Break Even Analysis

Break Even Analysis

The break-even point means the level of output or sales at which no profit or loss is
achieved. It indicates the position at which marginal profit or contribution is just sufficient
to cover fixed overheads. In other words, a business is said to break even when its income
equals its expenditure.

Break-even analysis is a system of determining that level of operation where the undertaking
neither earns profit nor suffers from a loss, i.e. where the total cost is equal to total sale i.e.
the point of zero profit (break-even point).

When production exceeds the “break-even point”, the business makes a profit and when it
is below the break-even point, the business makes loss.

Importance and Scope of Break Even Analysis

Break even analysis helps solving the following types of problems-

I. What volume of sales will be necessary to cover a reasonable return on capital employed?
II. Computing costs and revenues for all possible volumes of output to fix budgeted sales.
III. To find price of an article to give the desired profit.
IV. To determine variable cost per unit.

Break Even analysis can be carried in two ways:

(a) Algebraic method and
(b) Graphical Method.

Usually a break even analysis is presented graphically, as this method of visual presentation
is particularly well suited to the need of managers to appraise the situation at a glance. When
presented graphically the break even analysis takes the shape of a break even chart. The break
even chart shows the effect of volume of production on the profit contribution.
Assumptions in Break Even Analysis
I. The total cost of production can be divided into two categories- i. fixed cost and ii. variable
cost.
II. Fixed cost remains constant i.e. it is independent of the quantity produced and includes
executive salary, rent of building, depreciation of plant and equipment etc.
III. The variable cost varies directly and proportionately with the volume of production.
IV. The selling price does not change with the change in the volume of sale.
V. The firm deals with only one product, or the sales mix remains unchanged.
VI. There is a perfect synchronisation between production and sales. This assumes that every
product is sold and there is no change in the inventory of finished goods.
VII. Productivity per worker and efficiency of plant etc. remain mostly unchanged.

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Break Even Analysis

Any change in any one of the above factors will affect the break-even point and the profits
will be affected by factors other than volume. Hence, the result of the break-even analysis
should be interpreted subject to the limitations of the above assumptions.

Break- Even Chart

1. The cost and sales income (revenue) in rupees are plotted along the vertical axis.
2. The quantity (volume of production) is plotted along the horizontal axis.
3. Fixed cost is represented by a straight line parallel to the horizontal axis.
4. The variable costs are superimposed upon the horizontal line representing the fixed cost.
This top line then represents the total cost line.
5. The sales income line passes through the origin.
6. The point of intersection of the sales income line and total cost line represent the
breakeven point.
7. The area between the total cost line and sales income line on the left hand side of the BEP
indicates loss; whereas the area on the right hand side of the BEP shows profit.

Total Cost
Break Even
Point

variable cost
Cost and Income

fixed cost

Q1 Q2 Q3

Quantity

Break Even Point

The point of intersection of the total cost line and income line is called as the break-even
point. The break-even point is that junction where income and costs are exactly in balance.
This there is neither profit nor loss for that particular volume of production. Break-even point
indicates minimum operating level below which it is dangerous to fall. As the performance
reaches towards this non-profit point, corrective measure should be taken to cut down the
cost, increase output or raise selling price. BEP is also called as the “no-profit-no-loss point”.

Contribution
It is the difference between sales and variable cost (marginal cost). It is also called Marginal
Profit or Gross Margin. The marginal profit provides the contribution towards fixed cost and
profit. Contribution = Sales – Variable cost

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Break Even Analysis

Angle of incidence.
It is the angle at which income line or sales line cuts the total cost line. If the angle is large, it
is an indication that profits are being made at a high rate, on the other hand, if the angle is
small it indicates that less profits are being made and are achieved under less favourable
conditions.

Margin of safety. Margin of safety is the distance between the break-even point and the
output being produced. A large margin of safety indicates that the business can earn profit
even if there is great reduction in the output. If the margin of safety is relatively small, then it
indicates that the profit will be considerably small even if there is a small drop in output.

In other words, an excess of a company’s actual sales revenue over the breakeven sales
revenue, expressed usually as a percentage. The greater this margin, the less sensitive the
company is to any abrupt fall in revenue.
It is the output at full capacity minus the output at break-even point. If the margin of safety
is small, a small drop in production capacity will reduce the profit greatly. It can also be
expressed as:

Actual sales revenue − 𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 sales revenue

Margin of safety = ( ) × 100
Actual sales revenue

Calculation of Break Even Point

The break-even point can be calculated in terms of physical units and in terms of sales
turnover.
(1) In terms of Physical Units
The number of units produced (volume of production) to achieve the break-even point can
be calculated by the formula
FC FC
B.E.P. = or
SP−VC C
Where, FC= Fixed cost
VC= Variable cost per unit
SP= Sales price per unit
C= Contribution per unit (C= SP-VC)

(2) In terms of sales revenue

FC×SP FC
B.E.P. = = SP−VC Rs.
SP−VC
SP

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Break Even Analysis

Calculation of Various Overheads

Various overheads are calculated under the categories of Factory expenses, Administrative
expenses and Selling and distribution expenses. Most of them can be easily found out from
various records, but some overhead charges require good knowledge and experience of the
estimator. Following are such charges, and are being discussed hereunder:

1. Depreciation
2. Obsolescence
3. Interest on capital
4. Idleness
5. Repair and maintenance

1. Depreciation
Whenever any machine or equipment performs useful work, its wear and tear is bound to
occur. This can be minimised up to some extent by proper care and maintenance but cannot
be totally prevented. Its efficiency also reduces with the lapse of time and at onetime at
becomes uneconomical to be used further and needs replacement by another new unit.

Therefore, we can say efficiency and value of machine or asset constantly reduces with the
lapse of time during use, which is known as “Depreciation”. So, some money must be set
aside yearly from the profit, so that when that when that equipment becomes
uneconomical, it can be replaced by the new one. Therefore, the initial cost of machine plus
installing charges + repair charges + scrap value is charged against overheads and spread
over the machine’s useful life.

For this purpose, depreciation account for the complete plant or individual equipment is
opened in the company’s books and is known as “Depreciation Fund” or “Sinking Fund”. This
amount is deducted yearly from the profits and kept separate to have sufficient money for
replacement at the end of useful life.

2. Obsolescence
Suppose a factory owner purchases a machine for his production shop but after some
duration a better machine comes in the market, whose production rate is very high and is
much economical. Although the old machine is efficient but becomes out of fashion and
uneconomical due to the new better machine which has come in the market. This is known
as “Obsolescence”. Consideration of this fact is of much importance and some money
should be set aside from the profit for this cause.
Hence ‘Obsolescence’ is the depreciation of existing machinery or asset due to new and
better invention, design, equipment or processes etc.

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 Break Even Analysis

3. Interest on Capital
While preparing cost account, interest on capital invested is also considered. The rate of
interest is that, which would have been available, if that capital is deposited in some bank.
By charging the interest, cost of product increases, and the profit seems to be lesser.
Interest should be charged on the product produced, because:
i. Real profit is not received until interest on capital is charged. Because manufacturer gets
an amount equal to interest even when he does not work.
ii. The stock of raw and finished products cost more, because of the rent and interest on
the blocked money.
iii. If the capital is borrowed for business, then the interest has to be paid. Similarly, if
manufacturer himself provides capital he should be credited by a sum equal to the
interest.
Some manufacturer do not charge interest on the invested capital. They have the following
points to advocate their view:
i. An interest is also the part of the profit, it should not be charged separately.
ii. It is charged to show less profit to deceive the consumer and to increase the cost of
product.
iii. It complicates clerical work.

4. Idleness
Idleness in an industry may be of the following two kinds:
a. Idleness of machines
b. Idleness of workers
a) Idleness of machines
This is the time, when machines remain without doing any useful work. Idleness of
machines may be due to several reasons. Following are some of them:
a. Mechanical reasons. Examples of such reasons are breakdown of machines,
power failure, accident etc.
b. Bad Planning: Machines may remain idle due to bad planning. Reasons for such
idleness are not engaging the machine to their full capacities, providing more
machines or lack of supervision.

b) Idleness of worker
In this category worker remains idle but he is paid for this duration also. Idleness of
worker may be due to the following reasons:
a. Labour: In this category workers, do not perform useful work due to their
personal reasons e.g. due to lockouts, strikes, accident, natural calls etc.
b. Mechanical: Examples of mechanical reasons when worker remains free, are
power failure, breakdown of machines etc.
c. Supervisory: Due to poor supervision, sometimes worker wastes his time for
waiting to receive the instructions from supervisor. Sometimes workers

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Break Even Analysis

waste their time in gossiping or wandering here and there unnecessarily

because of poor supervision.
An estimator used to fix the percentage for the idleness effect based on his experience. He
should also consider all the above factors causing idleness.

5. Repair and Maintenance

Every machine requires maintenance for increasing its life and to keep the machine in
good condition and to remove unnecessary delays in production. For maintenance
machines are cleaned, lubricated and checked thoroughly from time to time and to
replace the worn-out parts.

Repair is the process of bringing the defective machine into efficient working condition.
Every machine must be repaired sometimes or other during its useful life. Some money
must be spent on the maintenance and repairs. For determining overheads this
expenditure should also be considered.