Break - Even Analysis

Break even analysis is a vital tool for the management accountant. In a very narrow interpretation of the term, break even analysis is understood as a system of determination of that level of activity where total cost is equal to total sales. However, break even analysis also involves determination of probable profit at any given level of activity.

Break even point:

A business is said to ‘break even’ when its total sales are equal to its total costs. It is a point of ‘no profit no losses. Break even point can be calculated ‘in units’ or ‘in value’. (i.e.) it can be expressed as the number of units to be produced and sold to ‘break-even’, or the sales required to be attained in rupees, so that there is a situation of “no profit – no loss”.

Cost- volume profit analysis (relation ship):

Cost volume profit (CVP) analysis is often misunderstood to be same as break- even analysis. Break even analysis, however, is only a part of CVP analysis studies the relationship between cost, number of units produced and sold, selling price and profit individually and collectively taken.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects of profit on account of various management decisions.

The scope of CVP analysis covers the study of behavior of cost in relation to volume, sensitivity of profits to variation in output, break even analysis, price formulation, etc. and provides valuable insight into effects on profit on account of various management decisions.

The main objectives of cost volume- profit analysis are given below:

i) The analysis helps to forecast profit fairly and accurately as it is essential to know the relationship between profits and costs on the one hand and volume on the other.

ii) This analysis is useful in setting up flexible budget which indicates costs at various levels of activity.

iii) This analysis assists in evaluation of performance for the purpose of control.

iv) This analysis also assists on formulating price policies by showing the effect of different price structures on cost and profits.

Analysis of break even chart:

A break even chart explains about the break even point, angle of incidence and margin of safety for a particular product of a business.

i) The lower the break even point, the better it is:

A low break even point implies that the organization can survive even if it is operating at lower level of activity.

ii) The larger the angle of incidence, the greater is the benefit:

Angle of incidence represents the difference between total sales and total cost. The larger the angle, the greater is the spread. The profits increase in a greater proportion with the increase in production. However, a fall in number of units produced will also have an adverse

iii) The larger the margin of safety the better it is:

Margin of safety reflects the cushion the organization has against a possible fall in sales. The greater the margin of safety, the more comfortable the organization will be. It has a greater capacity to with stand recessionary phases.

Break even chart:

The break even chart is a graphic representation of cost and revenue data which brings out their inter relationship, at different levels of activity.

Steps to construct break even graph:

i) Let the X-axis represent the volume or level of activity and the Y-axis represents the costs and revenue in rupees.

ii) Draw the fixed cost line parallel to X-axis, from the point in Y-axis which represents the amount of fixed cost.

iii) With the help of the data given, construct the total cost line. The total cost is the total of variable costs at any given level of activity and the fixed cost. The total cost line will intersect the Y- axis at the point of fixed cost, as total cost is equal to fixed cost at ‘zero’ level of activity.

iv) With the help of data given construct the ‘total revenue’ chart. The total revenue cost will pass through the origin as the revenues at ‘zero’ level of activity is nil.

v) The break even point is the point of intersection of the total cost line and the total revenue line.

vi) The angle between the two lines of total cost and total revenue is called ‘angle of incidence’.

Assumptions underlying break even chart:

i) All costs can be separated into fixed and variable costs.

ii) Fixed costs will remain constant and will not change with the change in level of output.

iii) Variable costs will fluctuate in the same proportion in which the volume of output varies. In other words, prices of variable cost factors i.e., wage rates; price of material, etc. will remain unchanged.

iv) Selling price will remain constant even though there may be competition or change in volume if production.

v) The number of units produced and sold will be the same so that there is no opening or closing stock.

vi) There will be no change in operating efficiency.

vii) There is only one product or in the case of many products, product mix will remain unchanged.

viii) Product specifications and methods of manufacturing and selling will not change.