Break-even analysis Essay
Every company’s corporate managers have a goal of maximizing shareholder wealth. However, given that no obvious, single course of action leads to fulfillment of that goal, managers must choose speciﬁc course of action and develop plans and controls to pursue that course. Because planning is future oriented, uncertainty exists and information helps reduce that uncertainty. Controlling is making actual performance align with plans, and information is necessary in that process. Much of the information managers’ use to plan and control reﬂects relationships among product cost, selling prices, and sales volumes.
Changing one of these essential components in the sales mix will cause changes in other components. Focuses on analyzing how volume, cost, proﬁt helps in predicting future conditions (planning) as well as in explaining, evaluating, and acting on results (controlling). Before generating proﬁt a company must ﬁrst reach its break-even point, which means that it must generate suﬃcient sales revenue to cover all cost? .By linking cost behavior and sales volume, managers can use the break even analysis. Information provided by these BEP analyses helps managers focus on the implications that volume changes would have an impact on organizational proﬁtability analysis. My objective is to analyze the term BEP analysis in a boarder sense with different costs concepts and other related matters which are needed to calculate BEP, providing the broad overview about BEP analysis and its implication in different aspect, which will ultimately help us to take different management decisions.
I have collected the information for this term paper about BEP analysis by library work from different books, journals, articles, internet browsing, papers of professional’s degrees and different BEP practice of different company with online logging into their sites.
Breakeven point analysis sometimes called cost volume-profit analysis, stresses the relationships between the factors affecting profits. Traditional break-even analysis is a relatively common managerial tool used in a wide variety of purposes for nearly all types of decision-making. Break-even analysis (sometimes called profit contribution analysis) is an important tool, which allows comparative studies between costs, revenues, and profits (Pappas and Brigham, 1981).
This analytical technique facilitates the evaluation of potential prices, the impact of price changes and fixed/variable costs on profitability (Powers, 1987). This analysis can also be used to expedite decisions on investment return criteria, required market shares, and distribution alternatives (Kotler, 1984). Break-even is the sales volume at which revenue and total cost are equal, resulting in no net income or loss. It is typical to graphically depict break-even as the point where a firm’s total cost and total revenue curves intersect. This is the sales point where both variable and fixed costs are covered by the sales volume for the relevant range. If the break-even point is not achieved, that business will (or should) eventually go out of business. The breakeven point the profit is zero that is; the contribution margin is equal to the fixed costs. If the actual volume of sales is higher than the break-even volume there will be profit.
FINDINGS BREAK-EVEN ANALYSIS Definition
An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. Investopedia explains ‘Break-Even Analysis’
Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It does not analyze how demand may be affected at
different price levels.
Moore & jaedicke
The break-even point of the company or a unit of a company is the level of sales income which will equal the sum of its fixed costs and its variable costs. These costs are also referred to as “out of pocket costs” and “period costs”.
(Source: ACCA, paper F, CVP analysis, page #47) ASSUMPTION OF BEP ANALYSIS
The break-even analysis is based on the following assumptions: 1. Costs segregation: It is based on the assumption that all costs can be segregated into fixed costs and variable costs. 2. Constant Selling Price: The selling price remains constant. That is, selling price does not change with volume or other factors. 3. Constant Fixed costs: Fixed costs are constant, at all levels of activity.
They do not change, with change in sales. 4. Constant Variable costs: Variable cost per unit is constant. So, variable costs fluctuate, directly, in proportion to changes in volume of output. In other words, they change in direct proportion to sales volume. 5. Synchronized production and sales: It is assumed production and sales are synchronized. That is, inventories remain the same in the opening stock and closing stock. 6. Constant sales mix: Only one product is manufactured. In case, more than one product is manufactured, sales mix of products sold does not change. 7. No Change in operating efficiency: There is no change in operating efficiency. 8. No other factors: The volume of output or production is the only factor that influences the cost. No other factors have any influence on break-even analysis.
BREAK-EVEN ANALYSIS COMPONENTS
To fully appreciate the break-even theory and related graphical depictions, it is necessary to have a basic understanding related to cost, revenue and profit. In order to facilitate this, one must first know the following components of break- even:
Semi variable costs
Fixed costs and variable costs
Margin of safety
Selling Price per Unit: The amount of money charged to the customer for each unit of a product or service Total cost: is the sum of fixed cost and variable costs.
Total revenue: is that amount of gross income received from product sales or a service rendered, and is equal to the price of a unit times the number of units sold. Forecasted Net Profit: Total revenue minus total cost. Enter Zero (0) if you wish to find out the number of units that must be sold in order to produce a profit of zero (but will recover all associated costs). Fixed costs: These are costs that are the same regardless of how many items you sell. All start-up costs, such as rent, insurance and computers, are considered fixed costs since you have to make these outlays before you sell your first item. Examples of fixed costs:
– Rent and rates
– Research and development
– Marketing costs (non- revenue related)
– Administration costs
Variable costs: These are recurring costs that you absorb with each unit you sell. For example, if you were operating a greeting card store where you had to buy greeting cards from a stationary company for $1 each, then that dollar represents a variable cost. As your business and sales grow, you can begin appropriating labor and other items as variable costs if it makes sense for your industry. Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output – e.g. machine hours), maintenance and certain labor costs.
Semi variable costs: often stay constant for a certain time period during production increases, then “step up” to a higher cost level at specific points of increased volume. An example of this is an insurance premium, which covers production to a certain level, which if exceeded, is changed to a new fixed level. To simplify the analysis process, semi variable costs are generally calculated and split into appropriate fixed and variable costs.
Margin of Safety: The margin of safety is the units sold or the revenue earned above the break-even volume. For example, if the break-even volume for a company is 200 units and the company is currently selling 500 units, then the margin of safety is 300 units (500-200). The margin of safety can be expressed in sales revenue as well. If the break-even volume is $200,000 and current revenues are $350,000, then the margin of safety is $150,000 ($350,000-$200,000). In addition, margin of safety sales revenue can be expressed as a percentage of total sales dollars, which some Managers refer to as the margin of safety ratio.
Contribution margin: is that amount which contributes to the fixed costs of the company and to its profits, after deducting the variable costs. Total variable costs are subtracted from total revenue to yield the contribution margin. The contribution margin can be expressed in total dollars, in dollars per unit, or as a percentage.
Relative range: is the limit of production or output levels over which fixed costs remain constant. Above the relative range cost evaluations and respective relationships are no longer applicable. For instance, if a construction firm’s work doubled or tripled, the company would have to hire more people, rent more office space, and acquire more equipment thus increasing fixed costs and altering the entire break-even cost and revenue structure.
PROCESS OF BEP ANALYSIS
There are 3 steps of BEP analysis; these are started after each and every steps is finished. The sequence of the BEP analysis is: 1. Conduct a cost/income analysis of the construction firm to determine: 1. Fixed costs
2. Variable costs
3. Total costs
4. Total revenue
2. Calculate contribution margin and perform break-even analysis (Moore & Jaedicke).
Variations of break-even:
3. Preparing different graphs charts statements.
Cost volume chart
Profit volume chart
METHODS OF BEP ANALYSIS
Break-even point can be determined by 4 ways with the break-even analysis. These methods are given bellow: 1. Break-even schedule.
2. Break-even charts
3. Algebraic formula
4. Income statement methods
5. Linear program. A detail overview has been given about the different methods of the break-even analysis. Break-even schedule: we can determine the break-even point with break-even schedule. The procedure of preparing break-even schedule is given follow: (with imaginary figure) Production
We can observe the schedule that, when the production and sales is 4000 units then there is no profit and loss. So in break-even point the sale is 4000
units or 40000 taka. Break-even charts:
The break-even point can be presented graphically. The pictorial presentation gives a better view of the relationship of cost, volume and profit. Graphical presentation gives immediate and clear understanding of the picture. This type of presentation always impresses the management as it gives instantaneous understanding of the situation The graphical chart of break-even analysis looks like this:
Following are the steps involved in preparing break-even chart: 1. Sales volume is plotted on the horizontal line i.e. X-axis. Sales volume may be expressed in terms of units, taka or as a percentage of capacity. 2. Vertical line i.e. Y-axis is used to represent revenue, fixed costs and variable costs. 3. Both horizontal and vertical lines are spaced, equally, with the same distance. 4. Break-even point is the point of intersection between total cost line and sales line. 5. Sales revenue at the break-even point can be determined by drawing a perpendicular line to X-axis from the point of above intersection.
6. Total sales line and Total cost line intersect forming an angle known as ‘Angle of Incidence’.
Break-even with profit volume chart:
Profit-volume graph visually portrays the relationship between profits operating income and units sold. Proﬁt -volume (PV) graph provides a depiction of the amount of proﬁt or loss associated with each sales level horizontal, or x, axis on the PV graph represents sales volume; the vertical, or y, axis represents dollars of proﬁt or loss. Amounts shown above the x-axis are positive and represent proﬁt; amounts shown below the x-axis are negative and represent losses. Two points can be located on the graph: total ﬁxed cost and break-even point.
Total ﬁxed cost is shown on the y-axis below the sales volume line as a negative amount. If no products were sold, the ﬁxed cost would still be incurred and a loss of that amount would result. Location of the BEP in units may be determined algebraically and is shown at the point where the proﬁt line intersects the x-axis; at that point, there is no proﬁt or loss. Amount of proﬁt or loss for any sales volume can be read from the y-axis. Slope of the proﬁt (diagonal) line is determined by the unit contribution margin and the points on the line represent the contribution margin earned at each volume level. Line shows that no proﬁt is earned until total contribution margin covers total ﬁxed cost.
The profit-volume chart is simply the conventional break-even chart re-arranged to show changes in profit or loss which occur through volume changes either of sales or output. It is less detailed since it does not show separate curves for costs and revenues, but its virtue lies in the fact that it reduces any changes down to two key elements-volume and profit. For this reason, the volume-profit chart is useful for illustrating the results of different management decisions
BEP Analysis with Algebraic Formula:
Single product BEP equations:
Breakeven Point =
Fixed Costs / (Unit Selling Price – Variable Costs) Breakeven Sales Point =
Fixed Costs / (1 – (Variable Costs – Unit Selling Price)) Breakeven Point=
BEP (sales value in taka)/ sales in units Breakeven Point( in taka)=
(Total fixed cost/CM per units)* Unit sales Break-even Sales (in taka) = Price per Unit × Break-even Sales Units The formula to calculate the breakeven point in units is:
= Fixed expenses + operating income Unit contribution margin
The formula to calculate the breakeven point in dollars is:
= Fixed expenses + Operating income Contribution margin ratio Or
Target Profit Point in Units=
Multiple product BEP analysis:
Breakeven Point in Units:
BEP Analysis with income statement method:
Breakeven can be computed by using either the income statement approach or the contribution margin formula approach. With the income statement equation approach, breakeven sales in units is calculated as follows: = (unit sale price x units sold) – (variable unit cost x units sold) – fixed expenses = operating income (solve for units sold to get breakeven unit sales). At the breakeven point, a sale minus variable expenses equals fixed expenses (there is no operating income at breakeven). So we can show the statement for BEP analysis with imaginary figures: Income statement (for BEP)
Sales (at $16 per Unit)
Less Variable Costs (at $12 per Unit)
Less Fixed Costs
The observing figure indicating that contribution margin is 960,000 is equal to the fixed cost 960,000. So it has fulfilled the condition of break-even
point at 24,000 units of sales.
Break-even point analysis with linear programming method (multiple products): With the use of linear programming, break-even analysis proves to be much more useful. In fact, linear programming stretches the CVP relationships inherent in BP analysis into a fairly realistic quantitative approach to the incremental cost and revenue concept of microeconomics. There is no doubt that more businessmen and accountants will begin to consider the possibility of using LP to express CVP relationships and to drive the optimum combination of costs, volumes, profits. One need not worry about the size of the equations or the numbers of equations since computers are readily available to use the “simplex method” of solving linear equations. Furthermore, there is the possibility that the number of factors and equations could be loss in some situations. The process of BEP analysis in LP is following: Objective function: maximization or minimization.
Production constraints determination.
Sales constraints identification.
Non negativity constraints.
The objective function represents the fact that we are seeking the combination of products which when multiplied by their respective profit contributions will maximize the total profit contribution and thus profits. The constraints represent the facts there are limits on the available combination of products. A sales constraint indicates the upper limits of possible sales and production constraints indicate upper limits of production possibilities. Linear programming method is applied to the study of a real case in a small enterprise. The characteristics of this method are to make it necessary to use integer linear programming. Cash break-even point analysis:
Many a time, it is difficult for the industrial units to become break-even in the initial years. From that environment, the concept of cash-breakeven point has emerged. The Cash break-even point may be defined as that point of sales volume, where cash revenues are equal to cash costs. In other words, if we eliminate non-cash items from revenues and costs, the break- even analysis on cash basis can be computed. Depreciation is, generally, a fixed cost. However, when plant and machinery is used for additional shifts, the additional depreciation is a variable cost. Reason for treating the additional depreciation as variable cost is the firm can avoid additional shift, at any time, and in such circumstances this cost would not be incurred. To calculate cash- breakeven point, depreciation is to be removed from fixed costs. Additional depreciation, component, treated as variable cost, is also to be excluded from variable costs. Similarly, deferred expenses are to be excluded from the fixed cost. Thus, cash-breakeven point may be calculated as below:
Cash Fixed Cost Cash break-even Point (in terms of units) =
Cash Contribution per unit
BREAK-EVEN ANALYSIS FOR PARTS OF THE FIRM
One can use break-even analysis for parts of the firm by recognizing the fact that many firms are multiproduct, multiplant, and multiterritory operations. In recognizing these complexities of modem-day business activities, the problems of cost allocation are quickly brought to the fore. Substantial amounts of factory overhead, distribution costs, and administrative costs are not traceable to individual products, product lines, manufacturing plants, and even sales territories. These no traceable costs are normally fixed costs such as factory administrative costs and general administrative costs. In order to illustrate the consequences of nonallocation of common fixed costs, the following types of companies will be considered:
One product—one plant
Two products—one plant
One product—two plants
Two products—two plants
One product—one plant—two territories
Two products—one plant—two territories
Two products—two plants—two territories.
One Product-One Plant Company
In a company such as this, all costs are traceable to the product and to the
plant. Thus there is no problem of allocation. With the facts given le1ow, the contribution per unit and break-even point can be calculated as shown: (with imaginary figure)
Fixed costs ………………………$265,000 Variable costs ………………………$4.00 per unit Sales price ……………………… $8 .50 per unit Contribution per unit = $8.50 – 4.00 = $4.50 Break-even point = = 58,888 units. Two Product-One Plant Company
In a two product-one plant situation, some costs will not be traceable to products. These are the common fixed costs. The fixed costs which are traceable to each product can be described as direct fixed costs. With the data given, break-even calculations can be made as shown below.
Direct fixed costs………….
Common fixed costs………
Contribution per unit………..
Break-even to cover direct fixed costs………………….
Two Product-Two Plant Company
In a more complex situation with two products and two plants, there arise three layers of common fixed costs. These layers represent the costs common to products A and B in plant I and in plant 11 and the costs common to the entire operation of all products and all plants. Below are shown break-even data and break-even calculations to illustrate the two product—two plant situation. Break-even Data
Direct fixed costs……………
Variable costs per unit………….
Sales prices per unit…………
Fixed costs common to products. …
Fixed costs common to total operations……………………
Contribution per unit…….
Break-even to cover direct fixed cost…………..
One product one Plant—Two Territory Company
When sales territories are considered in a break-even situation, there aulses the possibility of fixed costs common to the sales territories as well as the possibility of dealing with variable costs segregated by sales and production. Descriptions
Direct fixed costs………………
Variable costs per unit s……….
Sales prices per unit……………
Common fixed costs…
Common to both territories…………
Common to all operations………..
Break-even Calculations Descriptions
Contribution per unit (sales price minus all variable costs)…………………………………………………. Break-even to cover direct fixed costs of each
Two Product-One Plant—Two Territory Company
The two product-one plant—two territory situations are very similar to the preceding illustration. Actually, the only differences are the extra layers of common fixed costs.
Direct fixed costs………
Variable costs per unit….
Sales prices per unit.
Common fixed costs:
Common to Products….
Common to territory…..
Common to all operations…
APPLICATIONS OF BEP ANALYSIS IN SERVICE INDUSTRIES
While many of the examples used have assumed that the producer was a manufacturer (i.e., labor and materials), break-even analysis may be even more important for service industries. The reason for this lies in the basic difference in goods and services: services cannot be placed in inventory for later sale. What is a variable cost in manufacturing may necessarily be a fixed cost in services. For example, in the restaurant industry, unknown demand requires that cooks and table-service personnel be on duty, even when customers are few. In retail sales, clerical and cash register workers must be scheduled. If a barber shop is open, at least one barber must be present. Emergency rooms require round-the-clock staffing. The absence of sufficient service personnel frustrates the customer, who may balk at this visit to the service firm and may find competitors that fulfill the customer’s needs.
The wages for this basic level of personnel must be counted as fixed costs, as they are necessary for the potential production of services, despite the actual demand. However, the wages for on-call workers might be better classified as variable costs, as these wages will vary with units of production. Services, therefore, may be burdened with an extremely large ratio of fixed-to-variable costs. Service industries, without the luxury of inventor able products, have developed a number of ways to provide flexibility in fixed costs. Professionals require appointments, and restaurants take reservations; when the customer flow pattern can be predetermined, excess personnel can be scheduled only when needed, reducing fixed costs. Airlines may shift low-demand flight legs to smaller aircraft, using less fuel and fewer attendants. Hotel and telecommunication managers advertise lower rates on weekends to smooth demand through slow business periods and avoid times when the high-fixed-cost equipment is underutilized. Retailers and banks track customer flow patterns by day and by hour to enhance their short-term scheduling efficiencies.
Whatever method is used, the goal of these service industries is the same as that in manufacturing: reduce fixed costs to lower the break-even point. Break-even analysis is a simple tool that defines the minimum quantity of sales that will cover both variable and fixed costs. Such analysis gives managers a quantity to compare to the forecast of demand. If the break-even point lies above anticipated demand, implying a loss on the product, the manager can use this information to make a variety of decisions. The product may be discontinued or, by contrast, may receive additional advertising and/or be re-priced to enhance demand. One of the most effective uses of break-even analysis lies in the recognition of the relevant fixed and variable costs. The more flexible the equipment and personnel, the lower the fixed costs, and the lower the break-even point. (Source: www.assignmentpoint.com)
CVP ANALYSIS VS BEP ANALYSIS
CVP analysis is the boarder sense but BEP is the part of the whole system of CVP analysis. CVP analysis is differ from BEP analysis since former takes into account the amount of profit earned by a concern at present level of output and sales. But there is also those who feel that BEP analysis is just another name of CVP analysis. There are others who feel that BEP analysis is appropriate up to the point at which costs become equal to revenue and beyond this point, it is the study of CVP relationship. CVP is not static but BEP is fundamentally a static analysis the graph and charts are used can be changed with management decisions. The purpose of CVP analysis is to examine the effect of change in costs, volume, and price on profits. This is a comprehensive study. Break-even analysis is a part of CVP analysis.
CHANGES IN BEP
There are 5 common reasons of changing in BEP analysis. These are given bellow: 1. If there is any change in variable cost P/V ratio and BEP also changed. 2. If there is change in sales price of the product then the BEP also changes. 3. If sales mixed is changed than the P/V ratio & BEP changes. 4. If fixed costs changes the P/V ratio is not change but BEP ratio changes. 5. If the variable costs and fixed costs change at a time and in the same direction than the BEP also changes quickly.
(Source: Marginal costing- CVP analysis by Prof. Mukbul Hossen)
USES OF BEP ANALYSIS
Break even analysis enables a business organization to: Measure profit and loss at different levels of production and sales. T o predict the effect of changes in price of sales. To analysis the relationship between fixed cost and variable cost. To predict the effect on profitability if changes in cost and efficiency. The break even analysis has different application in the business. In planning stage, the analysis is used in sales projection to determine how many units will have to be sold for the company to cover the cost associated with the production. Sales above breakeven point will results into profits. The analysis can be used by financiers to access the viability of business by accessing the units required to be sold before turning the venture into profitable business. Breakeven point can also be used by investors to determine the selling price of an investment at price which will not result into loss due to the sale of investments.
LIMITATIONS OF BREAK-EVEN ANALYSIS
Despite many advantages, break-even analysis and charts suffer from the following limitations: 1. Number of Assumptions: Break-even analysis is based on several assumptions and they may not hold well, under all circumstances. Fixed costs are presumed to be constant, irrespective of the level of output. It does not happen. When the production increases, above the installed capacity, fixed costs change as new plant and machinery has to be installed for increased production. Variable costs do not vary in direct proportion to the change in volume of output, due to the laws of diminishing returns. Selling price that is supposed to be constant also changes due to increased competition. 2. Application in Short Run: Break-even analysis is a short run analysis. In long run, the cost analysis may not hold good as the assumptions may vary and situation may be, totally, different.
3. Applicable in Single Product line: This analysis is applicable for a single product only. If break-even point for each product is to be calculated, fixed costs have to be allocated to different products, which is a practical problem in the real life. Otherwise, BEP for the overall firm only is possible to calculate. 4. No Remedial Action: It does not suggest any remedy or action to the management for solving the problem. 5. Other Factors Ignored: Other important factors such as amount of investment, problems of marketing and policies of Government influence the problem. Break-even analysis does not consider them. This analysis focuses only on cost volume profit relationship. 6. Limited Information: Break-even charts provide limited information. If we want to study the effects of changes in fixed costs, variable costs and selling prices on profitability, a number of charts have to be drawn. It becomes rather more complicated and difficult to understand. 7. Static View: More often, a break-even chart presents a static view of the problem under consideration.
CONCLUSION This term paper is introduced on basics of economic break-even analysis. There are two primary beneficial uses for break-even analysis. These include techniques in company evaluation of desired profit levels and cost reduction impact analysis.
Also, the decision making process can be enhanced by using break-even analysis in combination with other analytical tools such as Break-even Default Ratios, graphical, linear programming, income statement method (a sensitivity analysis on the limit of decreasing unit prices) and Degree of Operating Leverage (analysis on how a change in volume affects profits) for both single and multiple products. Inclusion of these tools to the BEP analysis’ in companies for business position and profitability analysis assist in enhancing the critical thinking process. It also provides these future managers of manufacturing and service with another tool to produce safe and sound managerial decisions, a typical requirement of graduate level students entering the workforce needed in the critical analysis of the connection between theoretical knowledge and with practice. Though the BEP analysis has the different limitation but it is widely using in managerial decision making.
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v. Management Accounting by Garrison. Noreen, Brewer.
vi. Practical Business Application of Break Even Analysis in Graduate Construction Education by Charles W. Berryman, PhD. Journal of Construction Education Spring 1999, Vol. 4, No. 1, pp. 26-37. vii. “Experience managerial decision” by Boyne Resorts.
viii. “Break-even analysis” by Jon Wittwer.
ix. “Break-Even Analysis and Forecasting” by Professor Hussein Arsham. x. “Break-Even Point and Cost-Volume-Profit Analysis” chapter 9, page# 381 xi. Accounting for manager, costing for decision making , chapter 18, page #429 xii. “ How to Do a Breakeven Analysis” “Breakeven analysis helps determine when your business revenues equal your costs” by Daniel Richards xiii. “Importance of Break Even Analysis” by Kaveh M, Thursday, January 05, 2012 xiv. Break-even analysis | Business plan template. www.Google.com xv. ACCA, Paper F. Cost and profit volume analysis. Page# 47. xvi. Student accountant issues 14/2010. ACCA .paper F5.