Break even analysis
- 1. What Is the Difference Between Fixed Cost and Variable Cost? Fixed Costs • In accounting, fixed costs are expenses that remain constant for a period of time irrespective of the level of outputs. • Even if the output is nil, fixed costs are incurred. • Fixed costs are also known as overhead costs, period costs or supplementary costs. Variable Costs • Variable costs are expenses that change directly and proportionally to the changes in business activity level or volume. • The cost increases/decreases based on the output. • Variable costs are also referred to as prime costs or direct costs as it directly affects the output levels.
- 2. What Is the Difference Between Fixed Cost and Variable Cost? Fixed Costs • Fixed costs are time-related i.e. they remain constant for a period of time. • Depreciation, interest paid on capital, rent, salary, property taxes, insurance premium, etc. Variable Costs • Variable costs are volume- related and change with the changes in output level. • Commission on sales, credit card fees, wages of part-time staff, etc.
- 3. Why Is It Important to Distinguish Between Fixed Costs and Variable Costs? • As a small business owner, it is vital to track and understand how the various costs change with the changes in the volume and output levels. • The breakdown of these expenses determines the price level of the services and assists in many other aspects of the overall business strategy. • These costs are also the primary ingredients to various costing methods employed by businesses including job order costing, activity- based costing and process costing.
- 4. •Break even Analysis- A decision-making aid that enables a manager to determine whether a particular volume of sales will result in losses or profits. • The theory behind the breakeven analysis • Madeup of four basicconcepts • Fixedcosts- costs that do notchange • Variablecosts- costs that rise in propitiation to sales • Revenue-the total income received • Profit-the money you have after subtracting fixed and variable cost from revenue
- 5. BREAK-EVEN ANALYSIS • The knowledge of the fixed and variable expenses is essential for identifying a profitable price level for its services. • This is done by performing the break-even analysis (dollars at which total revenues equal total costs). • Volume needed to break even = fixed costs / (price – variable costs) • The equation provides not only valuable information about pricing but can also be modified to answer other important questions such as the feasibility of a planned expansion. • It can also give entrepreneurs, who are considering buying a small business, information about projected profits.
- 6. This chart shows that the breakeven point is where the income and costs are equal
- 7. • If we rearrange the where the breakeven is X then the formula look like this. X = F /( P – V) • This formula says that the breakeven point is where the number of sales needed to make the cost equal to the revenue.
- 8. USES OF BREAK EVEVN POINT • Helpful in deciding the minimum quantity of sales • Helpful in the determination of tender price • Helpful in examining effects upon organization’s profitability • Helpful in deciding about the substitution of new plants • Helpful in sales price and quantity • Helpful in determining marginal cost
- 9. Assumptions of Break-EvenAnalysis: i. The total costs may be classified into fixed and variable costs. It ignores semi-variable cost. ii. The cost and revenue functions remain linear. iii. The price of the product is assumed to be constant. iv. The volume of sales and volume of production are equal. v. The fixed costs remain constant over the volume under consideration. vi. It assumes constant rate of increase in variable cost.
- 10. • It assumes constant technology and no improvement in labour efficiency. • The price of the product is assumed to be constant. • The factor price remains unaltered. • Changes in input prices are ruled out. • In the case of multi-product firm, the product mix is stable.
- 11. Managerial Uses of Break-EvenAnalysis: •To the management, the utility of break-even analysis lies in the fact that it presents a microscopic picture of the profit structure of a business enterprise. •The break-even analysis not only highlights the area of economic strength and weakness in the firm but also sharpens the focus on certain leverages which can be operated upon to enhance its profitability. •It guides the management to take effective decision in the context of changes in government policies of taxation and subsidies.
- 12. Thebreak-evenanalysiscanbeusedforthe followingpurposes: Safety Margin: • The break-even chart helps the management to know at a glance the profits generated at the various levels of sales. The safety margin refers to the extent to which the firm can afford a decline before it starts incurring losses. • The formula to determine the sales safety margin is: • Safety Margin= (Sales – BEP)/ Sales x 100
- 13. Target Profit: • The break-even analysis can be utilized for the purpose of calculating the volume of sales necessary to achieve a target profit. • When a firm has some target profit, this analysis will help in finding out the extent of increase in sales by using the following formula: • Target Sales Volume = Fixed Cost + Target Profit / Contribution Margin per unit
- 14. Change in Price: • The management is often faced with a problem of whether to reduce prices or not. Before taking a decision on this question, the management will have to consider a profit. A reduction in price leads to a reduction in the contribution margin. • This means that the volume of sales will have to be increased even to maintain the previous level of profit. The higher the reduction in the contribution margin, the higher is the increase in sales needed to ensure the previous profit.
- 15. • 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. • Changein Costs: • When costs undergo change, the selling price and the quantity produced and sold also undergo changes. • Changes in cost can be in two ways: (i)Change in variable cost, and (ii)Change in fixed cost.
- 16. Variable Cost Change: • 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. • 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
- 17. Fixed Cost Change: • An increase in fixed cost of a firm may be caused either due to a tax on assets or due to an increase in remuneration of management, etc. It will increase the contribution margin and thus push the break-even point upwards. Again to maintain the earlier level of profits, a new level of sales volume or new price has to be found out. New Sales Volume = Present Sale Volume + • (New Fixed Cost + Present Fixed Costs)/ (Present Selling Price-Present Variable Cost) New Sale Price = Present Sale Price + • (New Fixed Costs – Present Fixed Costs)/ Present Sale Volume
- 18. Decision on Choice of Technique of Production: • A firm has to decide about the most economical production process both at the planning and expansion stages. There are many techniques available to produce a product. These techniques will differ in terms of capacity and costs. The breakeven analysis is the most simple and helpful in the case of decision on a choice of technique of production. • For example, for low levels of output, some conventional methods may be most probable as they require minimum fixed cost. For high levels of output, only automatic machines may be most profitable. By showing the cost of different alternative techniques at different levels of output, the break-even analysis helps the decision of the choice among these techniques.
- 19. Make or Buy Decision: • Firms often have the option of making certain components or for purchasing them from outside the concern. Break-even analysis can enable the firm to decide whether to make or buy. • PlantExpansion Decisions: The break-even analysis may be adopted to reveal the effect of an actual or proposed change in operation condition. This may be illustrated by showing the impact of a proposed plant on expansion on costs, volume and profits. Through the break-even analysis, it would be possible to examine the various implications of this proposal.
- 20. • Plant Shut Down Decisions: • In the shut down decisions, a distinction should be made between out of pocket and sunk costs. Out of pocket costs include all the variable costs plus the fixe cost which do not vary with output. Sunk fixed costs are the expenditures previously made but from which benefits still remain to be obtained e.g. depreciation. • Decision Regarding Addition or Deletion of Product Line: • If a product has outlive utility in the market immediately, the production must be abandoned by the management and examined what would be its consequent effect on revenue and cost. Alternatively, the management may like to add a product to its existing product line because it expects the product as a potential profit spinner. The break- even analysis helps in such a decision.
- 21. • Advertising and Promotion Mix Decisions: • The main objective of advertisement is to stimulate or increase sales to all customers-former, present and future. If there is keen to undertake vigorous campaign of advertisement. • The management has to examine those marketing activities that stimulate consumer purchasing and dealer effectiveness. • The break-even point concept helps the management to know about the circumstances. It enables him not only to take appropriate decision but by showing how these additional fixed cost would influence BEPs. • The advertisement pushes up the total cost curve by the amount of advertisement expenditure.
- 22. LIMITATIONS • In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the cost function is linear. In practice, it will not be so. • In the break-even analysis since we keep the function constant, we project the future with the help of past functions. This is not correct. • The assumption that the cost-revenue-output relationship is linear is true only over a small range of output. It is not an effective tool for long-range use. • Profits are a function of not only output, but also of other factors like technological change, improvement in the art of management, etc., which have been overlooked in this analysis.
- 23. • Selling costs are specially difficult to handle break-even analysis. This is because changes in selling costs are a cause and not a result of changes in output and sales. • When break-even analysis is based on accounting data, as it usually happens, it may suffer from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and inappropriate allocation of overheads. It can be sound and useful only if the firm in question maintains a good accounting system.
- 24. • The simple form of a break-even chart makes no provisions for taxes, particularly corporate income tax. • It usually assumes that the price of the output is given. In other words, it assumes a horizontal demand curve that is realistic under the conditions of perfect competition. • Matching cost with output imposes another limitation on break- even analysis. Cost in a particular period need not be the result of the output in that period. • Because of so many restrictive assumptions underlying the technique, computation of a break- even point is considered an approximation rather than a reality.
- 25. Conclusion • A Breakeven Analysis is a simple tool to use to determine if you have priced your product correctly • A Breakeven Analysis helps you calculate how much you need to sell before you begin to make a profit. You can also see how fixed costs, price, volume, and other factors affect your net profit.
- 26. Example • Lets say you own a business selling burgers It costs $1.00 to make one burger That’s your V or Variable cost You sell each burger for $2.80 That’s your P or price per unit Your cost for rent, utilities, overhead, etc... is $100,000 per month That's your F or fixed cost • V = $1.00 • P = $2.80 • F = $100,000 • X = F /( P – V) • X = 100,000 / ( 2.80 - 1 ) • X = 100,000 / ( 1.80 ) • X = 55,555 • To breakeven you would need to sell 55,555 burgers