Break even analysis - Introduction

Break even analysis is the analysis of the relationship of cost, volume ,profit revenue, volume of sale for a
particular product of a company. Break even analysis is usually done with the help of a break even
chart. Break even chart is a graphical representation of various components like Fixed cost, Variable
cost, Total cost, Quantityof production/sales, sales revenue, profit/lose and margin of safety.
The chart has Quantity of production/sales on X axis and cost/sales revenue in Rupees on
Y axis. It is assumed that thequantities of production and sales are same

Break even or CVP analysis assumptions:

Assumptions and Terminology: Following are the assumptions on which the theory
of CVP or break even analysis is based:

1. The changes in the level of various revenue and costs arise only because of
the changes in the number of product (or service) units produced and sold, e.g., the
number of television sets produced and sold by Sigma Corporation. The number of
output (units) to be sold is the only revenue and cost driver. Just as a cost driver is
any factor that affects costs, a revenue driver is any factor that affects revenue.

2. Total costs can be divided into a fixed component and a component that is
variable with respect to the level of output. Variable costs include the following:
o Direct materials
o Direct labor
o Direct chargeable expenses
Variable overheads include the following:
o Variable part of factory overheads
o Administration overheads
o Selling and distribution overheads

3. There is linear relationship between revenue and cost.

4. When put in a graph, the behavior of total revenue and cost is linear (straight
line), i.e. Y = mx + C holds good which is the equation of a straight line.

5. The unit selling price, unit variable costs and fixed costs are constant.

6. The theory of CVP is based upon the production of a single product.

However, of late, management accountants are functioning to give a theoretical
and a practical approach to multi-product CVP analysis.
7. The analysis either covers a single product or assumes that the sales mix sold
in case of multiple products will remain constant as the level of total units sold
changes.

8. All revenue and cost can be added and compared without taking into account
the time value of money.

9. The theory of CVP is based on the technology that remains constant.

10. The theory of price elasticity is not taken into consideration.

Many companies, and divisions and sub-divisions of companies in industries such

as airlines, automobiles, chemicals, plastics and semiconductors have found the
simple CVP relationships to be helpful in the following areas:

Strategic and long-range planning decisions

Decisions about product features and pricing

In real world, simple assumptions described above may not hold good. The theory
of CVP can be tailored for individual industries depending upon the nature and
peculiarities of the same.For example, predicting total revenue and total cost may
require multiple revenue drivers and multiple cost drivers. Some of the multiple
revenue drivers are as follows:

Number of output units

Number of customer visits made for sales
Number of advertisements placed
Some of the multiple cost drivers are as follows:
Number of units produced
Number of batches in which units are produced

Managers and management accountants, however, should always assess whether

the simplified CVP relationships generate sufficiently accurate information for
predictions of how total revenue and total cost would behave. However, one may
come across different complex situations to which the theory of CVP would rightly
be applicable in order to help managers to take appropriate decisions under
different situations

Marginal Cost Equations and Breakeven Analysis

Algebric method:

From the marginal cost statements, one might have observed the following:
Sales – Marginal cost = Contribution ......(1)Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal cost equation as
follows:
Sales – Marginal cost = Fixed cost + Profit ......(3)
This fundamental marginal cost equation plays a vital role in profit projection and has
a wider application in managerial decision-making problems.The sales and marginal
costs vary directly with the number of units sold or produced. So, the difference
between sales and marginal cost, i.e. contribution, will bear a relation to sales and the
ratio of contribution to sales remains constant at all levels. This is profit volume or
P/V ratio. Thus,
Contribution (c)
P/V Ratio (or C/S Ratio) =
Sales (s) ......(4)
It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
Or, Contribution = Sales x P/V ratio ......(5)

Or, Sales = Contribution

P/V ratio ......(6)
The above-mentioned marginal cost equations can be applied to the following heads:
1. Contribution
Contribution is the difference between sales and marginal or variable costs. It
contributes toward fixed cost and profit. The concept of contribution helps in deciding
breakeven point, profitability of products, departments etc. to perform the following
activities:

 Selecting product mix or sales mix for profit maximization

 Fixing selling prices under different circumstances such as trade depression,
export sales, price discrimination etc.
2. Profit Volume Ratio (P/V Ratio), its Improvement and ApplicationThe ratio of
contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales
and since the fixed cost remains constant in short term period, P/V ratio will also
measure the rate of change of profit due to change in volume of sales. The P/V ratio
may be expressed as follows:

Sales – Marginal cost of Changes in Change in

P/V ratio Contribution
sales = = contribution = profit
=
Sales Sales Changes in sales Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant
at different levels of activity.
A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in
determining the following:
 Breakeven point
 Profit at any volume of sales
 Sales volume required to earn a desired quantum of profit
 Profitability of products
 Processes or departments
The contribution can be increased by increasing the sales price or by reduction of
variable costs. Thus, P/V ratio can be improved by the following:
 Increasing selling price
 Reducing marginal costs by effectively utilizing men, machines, materials and
other services
 Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point: Breakeven point is the volume of sales or production where
there is neither profit nor loss. Thus, we can say that:
Contribution = Fixed cost
Now, breakeven point can be easily calculated with the help of fundamental marginal
cost equation, P/V ratio or contribution per unit.a. Using Marginal Costing Equation
S (sales) – V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S – V = F
By multiplying both the sides by S and rearranging them, one gets the following
equation:
S BEP = F.S/S-V
b. Using P/V Ratio

Contribution at BEP Fixed cost

Sales S BEP = =
P/ V ratio P/ V ratio
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:
400 x 2000
Breakeven point = = $. 1000
2000 - 1200
P/V ratio
Similarly, = 2000 – 1200 = 0.4 or 40%
800
So, breakeven sales = $. 400 / .4 = $. 1000c. Using Contribution per unit

Fixed cost
Breakeven point = = 100 units or $. 1000
Contribution per unit
 4. Margin of Safety (MOS)
Every enterprise tries to know how much above they are from the breakeven point.
This is technically called margin of safety. It is calculated as the difference between
sales or production units at the selected activity and the breakeven sales or production.
Margin of safety is the difference between the total sales (actual or projected) and the
breakeven sales. It may be expressed in monetary terms (value) or as a number of
units (volume). It can be expressed as profit / P/V ratio. A large margin of safety
indicates the soundness and financial strength of business.
Margin of safety can be improved by lowering fixed and variable costs, increasing
volume of sales or selling price and changing product mix, so as to improve
contribution and overall P/V ratio.

Profit at selected activity

Margin of safety = Sales at selected activity – Sales at BEP =
P/V ratio

Margin of safety (sales) x 100

Margin of safety is also presented in ratio or percentage as
%
follows:
Sales at selected activity

The size of margin of safety is an extremely valuable guide to the strength of a

business. If it is large, there can be substantial falling of sales and yet a profit can be
made. On the other hand, if margin is small, any loss of sales may be a serious matter.
If margin of safety is unsatisfactory, possible steps to rectify the causes of
mismanagement of commercial activities as listed below can be undertaken.
a. Increasing the selling price-- It may be possible for a company to have higher margin
of safety in order to strengthen the financial health of the business. It should be able to
influence price, provided the demand is elastic. Otherwise, the same quantity will not
be sold.
b. Reducing fixed costs
c. Reducing variable costs
d. Substitution of existing product(s) by more profitable lines e. Increase in the volume
of output
e. Modernization of production facilities and the introduction of the most cost effective
technology

Problem 1A company earned a profit of $. 30,000 during the year 2000-01. Marginal
cost and selling price of a product are $. 8 and $. 10 per unit respectively. Find out the
margin of safety.
Solution

Margin of safety = Profit

 P/V ratio

Contribution x 100
P/V ratio =
Sales

Problem 2
A company producing a single article sells it at $. 10 each. The marginal cost of
production is $. 6 each and fixed cost is $. 400 per annum. You are required to
calculate the following:
 Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
 P/V ratio
 Breakeven sales
 Sales to earn a profit of $. 500
 Profit at sales of $. 3,000
 New breakeven point if sales price is reduced by 10%
 Margin of safety at sales of 400 units

Solution Marginal Cost Statement

Particulars Amount Amount Amount Amount
Units produced 1 50 100 400
Sales (units * 10) 10 500 1000 4000
Variable cost 6 300 600 2400
Contribution (sales- VC) 4 200 400 1600
Fixed cost 400 400 400 400
Profit (Contribution –
-396 -200 0 1200
FC)

Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%

Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000
Sales at BEP = Contribution at BEP/ PVR = 100 units
Sales at profit $. 500
Contribution at profit $. 500 = Fixed cost + Profit = $. 900
Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)
Profit at sales $. 3,000
Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200
Profit = Contribution – Fixed cost = $. 1200 – $. 400 = $. 800
New P/V ratio = $. 9 – $. 6/$. 9 = 1/3

Sales at BEP = Fixed cost/PV ratio = $. 400 = $. 1,200

 1/3

Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %

(Actual sales – BEP sales/Actual sales * 100)

Breakeven Analysis-- Graphical Presentation

Apart from marginal cost equations, it is found that breakeven chart and profit graphs
are useful graphic presentations of this cost-volume-profit relationship.
Breakeven chart is a device which shows the relationship between sales volume,
marginal costs and fixed costs, and profit or loss at different levels of activity. Such a
chart also shows the effect of change of one factor on other factors and exhibits the
rate of profit and margin of safety at different levels. A breakeven chart contains, inter
alia, total sales line, total cost line and the point of intersection called breakeven point.
It is popularly called breakeven chart because it shows clearly breakeven point (a
point where there is no profit or no loss).
Profit graph is a development of simple breakeven chart and shows clearly profit at
different volumes of sales.

Construction of a Breakeven Chart

The construction of a breakeven chart involves the drawing of fixed cost line, total
cost line and sales line as follows:
1. Select a scale for production on horizontal axis and a scale for costs and sales on
vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing through this point
parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed cost line and join
these points. This will give total cost line. Alternatively, obtain total cost at different
levels, plot the points starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line by joining zero and
the point so obtained.
Uses of Breakeven Chart:
A breakeven chart can be used to show the effect of changes in any of the following
profit factors:
 Volume of sales
 Variable expenses
 Fixed expenses
 Selling price
Problem: A company produces a single article and sells it at $. 10 each. The marginal
cost of production is $. 6 each and total fixed cost of the concern is $. 400 per annum.
Construct a breakeven chart and show the following:
 Breakeven point
 Margin of safety at sale of $. 1,500
 Angle of incidence
 Increase in selling price if breakeven point is reduced to 80 units
SolutionA breakeven chart can be prepared by obtaining the information at these
levels:

Output units 40 80 120 200

$. $. $. $.
Sales
400 800 1,200 2,000
 Fixed cost 400 400 400 400
Variable cost 240 480 400 720
Total cost 640 880 1,120 1,600

Fixed cost line, total cost line and sales line are drawn one after another following the
usual procedure described herein:
This chart clearly shows the breakeven point, margin of safety and angle of incidence.
a. Breakeven point-- Breakeven point is the point at which sales line and total cost line
intersect. Here, B is breakeven point equivalent to sale of $. 1,000 or 100 units.
b. Margin of safety-- Margin of safety is the difference between sales or units of
production and breakeven point. Thus, margin of safety at M is sales of ($. 1,500 - $.
1,000), i.e. $. 500 or 50 units.
c. Angle of incidence-- Angle of incidence is the angle formed by sales line and total
cost line at breakeven point. A large angle of incidence shows a high rate of profit
being made. It should be noted that the angle of incidence is universally denoted by
data. Larger the angle, higher the profitability indicated by the angel of incidence.
d. At 80 units, total cost (from the table) = $. 880. Hence, selling price for breakeven at
80 units = $. 880/80 = $. 11 per unit. Increase in selling price is Re. 1 or 10% over the
original selling price of $. 10 per unit.

Multiple Product Situations

In real life, most of the firms turn out many products. Here also, there is no problem
with regard to the calculation of BE point. However, the assumption has to be made
that the sales mix remains constant. This is defined as the relative proportion of each
product’s sale to total sales. It could be expressed as a ratio such as 2:4:6, or as a
percentage as 20%, 40%, 60%.
The calculation of breakeven point in a multi-product firm follows the same pattern as
in a single product firm. While the numerator will be the same fixed costs, the
denominator now will be weighted average contribution margin. The modified
formula is as follows:

Fixed costs
Breakeven point (in units) =
Weighted average contribution margin per unit

One should always remember that weights are assigned in proportion to the relative
sales of all products. Here, it will be the contribution margin of each product
multiplied by its quantity.

Breakeven Point in Sales Revenue

Here also, numerator is the same fixed costs. The denominator now will be weighted
average contribution margin ratio which is also called weighted average P/V ratio.
The modified formula is as follows:

Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio
Problem Ahmedabad Company Ltd. manufactures and sells four types of products
under the brand name Ambience, Luxury, Comfort and Lavish. The sales mix in value
comprises the following:
Brand name Percentage

Ambience 33 1/3
Luxury 41 2/3
Comfort 16 2/3
Lavish 8 1/3
------
100
 The total budgeted sales (100%) are $. 6,00,000 per month.The operating costs are:
Ambience 60% of selling price Luxury
Luxury 68% of selling price Comfort
Comfort 80% of selling price Lavish
Lavish 40% of selling price

The fixed costs are $. 1,59,000 per month.

a. Calculate the breakeven point for the products on an overall basis.
b. It has been proposed to change the sales mix as follows, with the sales per month
remaining at $. 6,00,000:
Brand Name Percentage

Ambience 25
Luxury 40
Comfort 30
Lavish 05
---
100

Assuming that this proposal is implemented, calculate the new breakeven

point.Solution

a. Computation of the Breakeven Point on Overall Basis

b. Computation of the New Breakeven Point

Product Mix & Limiting Factor

So far, it has been assumed for the sake of simplicity that only one product is manufactured and
sold. In the real world, however, businesses manufacture and sell a mix of products.

A Limiting Factor is any factor that limits the activities of a business. The most common limiting
factor is sales volume because a business may not be able to sell its entire output.

The concept of a Limiting Factor helps a business to identify resources constraints and determine
the best combination of available resources to maximize profit. The Limiting Factor in a business
might be raw material, labour hours or machine hours. Simple Limiting Factor Analysis can be
applied where there is only one limiting factor. Where there is more than one limiting factor, the use
of Linear Programming is appropriate. That is beyond the scope of this article.

In simple Limiting Factor Analysis, the contribution per unit of each product (sales less variable cost)
is calculated first. Next, the contribution is divided by the total number of units of the Limiting Factor
to obtain the contribution per unit of Limiting Factor.

Suppose raw material R is in short supply (that is it is a limiting factor).

(All data below is given on a per unit basis)

Consider the following data:

Product A: Selling Price: Rs.1000; Product B Selling Price: Rs.2000

Variable Costs Product A: Rs.600; Variable Costs Product B: Rs.1400

Contribution per Unit of Product A ………. Rs.400

Contribution per Unit of Product B ………. Rs.600

Raw material R used per unit of A 10 Kg

Raw material R used per unit of B 20 Kg

Therefore:

Contribution per Kg of R for Product A ……….400/10 = Rs.40

Contribution per Kg of R for Product B ………. 600/20 = Rs.30

It is evident that for Product A, the Contribution per Kg of R is greater than that for Product B.
Therefore, the business should produce as many units of Product A as possible to maximize profit.
Any Raw Material R left after producing as many units of product A as can be sold in the market
should be used to produce Product B.

ADVANTAGES OF BREAK EVEN ANALYSIS

1Calculation of profit of different sales volume

2Calculation of sales volume to produce desired profit.

3Calculation of selling price per unit for a particular break even point

4Calculation of sales volume required to meet proposed expenditure

5Determination of sales required to offset price reduction

6Measurement of effect of changes in profit factors

7Choosing the most profitable alternatives

8Determining the optimum sales mix

9Deciding on changes in capacity

LIMITATIONS OF BE ANALYSIS
 The break even analysis is based on a number of assumptions which are rarely found in
reallife. Hence its managerial utility becomes limited. Its main limitations are as follows
1Both cost and revenue should be taken into account to determine the
b r e a k e v e n p o i n t . The one without the other has no meaning. But this analysis pre
suppose that prices do notchange while in actual life, price do changes as a result of
several factors eg-change indemand, fashion, styles etc
2It assumes that all costs can be divided into fixed and variable costs,
that they vary inlinear fashion and that the principle of cost variability
a p p l i e s t o t h e m . A l l t h e s e assumptions do not hold true
3This analysis ignores the time lag between production and sales. The
production quantitymay be kept constant, but the sales are bound to vary from period
to period. This featureof sales reduces the significance of BE analysis as a
management guide.
4Factors likeplant size, technology and methodology of productio
n h a v e t o b e k e p t constant in order to draw an effective break even chart. But it is
not found in actual life.
5The analysis does not take into account the capital employed in the
production and its costwhich is an important consideration in profitability decisions

Profit Volume Graph - Refer PDF file for the same

Summary
1. Fixed and variable cost classification helps in CVP analysis. Marginal cost is also
useful for such analysis.
2. Breakeven point is the incidental study of CVP. It is the point of no profit and no loss.
At this specific level of operation, it covers total costs, including variable and fixed
overheads.
3. Breakeven chart is the graphical representation of cost structure of business.
4. Profit/Volume (P/V) ratio shows the relationship between contribution and
value/volume of sales. It is usually expressed as terms of percentage and is a valuable
tool for the profitability of business.
5. Margin of safety is the difference between sales or units of production and breakeven
point. The size of margin of safety is an extremely valuable guide to the financial
strength of a business.