36 Break Even Analysis

A. Thahira Banu

epgp books

 

 

 

 

1.   INTRODUCTION:

 

Break even analysis is the key in any business sector set up or food operation system. Any one running a business would always be curious to know whether the revenue earned covers the cost of the production and the raw materials used. Similarly no one would like to lose money, but many do this may be due to the fact that they don’t take enough time to determine the factors that could lead to a profit or loss. To ensure a profitable business a break even analysis is required before a person ventures into it. This exercise will help to visualize the owners to understand the exact sales, needed on daily, weekly and monthly time frame to meet their profit goal.

 

2.   LEARNING OBJECTIVES:

 

Dear student welcome to this module of e-lesson. Today you have chosen to read the lesson on break even analysis .When you complete this you should be able to

  • To understand the term break even analysis
  • To know the uses of break even analysis
  • To understand Break even analysis cost
  • To gain knowledge on factors affecting losses

3.  WHAT IS A BREAK EVEN ANALYSIS

 

Break even analysis can be rightly described as a margin of safety for an enterprise based on its income received and associated costs. It covers the levels of sales needed to cover the total fixed costs.

 

This can be determined in 2 ways, one in terms of physical units and other in terms of money value or value of sales. This means number of units of a product that should be produced and sold to cover all expenditures related to a product, both fixed and variable cost.

 

To calculate the break-even point the following formula is used

 

Break-even point includes fixed and variable cost

 

Break-even point = fixed costs / (selling price – variable costs) ( what is fixed cost, what is variable cost)

 

 

Once you cross the break-even price, the company can start making a profit. The break-even point indicates that a point there is no gain or loss.

Let’s look at an example of how to calculate break-even point?

 

Illustaration 1

 

For example, you take a fixed cost for producing 50,000 packs of a product was Rs. 25,000 per year. Your variable cost is Rs. 8.00 for per materials and Rs. 6.00 for labour cost and Rs. 2 for overhead cost for a total of Rs. 16 / unit. If you keep the selling price to be Rs. 24 for each product then we can calculate break-even point

 

Breakeven point = fixed costs / (selling price – variable costs)

 

BEP   = 25,000 / 24 – 16

 

BEP   =25000 / 8 = 3125

 

3125 units have to be sold at the cost of Rs. 24. Only after this the business will start to make a profit. Now in this example a person has to sell 3125 units in order to cover this total cost (i.e.) breakeven point. With the illustration we can say that this point is referred to as no loss no gain, it means that the firm is not at loss or gain, if he is able to sell the specified number of units at the fixed selling price.

 

In case the firm decides to sell its product at a selling price of Rs. 30 per unit then it would have to sell 1785 number of units before it starts to make a profit.

 

Breakeven point = fixed costs / (selling price – variable costs)

 

BEP =   25,000 / 30 – 16

 

Initially the firm is at a loss of 300 when the sales is 150, further when it produces 600 units its Total revenue and Total Cost is equal to BEP, of 350

 

BEP =     25000 / 14 = 1785

 

In case the firm decides to sell its product at a selling price of Rs. 20 instead of Rs. 30 or Rs. 24, then would have to sell 5500 units of products only then it can start making profit.

 

In order to cover the total cost and hereafter make profit every firm should calculate the BEP. This helps to decide the number of units to be produced. Thus it can be concluded from this example that higher price would lower the breakeven point and the margin of safety will be bigger.

 

Illustration: 2

So, when we look into the table, we can find that the fixed cost is kept constant as Rs 350 throughout the four serial numbers. The total fixed cost has to be fixed and cost of unit is Rs 5, initially there is a loss and when the firm starts to produce 600 units the total cost and total revenue is equal.

 

In the first column the total number of products produced is 0, the total fixed cost is 350, the second it is 100, where as the total cost is 650. Third it is 400 the total cost is 2150, when they start producing 600 it is seen that the total revenue, total fixed cost, total cost and total variable cost is same. At this point it is said to be at break-even point. Hence the fixed cost is kept constant at 350 the cost of one unit is Rs. 5, initially there is a loss and when the firm starts to produce 600 units the Total revenue and Total Cost is equal to sum of Rs. 3000.

 

Initially the firm is at a loss of 300 when the sales is 150, further when it produces 600 units its Total revenue and Total Cost is equal to BEP, of 350 and the variable cost keeps on changing. Here cost of one unit is Rs. 5, fixed cost is kept constant.

Look, at the break even chart, the X axis says the quantity of food item sold and the Y axis shows the sales revenue and the sales value. At one point there is break even, when the total cost is equal to the total revenue. When the total cost and total revenue is equal then you call that point as a break-even point. The point which intersects gives the break-even point and hence, there is no loss no profit. Anything produced above the BEP is going to give a profit. This graph explains the break-even point.

 

Break-even point analysis measure the system that calculates margin of safety .By comparing the amount of revenues or units that must be sold to reach the target fixed and variable costs which is connected with making the sales.

 

4.   USES OF BREAK EVEN ANALYSIS

  • It is an important tool in terms of short-term planning and decision making.
  • Helps us to make a decision
  • Helps to do a production planning (The quantity of goods to be produced, how much has to be produced) ( what is production planning)
  • Helps to have a cost control for the cost components like over head cost, labour cost, raw material cost all these can be controlled once the break-even points are known.( Can ask the underlined ones)
  • Financial structure can be developed for the firm.

5.   BREAK EVEN ANAYLSIS AND MARGIN OF SAFETY

 

It shows the amount by which sales can drop before a loss will be incurred. It is a forecast. It is difficult to achieve revenues or profits and not all company can make it. Also to make profit, size of the company doesn’t matter. Many products costs are more to produce than the revenues they generate. And these bring failures to achieve the target as expenses are greater than the revenues; these products are of great loss. This is very clearly stated that some companies make better products, bigger products and there are real failures and the expenses for making products is going to be more then the revenue they are expecting out of it.

 

Next aspect is safety margin, how to decide on safety margin.

 

5.1 Safety Margin:

 

The break-even analysis guides the management to understand the profits generated at the various levels of sales. The safety margin refers to the extent to which the firm can manage to pay for a turn down before it begins to incurr loss. Margin of Safety can be expressed both in terms of sales and currency units. It is usually used as a measure the risk level.

 

The formula that is used to calculate the safety margin of sales is given below

 

Safety Margin= (Sales – BEP)/ Sales x 100

From the numerical example at the level of 250 units of output and sales, the firm is earning profit, the safety margin can be found out by applying the formula of safety margin

 

Safety Margin = 250- 150 / 250 x 100 =40%

 

This means that the firm which is now selling 250 units of the product can afford to decline sales upto 40 per cent. The margin of safety may be negative as well, if the firm is incurring any loss. In that case, the percentage tells the extent of sales that should be increased in order to reach the point where there will be no loss. So it can be in both way one it tells about decline in sale or increase sale of the product. This is how the safety margin is measured in industries. (Source: Smiriti Chand)

 

5.2 Target Profit: It is the decision taken by the management to finalise the level of profit it would make and eventually the number of units it would produce.

 

The break-even analysis can be used for the purpose of manipulating the volume of sales required to reach a target profit

 

When a FSI aims for target profit, this analysis will be of great use in charting out the quantity of increase in sales by using the formula given below:

 

Target profit quantity = Target profit+ Fixed cost/Contribution (Sales price-Variable cost)

 

Target Sales Volume = Fixed Cost + Target Profit / Contribution Margin per unit (profit – variable cost)

 

The formula for determining the new volume of sales to maintain the same profit, given a reduction in price, will be as follows:

 

New Sales Volume = Total Fixed Cost = Total Profit/ New Selling price – Average Variable Cost

 

5.3 Changes in Price:

 

Whenever there are some adverse conditions the FSI is put in a dilema of whether to reduce the selling prices or not. Before taking a decision on this question, the management should not go into loss and should work on its profit. A change in price leads to reduced contribution margin. In this condition the volume of sales have to be increased to maintain the previous profit level. So, this is about the change in price, during change in price then the company may go into loss. So, the earlier worked BEP may not be of use. Increase in the volume of sales has to be targeted, if going for the change in price.

5.4 Changes in Costs:

 

When a cost is subjected to change, the selling price and the quantity of products produced and sold also are subjected to changes.

 

Changes in cost can be in two ways:

 

(i)   Change in variable cost, and

(ii)   Change in fixed cost.

 

(i) Change in variable cost: An increase in variable costs leads to a reduction in the contribution margin. This reduction in the contribution margin will shift the break-even point downward. Conversely, with the fall in the proportion of variable costs, contribution margins increase and break-even point moves upwards.

 

ВЕР in term of Sales Value:

 

To determine the Break Even Point for more than one product the break-even point can be calculated byfinding the contribution margin (sales —variable costs) that would be equal to fixed costs. The contribution margin is given as a ratio to sales. The formula for calculating the break-even point for more than one product

 

BEP = Fixed Cost/Contribution Ratio

Contribution Ratio (CR) = Total Revenue (TR)-Total Variable Cost (TVC)/Total Revenue (TR)

For example, if TR is Rs. 1000 and TVC is Rs. 800, then the contribution ratio is

CR = 1000 – 800/1000/1000=200/ 1000 = 0.20

The Contribution Ratio is 0.20

 

BEP = Total Fixed Cost /Contribution Ratio

 

= 200/0.20 = 1000

 

The ВЕР for the FSO is reached when its sale reaches  Rs. 1000

 

An increase in variable costs leads to a reduction in the contribution margin. This reduction in the contribution margin will shift the break-even point downward. Conversely, with the fall in the amount of variable costs, contribution margins increase and break-even point moves upwards.

 

Under conditions of changing variable costs, the formula to determine the new quantity or the new selling price is:

 

(a) New Quantity or Sales Volume = Contribution to Margin/ Present Selling Price – New Variable Cost per Unit

(b) New Selling Price = Present Sale Price +New Variable Cost-Present Variable Cost

 

Breakeven analysis is used to determine when your business will be able to cover all its expenses and begin to make a profit. It is important to identify your startup costs, which will help you determine your sales revenue needed to pay for the ongoing business expenses

 

6. BREAKEVEN ANAYLSIS COSTS

  •  Fixed costs

Fixed costs are costs that must be paid whether or not any units are produced. These costs are “fixed” over a specified period of time or range of production.

 

Examples of fixed costs include:

  • Equipment (machinery, tools, computers, etc.)
  • Employee wages and payments

·   Variable costs

 

Variable costs are costs that vary directly with the number of products produced. For instance, the cost of the materials

Examples of variable costs include:

  • Utilities costs that increase with activity – for example electricity, gas, or water usage
  • Raw materials and overhead costs

 

7.  TYPES OF BREAK EVEN COSTS

 

There are two types of break even and they are:

 

(i)   Cash break-even

 

(ii)   Income break-even

 

(i) The Cash Break-Even:

 

A Food service Operation needs money for two main purpose one is to obtain capital possessions and to meet the operational capital needs. These needs can be to some extent met by the managements own investment and somewhat by loans from banks and other lending institutions. The FSO would need loans to buy capital assets like equipments, land and building. Incase loans are obtained then financial institutions would be interested to know whether the management is in a position to repay the loan in installments.Break even point has to be calculated not only including total cost but also the amount that is needed for loan repayment or installments.

 

This level of break-even is called the cash break-even. It is based on income and cost data involving cash inflows. The depreciation, savings, reserve and other provision of the cost items should be excluded and the amount needed for repayment of installment or loans must be added to the fixed cost.

 

Cash Break-Even Point = Fixed Cost+ Loan installment – Cash outflow/Contribution per unit

 

(ii)   The Income Break-Even:

 

There  may be many  financial sources for a firm such as the capital, borrowing, overdue payments and other sources. If these sources are insufficient the industry may seek the help of the bank for sponsoring its shares. If the share market does not give a positive reply, the equity risk falls on the sponser.

 

In this case one has to calculate income break-even point and the principal cash earnings should be added. The income breakeven point can be calculated in the following manner.

 

Income Break-Even Point = Fixed Cost + Earnings required for dividend/Contribution per unit

 

Calculation of Break-Even Point for multiple products:

 

The break-even point for a multiproduct can be calculated by knowing the‘product mix’. The product mix is the complete list of products available for sales. It maybe from one or two product lines to a several product lines.

 

Suppose a FSO is involved in the production of three items, namely A, B, and C. The contribution for items is given below:

 

X = Rs. 8 per unit

Y = Rs. 6 per unit

Z = Rs. 4 per unit

The product-mix given by the FSO is as follows:

 

X = 20,000 units

 

Y = 1,00,000 units

 

Z = 80,000 units

 

The product-mix are in the ratio of 1:5:4 calculation of contributions can be done as follows :

Product – Contribution x Unit Proportions – Total Contributions

 

X – 8 x 1 – 8

Y – 6 x 6 – 36

Z – 4 x 4 – 20

____ ____

10 – 64

 

Average Contribution per unit = 64/ 10 = Rs 6.4

 

 

BEP= Total Fixed Cost/ Average contribution per unit = 6, 20,000 / 6.4 = 96875 units ( Total cost = Total fixed cost +Total variable cost. Assume it to be Rs 6,20,000)

 

Break-even output for the three items can be arrived by dividing the BEP of 96875 units in the same proportion as 1:5:4

 

A = 9687

 

B = 48437

 

C = 38751

 

This indicates that the production manager has to ensure that production in the A line does not go below 9687 units, in the B line 48437 units and in the C line 38751units. If not, the industry should face a loss.

 

8. LIMITATIONS   OF BREAK EVEN ANALYSIS:

 

1.In the break-even analysis, many costs are kept constant. The selling price is assumed to be constant but in reality, it is not possible.

2. In the break-even analysis the cost of function is kept constant, the future is projected with the activities and functions of the past. It cannot be realistic.

3. Calculation of a breakeven point is considered as an estimate rather than an assurance.

4.Profits are a function of not only on the sales output, but also of other factors like technological up-gradation and improvement in management, which has been neglected in Break Even Analysis.

5.    Changes in selling costs are a cause and not results of changes in sales.

6.  The simple form of a break-even chart makes no requirements for taxes.

 

9.  FACTORS RESPONSIBLE FOR LOSSES

 

1. Lack of proper supervision at the point of receiving food from suppliers. At this stage money can be lost through a number of channels.

2..Improper weights of commodities: especially those which are loosely packed or perishable such as fruits, vegetables, meats etc.

3..Improper weighing equipment: At the delivery point can affect the weights of foods received, the mistake being made in the recording of the weights. Any extra weight recorded would push up the price of each portion obtained from the foods and vice versa.

4.Variable quality of foods received: The quality of a food directly affects the number of portions obtained from a standard weight of the item.

5.Pilferage at delivery point: At this stage it is much easier to pilfer without actually taking out the food from the establishment. Cases have been known in which the supplier directly delivers to the staff outside the establishment, while the invoices are routinely recorded in the book of the establishment.

 

On checking, the number of packs received is in order, but perhaps each one slightly lighter than they should be. Minor differences in weights are generally undetected by an observer, especially when very large quantities are delivered. Thus, the factor responsible for losses has to be considered when we are working with break even analysis and break even points. Otherwise analysis what we arrived at may not be realistic it may be too dramatic.

 

Example: apples of different sizes with blemishes or irregular surfaces can lead to loss of a lot of money through excessive peelings so on.

 

10.  SELF-CHECK EXERCISES

  1. Total cost is sum of fixed and ————– cost.
  2. Safety Margin= (Sales– ———-)/ ——- x 100
  3. A company makes a product with a selling price of Rs 10 per unit and variable costs of Rs 6 per unit. The fixed costs for the period are Rs 20,000. What is the required output level for a BEP
  4. How will you calculate the contribution margin?
  5. Rent is an example of fixed cost. True/False

(Ans. 1. Variable cost   2.  BEP & Sales 3. 5000 units 4. Profit- Variable cost  5. True)

  1. SUMMARY

To summarize, break even analysis is required to ensure there is a profitable business. Working on break even analysis will help to envisage the owners to understand the exact sales, needed on daily, weekly and monthly time frame to achieve their profit target.

 

Thus break even analysis can be described as a margin of safety for an enterprise based on its income received and associated costs. It covers the levels of sales needed to cover the total fixed costs.

 

you can view video on Break Even Analysis

Bibliography:

  1. Sethi, M and Malhan, S. M (2006). Catering Management an Integrated approach, IInd edition, New Age International (P) Limited, Publishers, New Delhi.
  2. Battista, G. L and Crowning Shield, G. R (1996). Cost Behaviour and Breakeven Analysis- a Different Approach. National Association of Accountants
  3. Michael Cafferky, (2010). Breakeven Analysis: The Definitive Guide to Cost-Volume-Profit Analysis (publisher- Business Expert Press)

 

Web links

 

  • http://yourarticlelibrary.com/economics/the-break-even-analysis-explained-with-diagram-economics/29085/
  • http://accounting explained.com/managerial/cvp-analysis/break-even-point-contribution-approach written by Irfnullah jan
  • http://textbook.stpauls.br/business_textbook/operations_management_student/printview.htm
  • http://www.investopedia.com/terms/b/breakevenanalysis.asp\
  • https://en.wikipedia.org/wiki/Break-even_(economics)
  • https://www.readyratios.com/reference/analysis/break_even_point.html
  • http://mrdashboard.com/index.php/break-even-analysis