Break-even analysis

Contents

• B.E.P. Definition Cost Volume Profit analysis &

Application Assumption of BEP analysis Calculation Method Formula

• Target profit

• Margin of safety Definition Formula

• Limitation of B.E.P.

• Basic equation of Marginal Costing

• Uses Of CVP Analysis

• Limitations Of CVP Analysis

• Profit Volume (P/V) Ratio

• Marginal costing

• Determination Of Marginal Cost

• Features of Marginal Costing

Definition• Breakeven analysis is also known as cost-volume profit analysis

• Breakeven analysis is the study of the relationship between selling prices, sales volumes, fixed costs, variable costs and profits at various levels of activity

Cost Volume Profit analysis• CVP analysis studies the relationship between expenses, revenues

and net income.

• The aim is to establish what will happen to financial results if a specified level of activity or volume fluctuates.

Application• Breakeven analysis can be used to determine a company’s breakeven

point (BEP)

• Breakeven point is a level of activity at which the total revenue is equal to the total costs

• At this level, the company makes no profit

Assumption of BEP analysis• Relevant range

The relevant range is the range of an activity over which the fixed cost will remain fixed in total and the variable cost per unit will remain constant

• Fixed cost Total fixed cost are assumed to be constant in total

• Variable cost Total variable cost will increase with increasing number of units produced

• Sales revenue The total revenue will increase with the increasing number of units produced

Calculation method• Breakeven point

• Target profit

• Margin of safety

• Changes in components of breakeven analysis

Breakeven point

Calculation method• Contribution is defined as the excess of sales revenue over the variable costs

• The total contribution is equal to total fixed cost

Formula

Breakeven point

Fixed cost

Contribution per unit

Sales revenue at breakeven point

= Breakeven point *selling price

=

Alternative method:

Sales revenue at breakeven point

Contribution required to breakeven

Contribution to sales ratio=

Breakeven point in units

Sales revenue at breakeven point

Selling price=

Contribution per unitSelling price per unit

Target profit

Formula

No. of units at target profit

Fixed cost + Target profit

Contribution per unit=

Required sales revenue

Fixed cost + Target profit

Contribution to sales ratio=

Margin of safety

Margin of safety• Margin of safety is a measure of amount by which the sales may decrease before a company suffers a loss.

• This can be expressed as a number of units or a percentage of sales

Formula

Margin of safety= Margin of safety Budget sales level

*100%

Margin of safety= Budget/Actual sales level – breakeven sales level

Sales revenueTotal Cost/Revenue $

Sales (units)

Total costProfit

BEP

Margin of safety

Limitations of breakeven analysis

• Breakeven analysis assumes that fixed cost, variable costs and sales revenue behave in linear manner. However, some overhead costs may be stepped in nature. The straight sales revenue line and total cost line tent to curve beyond certain level of production

• It is assumed that all production is sold. The breakeven chart does not take the changes in stock level into account

• Breakeven analysis can provide information for small and relatively simple companies that produce same product. It is not useful for the companies producing multiple products

In short:

• Contribution : is difference between sales volume and the marginal cost of sales.

• Break even point: refers to ascertainment of level of operations where total revenues equals to total cost.

• This is a situation of no profit and no loss. It means that at this stage, contribution is just enough to cover the fixed costs,

i.e. Contribution = Fixed cost• Margin of safety: refers to sales in excess of the break even volume.

• Margin of Safety = Sales – Break-even Sales

Basic equation of Marginal Costing• Profit = Sales – Total cost

• Profit = Sales – (Variable cost + Fixed cost)

• Profit + Fixed cost = Sales – Variable cost

• Sales – Variable cost = Contribution = Fixed cost + Profit

• Contribution – Fixed cost = Profit 

• Contribution = Sales – Variable Cost

• Contribution = Fixed Cost + Profit

Uses Of CVP Analysis

• It enables the prediction of costs and profits for different volumes of activity.

• It is useful in setting up flexible budgets.

• It helps in performance evaluation for the purpose of control.

• It helps in formulating price policies by projecting the effect on costs and profits.

• The study of CVP analysis is necessary to know the amount of overhead costs, which could be charged to products costs at various levels of operation.

Limitations Of CVP Analysis

• Variable cost per unit may not be constant.

• Fixed costs may stabilize at higher levels as volume increases.

• Selling prices may be lower at high volumes because of sales discounts allowed.

• Changes in efficiency will affect the CVP relationship.

Profit Volume (P/V) Ratio

• This ratio indicates the contribution earned with respect to one rupee of sales.

• It is also known as Contribution Volume or Contribution sales ratio.

• Fixed costs remain unchanged in the short run, so if there is any change in profits, that is only due to change in contribution.

P/V Ratio = Contribution x 100Sales

P/V Ratio = Changes in profit x 100 Changes in Sales

Marginal costing

•Marginal cost:The term “Marginal Cost” is defined as the amount at any given

volume of output by which aggregate costs are changed if the volume of output is increased or decreased by one unit. It is a variable cost of one unit of a product.

• Marginal Costing:

Marginal costing is a principle whereby variable costs are charged to cost units and the fixed costs attributable to the relevant period is written off in full against the contribution for that period.

Marginal costing is the ascertainment of marginal cost and the effect on profit of changes in volume or type of output by differentiating between fixed costs and variable cost.

Determination Of Marginal Cost

• Marginal cost is the additional cost for manufacturing one additional unit, which is nothing else but the variable cost per unit, and per-unit variable cost remains the same at all the levels of activity.

• Direct cost and indirect cost:

Direct cost is that which can be identified with the individual cot centers.

Indirect cost is that which cannot be identified with individual cost centers.

• Fixed cost and variable cost:

Variable costs are those which vary directly in proportion to the level of activity. Fixed costs are those which remain constant in spite of the variations in the level of activity.

Features of Marginal Costing• All costs are categorized into fixed and variable costs.

• Fixed costs are consider period costs and are not included in product cost.

• Variable costs are considered as product costs.

• Stock of work in progress and finished goods are valued at marginal cost of production.

• Prices are determined with reference to marginal cost and contribution margin.

• Profitability of departments, products etc. is determined with reference to their contribution margin.

Features of Marginal Costing

• In marginal process costing, products are transferred from one process to another are valued at marginal costs only.

• The difference in the magnitude of opening stock and closing stock does not affect the unit cost of production since all the product costs are variable costs.

• Presentation of data is oriented to highlight the total contribution and contribution from each product.

Arguments in favour of Marginal Costing

• Fixed costs are period costs in nature and it should be charge to the concerned period irrespective of the quantum or sale.

• Marginal cost method is simple in application and is easy for exerciser of cost control

• It is more informative and simple to understand.

• It helps the management with more appropriate information in taking vital business decisions like make or buy, continue or discontinue a product/division, product mix decision.