Break Even Analysis

Break-Even Analysis

The break-even analysis is the study of revenues and costs of a firm in relation to its volume of sales and specially the determination of that volume at which its costs and revenues are equal to each other. The break-even point (BEP) may be defined as that level of sales of a firm at which its total revenues are equal to its total costs and hence its net income is zero. BEP is also known as no profit and no loss point.

Determination of BEP
The BEP of a firm can be determined in two ways. They are: In terms of physical units i.e volume of output. In terms of money value i. e the value of sales.

(1) BEP in terms of Physical Units

This method is convenient for a firm producing a single product. The BEP is the no of units of the commodity that should be sold to earn enough revenue just to cover all the expenses of production. The revenue covers all the cost variable as well as fixed. The firm does not earn any profit nor does it incur any loss.

The BEP is illustrated in the following table:

Output in TFC (Rs) TVC (Rs) TC (Rs) units sold 0 10 1000 1000 __ 1000 1000 2000 TR (Rs)
at the rate of 150 /unit

__ 1500

20
30 40 50

1000
1000 1000 1000

2000
3000 4000 5000

3000
4000 5000 6000

3000
4500 6000 7500

Continued.

The table given above shows that ,when the output is zero the TFC is RS.1000 and this will be the TC. When the output is 10 units, the TC consisting of TFC is Rs.1000 and TVC is Rs.1000,is totally Rs.2000. The TR is Rs.1500,since the price is Rs.150/- unit the firm incurs a loss of Rs.500 at this point. When the output is 20 units, the TC is Rs.3000 and the TR is also Rs.3000 and hence TR = TC. At this level the firm is working at a point where there is no profit and no loss. This is called the BEP. From this level of output the firm starts earning profit.

BREAK EVEN CHART

Alternative method to find out BEP in terms of Physical units

There is another method of finding out BEP in terms of physical units of output. This is by means of formula. We adopt AR and AVC instead of TR and TC. The BEP is that level of output at which the price of the product (AR) covers the AC. The price should be sufficient to cover not only the AVC but also some portion of AC. The excess of selling price over AVC goes towards meeting some portion of the FC. The excess is called contribution margin. BEP = TFC Contribution margin per unit Where contribution margin = selling price average variable cost CM = SP AVC Therefore , BEP = TFC SP AVC

Continued
Example: Suppose the TFC of a firm is Rs.10000 per annum. The variable cost per unit i.e. AVC is Rs.6 and the selling price is Rs.10 per unit. Find the BEP in terms of physical units. BEP = 10000 = 2500 units 10 6 Thus the company would not make any profit or loss when the output is 2500 units. Verification: Total revenue = 2500 x 10 = Rs.25000 TVC = 2500 x 6 = 15000 TFC = +10000 TC = 25000 So TC = TR. Hence BEP = 2500 units.

BEP in terms of Money Value Or Sales Value

If a firm is producing many products the BEP has to be approached only in terms of money value of goods sold or total sales revenue. Here also total contribution margin (SP-AVC) would be equal to the TFC. But the contribution margin is expressed as a ratio to sales. This ratio is also known as profit volume ratio or P/V ratio. Contribution ratio = TR TVC / TR BEP = TFC / CR

Continued.
Ex: Total sales = Rs. 3000 TVC = Rs. 2000 Fixed cost = Rs.1000 CR = 3000 2000 / 3000 = 1/3
Now to find out BEP, BEP = TFC = 1000 = Rs. 3000 CR 1/3

TR = Rs. 3000 TFC = Rs. 1000 3000 = TR TVC = RS. 2000 In this way TR of Rs. 3000 = TC of Rs. 3000. Therefore no profit or no loss.

Margin Of Safety (or) Safety Margin

That amount of sales which is over and above the break-even sales value is known as margin of safety. Safety Margin = Total sales sales at BEP MS = TS BES Or MS = NP CR The margin of safety indicates the extent to which the sales may fall before the firm suffer loss. Larger the margin of safety, safer the firm.

Illustrations
TS = Rs.20,000 BES = 15,000 MS = TS BES = 20,000 15,000 = 5,000 Margin of safety can also be expressed as % of total sales. MS = margin of safety x 100 total sales = 5,000 x 100 20,000 = 25%

Continued
To find out MS: Total sales = 1,50,000 Variable cost = 75,000 Fixed cost = 50,000 CR = TR TVC = 1,50,000 75,000 = 1 TR 1,50,000 2 BES = TFC = 50,000 = 1,00,000 CR MS = TR BES =1,50,000 1,00,000 = Rs. 50,000

BreakEven Point as a % of Full Capacity

The term full capacity means maximum possible volume that can be produced with the firms existing capital equipment and operating policies and practices. This is also expressed as % of full capacity. For ex, if the full capacity is 10,000 units and BEP is 4000 units then the BEP can be expressed as 40% of full capacity.

Assumptions of Break Even Analysis

The quantity produced and sold are equal. The FC remains constant at different levels of output. The VC goes on increasing by a fixed amount. The price per unit remains constant and does not change. The TR goes on increasing proportionately to the output.

Managerial Uses of BreakEven Analysis

Microscopic View Profit Target To determine the value of sales to maintain the profit level Safety Margin To expand the production capacity Profit Projections Make or Buy decisions