = TVC + TFC
TC = AVC*Q + TFC (TVC is the variable cost per unit multiplied by the output produced and sold)
Let Qb is the break-even quantity at which TR = TC.
TR = TC
Qb = TFC + AVC. Qb
P.Qb – AVC.Qb = TFC
(P – AVG)Qb = TFC
Qb = TFC/ (P-AVC)
Thus, from the above equation, it can be said that the break-even quantity of output is determined by TFC, price and variable cost per unit of output.
Contribution Analysis
Refers to the analysis of incremental or additional revenue and costs of a business. Contribution is the difference between total revenue and variable costs.
Fixed costs are in addition to variable costs. Thus, the TC line is parallel to the variable costs line. In fig. OQ is the break-even point. TC minus VC equals FC. Below OQ, the contribution is less than the fixed cost whereas,,,,,,,, beyond OQ, the contribution exceeds the fixed cost. The shaded portion between TR and VC is the contribution.
Profit volume (PV) ratio
Refers to another method to find the break-even point. The formula for the profit volume ratio is:
PV ratio = (S-V)/S* 100
S = Selling price
V = Variable costs
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