BREAK-EVEN ANALYSIS

The Break-even Point is, in general, the point at which the gains equal the losses. A break-even
point defines when an investment will generate a positive return. The point where sales or
revenues equal expenses. Or also the point where total costs equal total revenues. There is no
profit made or loss incurred at the break-even point. This is important for anyone that manages a
business, since the break-even point is the lower limit of profit when prices are set and margins
are determined.

 Achieving Break-even today does not return the losses occurred in the past. Also it does not
build up a reserve for future losses. And finally it does not provide a return on your investment
(the reward for exposure to risk).

 The Break-even method can be applied to a product, an investment, or the entire company's
operations and is also used in the options world. In options, the Break-even Point is the market
price that a stock must reach for option buyers to avoid a loss if they exercise. For a Call, it is the
strike price plus the premium paid. For a Put, it is the strike price minus the premium paid.

 The relationship between fixed costs, variable costs and returns

Break-even analysis is a useful tool to study the relationship between fixed costs, variable costs
and returns. The Break-even Point defines when an investment will generate a positive return. It
can be viewed graphically or with simple mathematics. Break-even analysis calculates the
volume of production at a given price necessary to cover all costs. Break-even price analysis
calculates the price necessary at a given level of production to cover all costs. To explain how
break-even analysis works, it is necessary to define the cost items.

Fixed costs, which are incurred after the decision to enter into a business activity is made, are
not directly related to the level of production. Fixed costs include, but are not limited to,
depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs
are the sum of the fixed costs.

Variable costs change in direct relation to volume of output. They may include cost of goods
sold or production expenses, such as labor and electricity costs, feed, fuel, veterinary, irrigation
and other expenses directly related to the production of a commodity or investment in a capital
asset. Total variable costs (TVC) are the sum of the variable costs for the specified level of
production or output. Average variable costs are the variable costs per unit of output or of TVC
divided by units of output.
The Break-even Point analysis must not be mistaken for the Payback Period, the time it takes to
recover an investment.

 In Value Based Management terms, a break-even point should be defined as the Operating
Profit margin level at which the business / investment is earning exactly the minimum
acceptable Rate of Return, that is, its total cost of capital.
 

Break-even Point calculation

Calculation of the BEP can be done using the following formula:

BEP = TFC / (SUP - VCUP)

where:

 BEP   = break-even point (units of production)

 TFC    = total fixed costs,
 VCUP = variable costs per unit of production,
 SUP   = selling price per unit of production.

Benefits of Break-even Analysis

The main advantage of break-even analysis is that it explains the relationship between cost,
production volume and returns. It can be extended to show how changes in fixed cost-variable
cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even
points. Break-even analysis is most useful when used with partial budgeting or capital budgeting
techniques. The major benefit to using break-even analysis is that it indicates the lowest amount
of business activity necessary to prevent losses.

Limitations of break-even analysis

 It is best suited to the analysis of one product at a time;

 It may be difficult to classify a cost as all variable or all fixed; and
 There may be a tendency to continue to use a break-even analysis after the cost and
income functions have changed
 Profit Volume Ratio (P/V Ratio), its Improvement and Application

The 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 sales Contribution Changes in contribution

P/V ratio = = =
Sales Sales Changes in sales

Change in profit
=
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
Break-even point can also be indicated by graphing. Figure 1 below is a sample graph for a
business. To draw the graph, we should follow these steps:

1. Number of units produced is marked along the horizontal axis and the total revenue
expressed in dollars is set on the vertical axis.

2. The sales line is drawn to indicate the sales at each level of production.

3. A horizontal line is drawn at the $12,000 level of sales to represent the fixed costs for our
sample business.

4. A total cost line is drawn from the point of intersection of the fixed cost line and the
vertical axis to the point of total costs as full capacity --$28,000.

5. The intersection of the total cost line with the sales line represents the break-even point,
in this case $20,000. The dotted lines represent the level of production and the total costs
at this level of operation.

6. Areas of net loss and of net profit are marked.

The break-even point graph helps the business owner determine the levels of production that will
create profits for every level of sales. The business owner then works to increase profits without
investing extra funds. To do this, he/she should study the following important points:

1. A possible increase in utilization of existing capacity through reduction of idle time.

2. Better repair and maintenance of equipment to reduce down time --time elapsed from the
moment the machine breaks down to the time it gets back in service.

3. Improved working schedules and inventory levels.

4. Longer business hours.

5. Improved production control.