Break even analysis- A Comprehensive and Clear Description

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Break-Even AnalysisBreak-Even Analysis
Simplified for BetterSimplified for Better
UnderstandingUnderstanding

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Definition of Important factorsDefinition of Important factors
Marginal Costing:Marginal Costing:
Marginal costing necessiates analysis ofMarginal costing necessiates analysis of
costs into fixed and variable. It has beencosts into fixed and variable. It has been
designed to help the management to havedesigned to help the management to have
a clear perspective on the effect of thesea clear perspective on the effect of these
two types of costs on the profitabilitytwo types of costs on the profitability
margin and sales volume .margin and sales volume .

Cost-Volume-Profit RelationshipCost-Volume-Profit Relationship
This CVP( cost-volume-profit) analysisThis CVP( cost-volume-profit) analysis
pertains to management accountingpertains to management accounting
where the results can be interpreted towhere the results can be interpreted to
know theknow the
1.1. Actual cost of production under differentActual cost of production under different
circumstancescircumstances
2.2. What has to be the volume ofWhat has to be the volume of
production?production?
3.3. What profit can be earned?What profit can be earned?
4.4. What is the difference between theWhat is the difference between the

ContributionContribution
Contribution is the difference between sales andContribution is the difference between sales and
the variable cost and referred to as “Grossthe variable cost and referred to as “Gross
margin.”margin.”
It is visualised as some sort of fund or pool outIt is visualised as some sort of fund or pool out
of which all fixed costs are to be met and toof which all fixed costs are to be met and to
which each product has to contribute its share.which each product has to contribute its share.
The difference between contribution and fixedThe difference between contribution and fixed
cost is either profit or loss as the case may be.cost is either profit or loss as the case may be.

Variable or Marginal CostVariable or Marginal Cost
StatementStatement
Sales-Variable cost=Sales-Variable cost= ContributionContribution
Contribution-Fixed Cost=Contribution-Fixed Cost= ProfitProfit
Variable Cost StatementVariable Cost Statement
Sales RevenueSales Revenue xxxxxxxx
Direct Materials xxxxDirect Materials xxxx
Direct Labour xxxxDirect Labour xxxx
Variable OverheadVariable Overhead xxxxxxxx
Variable CostsVariable Costs ((xxxxxxxx))
ContributionContribution xxxxxxxx
Fixed OverheadFixed Overhead (xxxx)(xxxx)
ProfitProfit xxxxxxxx
(- )Read as minus symbol(- )Read as minus symbol

Concept of ContributionConcept of Contribution
The concept of contribution is useful inThe concept of contribution is useful in
Fixation of selling pricesFixation of selling prices
Determination of break-even pointDetermination of break-even point
Selection of product-mix for profitSelection of product-mix for profit
maximisationmaximisation
Ascertainment of profitability of products,Ascertainment of profitability of products,
departments etc.departments etc.

Contribution Margin RatioContribution Margin Ratio
The contribution margin is also useful forThe contribution margin is also useful for
determining the impact on profits of changes indetermining the impact on profits of changes in
sales. In particular, it can be used to estimatesales. In particular, it can be used to estimate
the decline in profits if sales drops, and so is athe decline in profits if sales drops, and so is a
standard tool in the formulation of budgets.standard tool in the formulation of budgets.
FormulaFormula: To calculate the contribution margin: To calculate the contribution margin
ratio, divide the contribution margin by sales.ratio, divide the contribution margin by sales.
The formula is:The formula is:
Contribution marginContribution margin
SalesSales

How to Calculate Con.MarginHow to Calculate Con.Margin
Example:Example:
Rs.Rs.
Revenue 10,00,000Revenue 10,00,000
Variable expenses 4,00,000Variable expenses 4,00,000
--------------------------------
Contribution margin 6,00,000Contribution margin 6,00,000
Fixed expensesFixed expenses 6,60,0006,60,000
Net lossNet loss 60,00060,000

Break-Even AnalysisBreak-Even Analysis
In itsIn its narrow sensenarrow sense, it is that point where, it is that point where
Total Revenues=Total Expenses, i.e., theTotal Revenues=Total Expenses, i.e., the
point of zero profit.point of zero profit.
In aIn a broader sensebroader sense, it denotes a system of, it denotes a system of
analysis that can be used to determine theanalysis that can be used to determine the
probable profit at any level of operations.probable profit at any level of operations.

Definition of Break-Even PointDefinition of Break-Even Point
At the breakeven point of a business,At the breakeven point of a business,
income is equal to expense and thereforeincome is equal to expense and therefore
there is no gain or loss.there is no gain or loss.
It is the starting point from which anIt is the starting point from which an
increase in sales or a reduction in costsincrease in sales or a reduction in costs
generates a gain and a reduction in salesgenerates a gain and a reduction in sales
or an increase in costs generates a loss.or an increase in costs generates a loss.

Why to calculate BE PointWhy to calculate BE Point
The breakeven point is an important referenceThe breakeven point is an important reference
point that enters into planning and carrying outpoint that enters into planning and carrying out
business activities.business activities.
A clear understanding of the level of salesA clear understanding of the level of sales
needed to cover all costs helps you to knowneeded to cover all costs helps you to know
1.1. How many units you must produce in the caseHow many units you must produce in the case
of a manufacturing businessof a manufacturing business
2.2. How many units you need to purchase and sell,How many units you need to purchase and sell,
in the case of a merchandising business.in the case of a merchandising business.
3.3. In a services business, the breakeven pointIn a services business, the breakeven point
indicates the number of billable hours you mustindicates the number of billable hours you must
work in order to cover your costs.work in order to cover your costs.

Assumptions of CVP AnalysisAssumptions of CVP Analysis
1.1. Costs are differentiated into fixed andCosts are differentiated into fixed and
variable components.variable components.
2.2. Fixed cost remains constant.Fixed cost remains constant.
3.3. Variable costs as the name indicatesVariable costs as the name indicates
vary in proportion with the volume.vary in proportion with the volume.
4.4. Selling price does not change withSelling price does not change with
volume.volume.
5.5. There is only one product or, in the caseThere is only one product or, in the case
of multiple products, sales mix remainsof multiple products, sales mix remains
constant.constant.

Assumptions of CVP AnalysisAssumptions of CVP Analysis
6. There will be no change in the general6. There will be no change in the general
price level.price level.
7. Productivity per worker remains7. Productivity per worker remains
unchanged.unchanged.
8. There is synchronisation between8. There is synchronisation between
production and sales.production and sales.
9. The efficiency of plant can be predicted.9. The efficiency of plant can be predicted.
10. The principle of cost variability is valid.10. The principle of cost variability is valid.

What is fixed costWhat is fixed cost
Fixed cost is invariable and has to be borne by the company regardless ofFixed cost is invariable and has to be borne by the company regardless of
the level of sales.the level of sales.
ExamplesExamples::
1. The cost to rent an office, shop, warehouse, factory, or other facilities1. The cost to rent an office, shop, warehouse, factory, or other facilities
2. Base salaries and wages of employees; employee benefit plans,2. Base salaries and wages of employees; employee benefit plans,
maintenance contracts; contracts for cleaning and security services;maintenance contracts; contracts for cleaning and security services;
advertising contracts; insuranceadvertising contracts; insurance
3. Base costs of utilities such as electricity, gas, water, and sewage3. Base costs of utilities such as electricity, gas, water, and sewage
4. Base costs of telephone land lines or cellular telephone; Internet connection;4. Base costs of telephone land lines or cellular telephone; Internet connection;
the monthly cost of a domain and website; real and personal property taxes;the monthly cost of a domain and website; real and personal property taxes;
licenses and permits; depreciation and amortization; and interest and otherlicenses and permits; depreciation and amortization; and interest and other
debt service expenses.debt service expenses.

What is variable costWhat is variable cost
The costs that are incurred in proportion to the level ofThe costs that are incurred in proportion to the level of
sales.sales.
Examples:Examples:
1.1. Raw materials and suppliesRaw materials and supplies
2.2. FreightFreight
3.3. Rental of machinery, equipment, and tools for specificRental of machinery, equipment, and tools for specific
jobsjobs
4.4. FuelFuel
5.5. Employee overtime pay; temporary contract labor;Employee overtime pay; temporary contract labor;
repairs and maintenance; office supplies; telephonerepairs and maintenance; office supplies; telephone
calls; travel expenses; and sales commissions.calls; travel expenses; and sales commissions.

What is Semi-variable costWhat is Semi-variable cost
The costs that possess both theThe costs that possess both the
characteristics of fixed and variable maycharacteristics of fixed and variable may
be termed as semi-variable costs or semi-be termed as semi-variable costs or semi-
variable over-heads.variable over-heads.
For example electricity can be consideredFor example electricity can be considered
as a fixed cost when it is utilised toas a fixed cost when it is utilised to
illuminate all the facilities in a plant and itilluminate all the facilities in a plant and it
also becomes variable when the level ofalso becomes variable when the level of
operation increases to produce moreoperation increases to produce more
units.units.

What is Angle of IncidenceWhat is Angle of Incidence
The angle at which the sales line cuts theThe angle at which the sales line cuts the
cost line.Any organisation would want thiscost line.Any organisation would want this
angle to be wide and large as it indicatesangle to be wide and large as it indicates
more quantum of profit where all the fixedmore quantum of profit where all the fixed
over-heads are absorbed.over-heads are absorbed.
A narrrow angle also covers the fixed-A narrrow angle also covers the fixed-
over-heads but still the profit margin is lowover-heads but still the profit margin is low
as compared to the former.as compared to the former.

What is Margin of SafetyWhat is Margin of Safety
When the volume of sales exceeds theWhen the volume of sales exceeds the
break-even point, that area is called thebreak-even point, that area is called the
margin of safety.margin of safety.
It is important that there should be aIt is important that there should be a
reasonable margin of safety. A low marginreasonable margin of safety. A low margin
indicates high fixed over-heads andindicates high fixed over-heads and
reduced activity which is not enough toreduced activity which is not enough to
absorb the fixed costs and accrue profit.absorb the fixed costs and accrue profit.

P/V Ratio or Profit-Volume RatioP/V Ratio or Profit-Volume Ratio
P/V ratio plays a very important role in all break-even pointP/V ratio plays a very important role in all break-even point
determination as it indicates the relationship between contributiondetermination as it indicates the relationship between contribution
and turn-over.and turn-over.
P/V ratio=P/V ratio= ContributionContribution
SalesSales
(or)(or)
Sales - Variable costSales - Variable cost
SalesSales
(or)(or)
Sales=Sales= ContributionContribution
P/V ratioP/V ratio
(or)(or)
Contribution= Sales * P/V ratioContribution= Sales * P/V ratio
This is basically expressed in percentage %This is basically expressed in percentage %

Calculation of BE pointCalculation of BE point
Break-even point=Break-even point= Fixed costFixed cost
P/V ratioP/V ratio
This formula is derived from the basic formula of break-even pointThis formula is derived from the basic formula of break-even point
which is:which is:
1.1. Fixed cost*SalesFixed cost*Sales
Sales-Variable expenses (or)Sales-Variable expenses (or)
2. Fixed costs /2. Fixed costs / Sales-Variable expensesSales-Variable expenses
Sales (or)Sales (or)
3. Fixed costs/ P/V ratio (or)3. Fixed costs/ P/V ratio (or)
4.4. Fixed costsFixed costs
P/V ratio (or)P/V ratio (or)
5. Fixed Cots*5. Fixed Cots* 11
P/V ratioP/V ratio

Break Even GraphBreak Even Graph

Contribution GraphContribution Graph

Profit and LossProfit and Loss

PROBLEMSPROBLEMS
1. Find the BEP of production in terms of unit and in terms of value if the price of the product1. Find the BEP of production in terms of unit and in terms of value if the price of the product
is Rs 250 per unit; variable cost is Rs 150 per unit and the fixed cost is Rs 1,50,000.is Rs 250 per unit; variable cost is Rs 150 per unit and the fixed cost is Rs 1,50,000.
SolutionSolution
In terms of unit:In terms of unit:
BEP = FC/(SP – VC)BEP = FC/(SP – VC)
= 1,50,000/(250 – 150) =1,500 units= 1,50,000/(250 – 150) =1,500 units
In terms of value:In terms of value:
BEP = FC/MC%BEP = FC/MC%
MC% = (SP – VC)/SPMC% = (SP – VC)/SP
= Rs (250 – 150)/ 250 = 0.40 = 40%= Rs (250 – 150)/ 250 = 0.40 = 40%
= Rs 1,50,000/0.40 = Rs 3,75,000= Rs 1,50,000/0.40 = Rs 3,75,000
2. If the product’s demand is price-inelastic, the firm raises the price of the product from Rs2. If the product’s demand is price-inelastic, the firm raises the price of the product from Rs
250 to Rs 300 with the same variable cost of Rs 150 and the unchanged fixed cost of Rs250 to Rs 300 with the same variable cost of Rs 150 and the unchanged fixed cost of Rs
1,50,000. Will the BEP change from that when it remains unchanged?1,50,000. Will the BEP change from that when it remains unchanged?
SolutionSolution
BEP with an increase in SP:BEP with an increase in SP:
Rs 1,50,000/(300 – 150) = 1,000 unitsRs 1,50,000/(300 – 150) = 1,000 units

Break even analysis- A Comprehensive and Clear Description

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Break even analysis- A Comprehensive and Clear Description