BBA I Semester Managerial Economics Break-Even Analysis Study Material Notes

BBA I Semester Managerial Economics Break-Even Analysis Study Material Notes: Introduction Break-Even Point BEP in Terms of Physical Units Total Revenue and Total Cost and BEP Break Even Chart Assumptions of Break-Even Analysis Multiple Product Firms and Break-Even Point Managerial Uses of Break-Even Analysis Limitations Exercise :

MCom I Semester Managerial Economics Capital Management Study Material Notes

BREAK-EVEN ANALYSIS

INTRODUCTION  

Break-even analysis is of vital importance in determining the practical application of cost functions. It is a function of three factors, i.e. sales volume, cost and profit. It aims at classifying the dynamic relationship existing between total cost and sale volume of a company. Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating condition that exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred in attaining that level of sales. The break-even point may be defined as that level of sales in which total revenues equal total costs and net income is equal to zero. This is also known as no-profit no-loss point. This concept has been proved highly useful to the company executives in profit forecasting and planning and also in examining the effect of alternative business management decisions.

Break-Even Point

The break-even point (B.E.P.) of a firm can be found out in two ways. It may be determined in terms of physical units, i.e., volume of output or it may be determined in terms of money value, i.e., value of sales.

BEP in terms of Physical Units

This method is convenient for a firm producing a product. The BEP is the number of units of a product that should be sold to earn enough revenue just to cover all the expenses of production, both fixed and variable. The firm does not earn any profit, nor does it incur any loss. It is the meeting point of total revenue and total cost curve of the firm. The break-even point is illustrated by means of Table 1 :

Table 1: Total Revenue and Total Cost and BEP

Some assumptions are made in illustrating the BEP. The price of the commodity is kept constant at Rs. 4 per unit, i.e., perfect competition is assumed. Therefore, the total revenue is increasing proportionately to the output. All the units of the output are sold out. The total fixed cost is kept constant at Rs. 150 at all levels of output. The total variable cost is assumed to be increasing by a given amount throughout. From the Table we can see that when the output is zero, the firm incurs only fixed cost. When the output is 50, the total cost is Rs. 300. The total revenue is Rs. 200. The firm incurs a loss of Rs. 100. Similarly when the output is 100 the firm incurs a loss of Rs. 50. At the level of output 150 units, the total revenue is equal to the total cost. At this level, the firm is working at a point where there is no profit or loss. From the level of output of 200, the firm is making profit

Break-Even Chart

Break-Even charts are being used in recent years by the managerial economists, company executives and government agencies in order to find out the break-even point. In the breakeven charts, the concepts like total fixed cost, total variable cost, and the total cost and total revenue are shown separately. The break even chart shows the extent of profit or loss to the firm at different levels of activity. The following Fig. 1 illustrates the typical break-even

In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis. Total revenue (TR) curve is shown Fixed as linear, as it is assumed that the Cost price is constant, irrespective of the output. This assumption is appropriate only if the firm is operating Units of output under perfectly competitive condi tions. Linearity of the total cost (TC) curve results from the assumption of constant variable cost. It should also be noted that the TR curve is drawn as a straight line through the origin (i.e., every unit of the output contributes a constant amount to total revenue), while the TC curve is a straight line originating from the vartical axis because total cost comprises constant / fixed cost plus variable cost which rise linearly. In the figure, B is the break-even point at OQ level of output.

In the preparation of the break-even chart we have to take the following considerations:

(a) selection of the approach

(b) output measurement

(c) total cost curve

(d) total revenue curve

(e) break-even point and

(f) the margin of safety.

The firm achieves its BEP when its sales are Rs. 600

Total Revenue = Rs.600

Total Cost = Rs.600

Net Profit/loss = Nil

Types of Break-Even Point

The above paragraph explains a simple type of break-even point which is based on cost and revenue i.e., the profit and loss break-even. There are two other types of break-even and they are:

(i) Cash break-even, and

(ii) Income break-even.

(i) The Cash Break-Even. An industry requires money for two purposes i.e., to acquire capital assets and to meet working capital requirements. These requirements can be partly met by his own investment and partly by loans and advances from financial institutions. The industry requires term loans to acquire capital assets like land and building, plant and machinery. In the case of term loans, the financial institutions shall have to find out the probability of the applicant being able to meet the interest and loan repayment schedule. It will be more interested in knowing the level of break-even point where not only total costs are required but also the full debt service. The level of break-even is called the cash breakeven. It is based on revenue and cost data involving cash flows. The depreciation, investment allowance reserve and other provision of the cost items should be excluded but at the same time the repayment of instalments should be added to fixed cost.

Fixed Cost + Loan instalment – Cash outflow Cash Break-Even Point = ?

Contribution per unit

(ii) The Income Break-Even. The various sources from which the industry is proposed to be financed such as the capital, long term borrowing, deferred payments and other sources. If these sources are inadequate the industry may approach the bank for under writing its shares. If the share market does not respond positively, the equity risk falls on the underwriter. As the share holder of the bank will expect a certain dividend just to cover the payment of interest for the term loans. In order to calculate income break-even point the equity capital cash earnings should be added. The income break-even point can be calculated in the following manner.

. Fixed Cost + Earnings required for dividend Income Break-Even Point = 5

Contribution per unit

Multiple-product Firms and Break-Even Point

The multiple products may differ in models, styles or sizes of their output. In the case of multi-product firms the break-even point for each product can be calculated if the product mix’is known. The product mix is the full list of products offered for sale by a company. It may range from one or two product lines to a combination of several product lines or groups.

X = 15,000

Y = 75,000

Z = 60,000

This reveals that the production manager has to ensure that production in the X line does not go below 15,000 units, in the Y line 75,000 units and in the Z line 60,000 units. If not, he has to sustain loss. The same method can be applied for computing the BEP in cases of multiple product industries producing any number of items.

Assumptions of Break-Even Analysis

The break-even analysis is based on the following set of assumptions:

(i) The total costs may be classified into fixed and variable costs. It ignores semivariable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(V) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

(vii) It assumes constant technology and no improvement in labour efficiency.

(viii) The price of the product is assumed to be constant.

(ix) The factor price remains unaltered.

(x) Changes in input prices are ruled out.

(xi) In the case of multi-product firm, the product mix is stable.

Managerial Uses of Break-Even Analysis

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. The break-even analysis not only highlights the area of economic strength and weakness in the firm but also sharpens the focus on certain leverages which can be operated upon to enhance its profitability. It guides the management to take effective decision in the context of changes in government policies of taxation and subsidies. The break-even analysis can be used for the following purposes:

(i) Safety Margin. The break-even chart helps the management to know at a glance the profits generated at the various levels of sales. The safety margin refers to the extent to which the firm can afford a decline before it starts incurring losses. The formula to determine the sales safety margin is:

(Sales – BEP) x 100 Safety Margin= Safety Mang

Sales From the numerical example at the level of 250 units of output and sales in Table 1, the firm is earning profit, the safety margin can be found out by applying the formula

Safety Margin =

250 – 150 x 100 = 40%

250

This means that the firm which is now selling 250 units of the product can afford to decline sales upto 40 per cent. The margin of safety may be negative as well, if the firm is incurring any loss. In that case, the percentage tells the extent of sales that should be increased in order to reach the point where there will be no loss.

(ii) Target Profit. The break-even analysis can be utilised for the purpose of calculating the volume of sales necessary to achieve a target profit. When a firm has some target profit, this analysis will help in finding out the extent of increase in sales by using the following formula:

Fixed Cost + Target Profit Target Sales Volume =

Contribution Margin Per Unit. By way of illustration, we can take Table 1 given above. Suppose the firm fixes the profit as Rs. 100, then the volume of output and sales should be 250 units. Only at this level, it gets a profit of Rs. 100. By using the formula, the same result will be obtained.

(iii) Change in Price. The management is often faced with a problem of whether to reduce prices or not. Before taking a decision on this question, the management will have to consider a profit. A reduction in price leads to a reduction in the contribution margin. This means that the volume of sales will have to be increased even to maintain the previous level of profit. The higher the reduction in the contribution margin, the higher is the increase in sales needed to ensure the previous profit. The formula for determining the new volume of sales to maintain the same profit, given a reduction in price, will be as follows:

Total Fixed Cost + Total Profit New Sales Volume = New Selling Price – Average Variable Cost

For example, suppose a firm has a fixed cost of Rs. 8,000 and the profit target is pe 20.000. If the sales price is Rs.8 and the average variable cost is Rs. 4, then the total Volume of sales should be 7,000 units on the basis of the formula given under target price. Suppose the firm decides to reduce the selling price from Rs.8 to Rs. 7, then the new sales volume should be on the basis of the above formula:

From this, we can infer that by reducing the price from Rs. 8 to Rs. 7, the firm has to increase the sales from Rs. 7,000 to Rs 9,330 if it wants to maintain the target profit of Rs. 20,000. In the same way, the sales executive can calculate the new volume of sales if it increases the price.

(iv) Change in Costs. When costs undergo change, the selling price and the quantity produced and sold also undergo changes. Changes in cost can be in two ways:

(i) Change in variable cost, and

(ii) Change in fixed cost.

(1) Variable Cost Change. An increase in variable costs leads to a reduction in the contribution margin. This reduction in the contribution margin will shift the break-even point downward. Conversely, with the fall in the proportion of variable costs, contribution margins increase and break-even point moves upwards. Under conditions of changing variable costs, the formula to determine the new quantity or the new selling price are:

Example :

The contribution margin is Rs. 64,000, the present sale price is Rs.10 and the present variable cost is Rs.6. If the variable cost per unit goes up from Rs.6 to Rs. 7, what will be the new sales volume and price?

(ii) Fixed Cost Change. An increase in fixed cost of a firm may be caused either due to a tax on assets or due to an increase in remuneration of management, etc. It will increase the contribution margin and thus push the break-even point upwards. Again to maintain the earlier level of profits, a new level of sales volume or new price has to be found out.

(v) Decision on Choice of Technique of Production. A firm has to decide about the most economical production process both at the planning and expansion stages. There are many techniques available to produce a product. These techniques will differ in terms of capacity and costs. The break-even analysis is the most simple and helpful in the case of a decision on a choice of technique of production. For example, for low levels of output, some conventional methods may be most probable as they require a minimum fixed cost. For high levels of output, only automatic machines may be most profitable. By showing the cost of different alternative techniques at different levels of output, the break-even analysis helps the decision of the choice among these techniques.

(vi) Make or Buy Decision. Firms often have the option of making certain components or for purchasing them from outside the concern. Break-even analysis can enable the firm to decide whether to make or buy.

Example

A manufacturer of car buys certain components at Rs. 20 each. In case he makes it himself, his fixed and variable cost would be Rs. 24,000 and Rs.8 per component respectively.

From this, we can infer that the manufacturer can produce the parts himself if he needs more than 2,000 units per year. However, certain considerations need to be taken into account of in a buying decision, such as

(i) Is the required quality of the product available?

(ii) Is the supply from the market certain and timely?

(iii) Do the supplies of the components try to take any monopoly advantage?

(vii) Plant Expansion Decisions. The break-even analysis may be adopted to reveal the effect of an actual or proposed change in operation condition. This may be illustrated by vying the impact of a proposed plant on expansion on costs, volume and profits. Through even analysis, it would be possible to examine the various implications of this proposal.

Example

A company has the capacity to produce goods worth of Rs. 40 crores a year. For this. it has incurred a fixed cost of Rs. 20 crores, the variable costs being 60% of the sales revenue. Now the company is planning to incur an additional Rs. 6 crores in fixed costs to expand its production capacity from Rs. 40 crores to Rs.60 crores. The survey shows that the firm’s sales can be increased from Rs. 40 crores to Rs. 50 crores. Should the firm go in for expansion?

Thus we can infer that the firm should go in for expansion only if its sales expand by more than Rs. 15 crores from its earlier level of Rs. 40 crores.

(viii) Plant Shut Down Decisions. In the shutdown decisions, a distinction should be made between out-of-pocket and sunk costs. Out of pocket costs include all the variable costs plus the fixed cost which do not vary with output. Sunk fixed costs are the expenditures previously made but from which benefits still remain to be obtained e.g. depreciation.

(ix) Advertising and Promotion Mix Decisions. The main objective of advertisement is to stimulate or increase sales to all customers–former, present and future. If there is keen competition, the firm has to undertake vigorous campaign of advertisement. The management has to examine those marketing activities that stimulate consumer purchasing and dealer effectiveness. The break-even point concept helps the management to know about the circumstances. It enables him not only to take appropriate decision but by showing how these additional fixed cost would influence BEPs. The advertisement cost pushes up the total cost curve by the amount of advertisement expenditure.

(x) Decision Regarding Addition or Deletion of Product Line. If a product has outlived its utility in the market immediately, the production must be abandoned by the management and examined what would be its consequent effect on revenue and cost. Alternatively, the management may like to add a product to its existing product line because it expects the product as a potential profit spinner. The break-even analysis helps in such a decision.

Example

A fan manufacturer possesses the following data regarding his firm:

Total Fixed Cost =Rs.1,50,000

Volume of Sales=5,00,000 units

Thus the contribution ratio of the entire product line=0.167+0.08+0.141=0.388. Total Contribution=Rs. 5,00,000 x 0.388-Rs.1,94,000 Profit=Rs.1,94,000 Rs.1,50,000=Rs 44,000

From the above analysis, we can infer that the manufacturer should drop heaters from his product line and add fancy fans to his product line so as to earn more profit.

Limitations

We may now mention some important limitations which ought to be kept in mind while using break-even analysis.

1 In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small range of output. It is not an effective tool for long-range use.

4. Profits are a function of not only output but also of other factors like technological change, improvement in the art of management, etc., which have been overlooked in this analysis.

5. When break-even analysis is based on accounting data, as it usually happens, it may suffer from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and inappropriate allocation of overheads. It can be sound and useful only if the firm in question maintains a good accounting system.

6. Selling costs are especially difficult to handle break-even analysis. This is because changes in selling costs are a cause and not a result of changes in output and sales.

7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate income tax.

8. It usually assumes that the price of the output is given. In other words, it assumes a horizontal demand curve that is realistic under the conditions of perfect competition.

9. Matching cost with output imposes another limitation on break-even analysis. Cost in a particular period need not be the result of the output in that period.

10. Because of so many restrictive assumptions underlying the technique, computation of a break-even point is considered an approximation rather than a reality.

Uses

The main advantages or uses of break-even analysis in managerial decision-making are the following:

1 It helps in determining the optimum level of output below which it would not be profitable for a firm to produce.

2. It helps in determining the target capacity for a firm in order to get the benefit of the minimum unit cost of production.

3. With the help of the break-even analysis, the firm can determine the minimum cost for a given level of output.

4. It helps in deciding which products to be produced and bought by the firm.

5. Plant expansion or contraction decisions are often based on the break-even analysis of a particular situation.

6. The impact of changes in prices and costs on the profits of the firm can also be analyzed with the help of the break-even technique.

7. Sometimes the management has to take decisions regarding dropping or adding a product to the product line. The break-even analysis helps in such situations.

8. It evaluates the percentage financial yield from a project, and thereby helps in the choice between various alternative projects.

9. The break-even analysis can be used in finding the selling price which would be most profitable for the firm.

10. By finding out the break-even point, the break-even analysis helps in establishing the point where from the firm can start payment of dividends to its shareholders.

EXERCISES

1 Define the break-even point.

2. How can you determine the break-even point?

3. Explain the various assumptions of the break-even point.

4. What are the managerial uses of break-even analysis?

5. What is the safety margin?

6. How can you find out the target profit?

7. Explain the various limitations of break-even analysis.

8. What is break-even analysis? State its limitations and uses.

9. What are the objectives of break-even analysis?

10. Write a note on the break-even chart.