MODULE 2

Introduction and Break even Analysis

BREAK EVEN ANALYSIS:

It is necessary for a firm to plan its Profits. Therefore, it has to understand the
relationship between Cost, Price and Profit. The most important method of
determining this is Break-Even Analysis.

Also called Profit Analysis or Cost-volume-profit (CVP) analysis.

Meaning of Break-even Analysis:
Break-even Point is the point at which the contribution margin is able to cover the
total fixed costs. At Break-even Point, the organization will have no-profit, no loss,
but would have covered all the fixed costs invested in the system.
Every individual unit sells at a price 'P' and has incurred a variable cost of 'V', the
difference between the two is the excess over the variable cost that could cover the
fixed costs. This quantity is known as the Contribution Margin (C).

Break-even Sales refers to the number of units to be sold at the Break-even Point.
BEPsales = F/C

Fixed Costs
Fixed costs are those business costs that are not directly related to the level of
production or output. In other words, even if the business has a zero output or high
output, the level of fixed costs will remain broadly the same. In the long term fixed
costs can alter - perhaps as a result of investment in production capacity (e.g. adding a
new factory unit) or through the growth in overheads required to support a larger,
more complex business.

Examples of fixed costs:

-

Rent and rates

Depreciation
Research and development
Marketing costs (non- revenue related)
Administration costs

Variable Costs
Variable costs are those costs which vary directly with the level of output. They
represent payment output-related inputs such as raw materials, direct labour, fuel and
revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable
costs.

Direct variable costs are those which can be directly attributable to the production
of a particular product or service and allocated to a particular cost center. Raw
materials and the wages of those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do
vary with output. These include depreciation (where it is calculated related to output
- e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of
categorizing business costs, in reality there are some costs which are fixed in nature
but which increase when output reaches certain levels. These are largely related to
the overall "scale" and/or complexity of the business. For example, when a business
has relatively low levels of output or sales, it may not require costs associated with
functions such as human resource management or a fully-resourced finance
department. However, as the scale of the business grows (e.g. output, number people
employed, number and complexity of transactions) then more resources are required.
If production rises suddenly then some short-term increase in warehousing and/or
transport may be required. In these circumstances, we say that part of the cost is
variable and part fixed.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at
various levels of activity shown on the same chart as the variation of income (or sales,
revenue) with the same variation in activity. The point at which neither profit nor loss
is made is known as the "break-even point" and is represented on the chart below by
the intersection of the two lines:
In the diagram, the line OA
represents the variation of
income at varying levels of
production activity ("output").
OB represents the total fixed
costs in the business. As output
increases, variable costs are
incurred, meaning that total
costs (fixed + variable) also
increase. At low levels of output,
Costs are greater than Income.
At the point of intersection, P,
costs are exactly equal to
income, and hence neither profit
nor loss is made.

Assumptions of Break Even Analysis.

1) Fixed costs are constant, only variable costs change.
2) The firm produces only one product, or if it is multiple products the sales
mix does not change.
3) Selling price remains constant, does not change with volume of scale.
4) Constant technology.
5) Costs and revenue change with changes in sales volume.

BEP is defined as that point of activity (sales volume) at which the total
revenues equal the total cost and the net income is zero. Point of zero
profit.
Determination of BEP
BEP can be determined in terms of physical units (products) to be produced,
or in terms of money (sales value in rupees) or as a % of full capacity.
Q = Physical output of the firm.
QBEP = Output at BEP.
BEP = Break even point.
P = Price per unit or average revenue.
TR = Total revenue = P * Q.
TFC = Total fixed cost.
TVC = Total variable cost.
TC = Total Cost = TFC + TVC.
AFC = Average Fixed Cost (or fixed cost per unit).
AVC = Average Variable Cost (or variable cost per unit).
AC = Average Cost = AFC + AVC.

Break even analysis in terms of Physical Units:

Break-even volume is the number of units of a product which
must be sold in order to cover all the expenses.
BEP = Fixed Cost
________________
Selling Price Variable Cost per unit

Break even analysis in terms of Sales Value:

Break-even volume is the number of units of a product which must

be sold in order to cover all the expenses.
BEP =

Fixed Cost
________________
P/V Ratio

P/V Ratio =

Contribution
_______________
Sales

Break even analysis as a Percentage of Full Capacity:

The Full Capacity of a manufacturing plant is defined as the

maximum possible volume attainable with the firms existing
fixed equipment, operating policies and procedures. Here, BEP is
usually expressed as a percentage of full capacity.
BEP(as a % of capacity) = Fixed Cost
___________
Total Contribution
(Or)
Break-even Sales
______________
Capacity Sales

Break-even Analysis for Multi-Product Firms

The unit so far has assumed that the company produces and sells a single product.
However, most companies produce and sell more than one product. Each of the
products has its own contribution margin, and any changes in one product's
contribution margin will affect the total contribution margin.
In multi-product situations, the break-even point is calculated by dividing the total
fixed costs of the company by the average contribution margin ratio of all products:
Break-even point

=
F
_______________________
Summation[(1-Vi/Pi) * Wi]

This average contribution margin ratio assumes a constant sales mix of

products. When a change in the mix of sales occurs, a change in the
average contribution margin ratio will result - unless all products carry
the same contribution margin. This will affect both the break-even
point and the profit.
Where the sales mix changes in favor of a product having a high
contribution margin ratio, then the average CM ratio will increase
(improve) and so will profits. Conversely, when there is a decrease in
sales of a high contribution product, the average contribution ratio will
decrease (worsen) and so will profits.
It is essential, therefore, when doing break-even analysis where
multiple products are involved, that the mix of sales is taken into
account. Before the average contribution margin ratio can be
determined, it is necessary to know the sales mix of the products
that is, the ratio that sales of each product bears to the total sales.

Capacity Extension Decisions:

There are two other issues that should be addressed before making capacity decisions, that is,
when to adjust capacity levels and by how much. These two things are related, that is, if demand is
increasing and the time between increments increases, the size of the increments must also
increase.
The following two extreme strategies may be helpful if you are looking to expand your capacity:
The expansionist strategy and The wait-and-see strategy.
Expansionist strategy
The expansionist strategy involves staying ahead of demand and therefore minimising the chance
of sales lost to insufficient capacity. This strategy is often favoured as it can result in
economies of scale, allowing an organisation to reduce its costs and compete on price.
Implementing this strategy can either result in increasing your overall market share or act as a
form of pre-emptive marketing. For example, if you decide to make a large capacity expansion or
at least announce that you have plans to do so, you can pre-empt the expansion of other
organisations.
As a result, your competitors must sacrifice some of their market share or risk burdening the
industry with overcapacity.
However, in order for this strategy to be successful, you must have the credibility to persuade
your competitors that you actually have the resources to go ahead with your proposed expansion
and you must announce it before they can act.

Wait-and-see strategy

The wait-and-see strategy involves lagging behind demand and using short-term options
such as overtime, temporary workers, and subcontractors to deal with any shortfalls.
The aim of this strategy is to expand capacity in smaller increments, such as renovating
existing facilities rather than building new ones.
By following demand, the risk of over expansion based on overly optimistic demand
forecasts, obsolete technology, or inaccurate assumptions regarding your competitors
are significantly reduced.

However, this is not to say that the wait-and-see strategy does not have any risks of
its own. If you decide to adopt this approach, you may be pre-empted by a competitor
or may not be able to respond to sudden and unexpected high levels of demand. This
strategy is more suited to businesses that are focused on the short-term. As an
operations manager, you will have to select the most appropriate strategy for your
organizations needs. Although the above mentioned strategies are extreme and may not
be suited for everyone, there are other strategies in between that may be adopted.
Such a strategy is the follow the leader' strategy, which basically involves expanding
capacity when your competitors do so. This way, if they are right, then so are you and
nobody gains a competitive advantage, but if they make a mistake, then so do you, which
means that everyone has to deal with overcapacity.

MAKE or BUY DECISIONS:

The act of choosing between manufacturing a product in-house or purchasing
it from an external supplier. In a make-or-buy decision, the two most
important factors to consider are COST & AVAILABILITY OF
PRODUCTION CAPACITY.

An enterprise may decide to purchase the product rather than producing it, if
is cheaper to buy than make or if it does not have sufficient production
capacity to produce it in-house. With the phenomenal surge in global
outsourcing over the past decades, the make-or-buy decision is one that
managers have to grapple with very frequently.
Factors that may influence a firm's decision to buy a part rather than
produce it internally include lack of in-house expertise, small volume
requirements, desire for multiple sourcing, and the fact that the item may not
be critical to its strategy. Similarly, factors that may tilt a firm towards
making an item in-house include existing idle production capacity, better
quality control or proprietary technology that needs to be protected.

MAKE or BUY DECISIONS:

- Available Capacity.
- Expertise.
- Quality.
- Nature of Demand.
- Cost (Availability & Reliability of Suppliers, Control of Design Secrets,
Availability of R & D, Lead time procurement versus in house manufacture,
Delivery Schedules, Employee preferences).
When to Make?
-

Higher purchase price per unit.

Timely availability.
Required facilities and capacities in house.
Better control of quantity.
To preserve trade secrets.
Save on transportation costs.
Long term requirement of product Stability & Demand.

EQUIPMENT SELECTION DECISIONS:

Process type indicates the equipment suitable for production: a job shop
requires general purpose machines to produce a variety of products,
whereas an assembly operation requires special purpose dedicated
machines to produce large quantities efficiently. Factors that influences
selection of equipment are : Price, Ease of use, Output rate and quality,
availability of parts, skill and training requirements. Break-even analysis
is also considered.
Equipment Selection Decisions are made while adding resources to existing
operations or replacing existing resources. The type of equipment which is
capable of producing at the lowest cost to meet the anticipated demand is
the preferred alternative if the focus is on economic criterion.

Production Process Selection Decision:

The types of Production processes/systems are classified on the basis of:
- Product/Output Variety
&
- Product/Operations/Output Volume.
Based on the extent to which a factory has the Flexibility to produce a
variety of products:

They are broadly classified as:

- Continuous Production Process.
a) Process/Flow Production.
b) Mass Production.
- Intermittent Production Process.
a) Batch Production.
b) Job-Shop Production.
c) Project Production.

Project
Job-Shop
Production
Process

VARIETY

Intermittent
Production
System

Batch
Production
Process

Continuous
Production
System

Mass
Production
Process

Flow
Production
Process

VOLUME

Production Processes/Manufacturing Operations may broadly be

divided into three Categories:
- Made to Stock Production Process.
These firms make items that are completed and placed in
stock before customer order is received.
- Made to Order Production Process.
These complete the end item only after receiving a
customer order. This is because the manufacturer cannot anticipate
what each customer wants.
- Assemble to Order Production Process.
The company produces standard modules and assembles
these modules, according to the customer order specifications.
Example: PVC Window Assemblers, Modular Kitchen Board
Assemblers.

Basis of Comparison of Production Processes:

Manufacturing Cost.
Capital Investment.
- Plant.
- Inventory.
Size of Plant.
Technical Requirements.
Organizational Structure.
Flexibility of Production.
Types of Products produced.
Material Handling.
Equipment Usage.
Security of Job.
- To workers & Employees.

MANAGERIAL USES OF BREAK-EVEN ANALYSIS:

1) What happens to overall profitability when a new product is introduced?
2) Level of Sales required to cover all costs and earn profits.
3) What happens to overall profitability of a firm, if the company purchases
new capital equipment or incurs higher or lower fixed or variable cost.
4) Between two alternative investments, which one offers the greater margin
of safety/profit?
5) What are the revenue and cost implication of changing the process of
production?
6) Should one Make, Buy or Lease, Capital Equipment?
7) Helps in determining the optimum level of output below which it would not
be profitable for a firm to produce. (Economies of Scale)
8) The firm can determine minimum cost for a given level of output.
9) Plant expansion and contraction decisions.
10) Helps in determining the Selling price which would be most profitable for
the firm.
11) Helps in establishing the point at which the firm can start payment of
dividends to the shareholders

LIMITATIONS OF BREAK-EVEN ANALYSIS:

1) All costs resolved into fixed or variable.
2) Variable costs fluctuate in direct proportion to volume.
3) Fixed costs remain constant over the volume range.
4) The selling price per unit is constant over the entire volume range.
5) The company sells only one product, or mix of products tends to remain
constant.
6) Volumetric increase is the only factor affecting costs.
7) The efficiency in the use of resources will remain constant over the period.