Project on Basics of Economics

Project Title: Application of Break-Even Analysis

Submitted to: Prof. Rajkishan Nair

Submitted by: SAMARJIT CHATTERJEE FT-11-1036

IILM Graduate School of Management

Application of Break Even Analysis (C-P-V analysis)

Break Even Point: The point at which total revenue of the firm is equal to its total cost is called the Break Even Point. At this point total profit is zero as total revenue equals total cost. We can determine break-even level of output as follows. Suppose, total revenue of the firm = R, price unit of output = p and the level of output = x. Now, we know that R = px. On the other hand total cost = C, total fixed cost = F and per unit variable cost = b. Then the total cost function is C= F + bx. Now, at the break-even point total revenue is equal to total cost, (R = C). Break-Even analysis is used to give answers to questions such as what is the minimum level of sales that ensure the company will not experience loss or how much can sales be decreased and the company still continues to be profitable. Break-even analysis is the analysis of the level of sales at which a company would make zero profit. As its name implies, this approach determines the sales needed to break even. Break-Even point is determined as the point where total income from sales is equal to total expenses. In other words, it is the point that corresponds to this level of production capacity, under which the company operates at a loss. If all the companys expenses were variable, break-even analysis would not be relevant. But, in practice, total costs can be significantly affected by long-term investments that produce fixed costs. Therefore, a company in its effort to produce gains for its shareholders has to estimate the level of goods sold that covers both fixed and variable costs. Break-even analysis is based on categorizing production costs between those which are variable and those that are fixed. The distinction between fixed costs and variable costs can easily be made, even though in some cases, such as plant maintenance, costs of utilities and insurance associated with the factory and production managers wages need special treatment. Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss.

Application of Break-Even analysis

The break-even analysis has many uses. 1) This analysis may be applied for profit planning. From this analysis we can know the volume of profit at different output levels. It helps to determine the minimum volume of sales required to avoid losses. It can also be used to determine the profit maximizing level of output and it is necessary to know the relationship among cost, volume and profit in order to forecast future profit. 2) The break-even analysis helps the management to take different decisions. The analysis helps to resolve the following questions:Should emphasis be given on increasing the production & sales? What will be the effect on profit if output rises? ii. Would an increase in price of the product be desirable even if it leads to a fall in sales? iii. Should efforts be made to reduce costs, rather than increasing price or sales? If costs are to be reduced, which type of costs should be reduced fixed or variable cost? iv. For a multiproduct firm, which is the most profitable product & which is the least profitable product? What will be the effect on total profit if the product mix changed? v. Should the firm continue production in the short run even it is losing? 3) We can determine the required sales value in order to earn a target level of profit. This can be obtained from this relation:Required sales value = 4) The CVP analysis may be used for compare the financial position of different firms. For example, a firm with a higher margin of safety will have a better financial position. Again, a firm with a larger angle of incidence will be able to earn profit more quickly than a firm with smaller angle of incidence. i.

5) The break-even analysis helps to determine whether an expansion of capacity is desirable or not. When a firm expands, its fixed cost rises. With it, the level of output and variable cost also increase. The break-even output also increase. To maintain the current rate of profit, sales are to be raised. So, before taking any decision on expansion of capacity, the firm will have to examine how these variables change. All these can be known from the CVP analysis. 6) The CVP analysis can also be utilized to know whether it is profitable to add a new product or to drop an existing product. The firm will have to see whether profit rises or not if a new product is produced instead of an old product. This can be seen from the CVP analysis. 7) Most often a firm has to decide whether certain inputs should be produced by itself or bought from outside. The CVP analysis helps to take decision in this case also. 8) The break-even analysis can also be utilized to determine the degree of operating leverage of the firm. The degree of operating leverage is defined as:-

Example: Applying Break-Even Analysis in Service Industry

Break-even analysis can be used not only for companies that sell products, but also for companies that offer services. The following example is taken from the services sector and shows us the calculation that the finance department of advertising ltd. has made in order to evaluate a future project. Specifically, the Marketing department of advertising ltd. came up with the idea of buying advertising space of urban buses in town Ville. They believe that many local companies will be willing to be advertised in urban buses by having their logos and various advertisements placed along buses sides. Also, they believe that annual bus rental can be sold for 1500. Municipal Bus Line, during negotiations with advertising ltd, made the following proposal: Fixed payment of 500 for each bus of its fleet and extra payment 200 for each bus that will be used as for advertisement by advertisings clients. Given that the agreement will be valid for every single local bus of municipal lines (40 buses in total) the Finance Department calculated, as follows, the break-even point: B.E.P = = = = 154 buses

Break-Even Point Graph, Municipal Bus Line Proposal

The answer in this case is 154 buses, which is the target number, the expected volume that covers both fixed and variable rental expenses of this new project. The management of Advertising Ltd. considered that pre-start projections and operating realities may be different and that the company may fall below the break-even volume. Generally, there are three ways for a company to lower its break-even volume, two of them involve cost controls: Lower direct costs (controlling inventory), which will raise the gross margin, exercise cost controls on fixed expense (use of capital budgeting) and raise prices (not easy in a price-sensitive market).

Conclusion
Break-even analysis is useful as a first step in developing financial applications, which can be used in invoicing and budgeting. The main purpose of this analysis is to have some idea of how much to sell, before a profit will be made. Break-even analysis is extremely important before starting a new business because it gives answers to crucial questions such as how sensitive is the profit of the business to decreases in sales or increases in costs. This analysis can be also extended to early stage business in order to determine how accurate the first predictions were and monitor whether the firm is on the right path or not. Even, mature business must take into consideration their current B.E.P. and find ways to lower that benchmark in order to increase profits.