Break-Even Analysis | Cost Accounting

In this article we will discuss about:- 1. Definition of Break-Even Analysis 2.

Formulae for Break-Even Analysis 3. Assumptions and Limitations of Break-Even
Analysis 4. Profit-Volume Ratio 5. Margin of Safety 6. Profit Volume Ratio 7.
Angle of Incidence 8. Relationship of BEP, Margin of Safety and Angle of
Incidence.
Definition of Break-Even Analysis:
Break-even analysis refers to ‘ascertainment of level of operations where total
revenue equals to total costs’. It is an analysis used to determine the probable
profit or loss at any level of operations. Break-even analysis is a method of
studying the relationship among sales revenue, variable cost and fixed cost to
determine the level of operation at which all the costs are equal to its sales
revenue and it is the no profit no loss situation.
This is an important technique used in profit planning and managerial decision
making. Break-even analysis is made through graphical charts. Break-even chart
indicates approximate profit or loss at different levels of sales volume within a
limited range. The break-even charts show fixed and variable costs and sales
revenue so that profit or loss at any given level of production or sales can be
ascertained.

Steps in Construction of Break-Even Chart:

The following steps are involved in construction of a break-even chart:
Step 1: Select a scale for sales (units) on horizontal axis.
Step 2: Select a scale for costs and revenues on vertical axis.
Step 3: Draw the fixed cost line parallel to the horizontal axis.
Step 4: Draw the total cost line, starting from the point on the vertical axis which
represents fixed costs.
Step 5: Draw the sales line, starting from the point of origin (zero) and finishing
at point of maximum sales.
Step 6: The sales line will cut the total cost line at the point where the total cost
equal to total revenues.
Step 7: The point of intersection of two lines is called ‘break-even point’ i.e. the
point of no profit no loss.
Step 8: The lines drawn from intersection to horizontal axis and vertical axis give
the sales value and number of units produced at break-even point.
Step 9: The loss is shown if the production is less than the break-even point and
profit is shown if the production is more than the break-even point.
Step 10: The total sales minus break-even sales represent the margin of safety.
Step 11: The angle which the sales line makes with total cost line, while
intersecting it at breakeven point is called ‘angle of incidence’.
Break-even point helps in assessing the viability of the organization and to take
decisions in profit planning and cost control. Break-even point is the point of
zero net income i.e. the level of sales is just equal to its costs. Costs include both
fixed and variable costs.
It is used as a useful tool in financial planning to recover costs and to maximize
profits. The changes in operating condition such as, selling price, variable cost
and fixed cost will change the break-even point. For calculation of break-even
point, the costs need to be segregated into fixed cost and variable costs.
The basic assumption in ascertainment of break-even point is that the selling
price per unit and variable cost per unit are constant and the fixed costs, in total,
are constant. Break-even point indicates the level of operating capacity and
sales to be achieved to recover all costs. Any further activity or sales beyond
break-even point will lead to earn profit for the concern.
Formulae for Break-Even Analysis:
Assumptions and Limitations of Break-Even Analysis:
The following assumptions and limitations are important considerations in
break-even analysis:
(a) The break-even analysis requires that all costs should be segregated into
fixed and variable components. There is difficulty in segregation of semi-variable
expenses into variable and fixed elements of costs accurately.
(b) It is assumed that all fixed costs remain constant at various levels of activity.
But in practice, it may not be fixed in the long-run.
(c) Another assumption is that variable costs are really variable and changes in
direct proportion to the volume of output. It means that variable cost per unit
of product remains constant. In practice variable costs are not necessarily
strictly variable with output.
(d) In break-even analysis, it is assumed that production units and sales units are
equal and no inventory exists in the beginning or at the end of the period for
which analysis is made. In practice there will always be existence of inventory.
(e) There will be no change in selling price and it remains constant at all levels
of output and further assumed that there is no change in sales mix. In the real
world situation, to increase the sales, it may necessitate to frequently change
the selling prices and sales mix of the products.
(f) It is assumed that productivity, operating efficiency, product specifications
and methods of manufacture and sale will not undergo any change. In actual
situation, the operating efficiency and productivity depends upon the
manpower, it is impractical to assume that these factors remain constant.
(g) A break-even chart can depict the position of only one product and fails to
present various products in the sales mix in one chart and different charts are
required to be drawn for different products.
(h) Break-even analysis ignores the capital employed in business, which is one
of the important facts in determination of profitability of the company and its
products.
(i) The break-even charts assumes that total cost and total revenue can be
represented in straight lines. In practice, the function of costs and revenue are
curvilinear in nature.

Profit-Volume Ratio:

Profit-Volume Ratio (P/V) reveals the rate of contribution per product as a

percentage of turnover. It indicates the relationship of the contribution to sales.
It helps in knowing the profitability of business.

This ratio is calculated as:

P/V Ratio = Contribution/Sales x 100

How to Improve P.V. Ratio?

Better P.V. ratio is an index of sound financial health of company’s product. P.V.
ratio can be improved, if contribution is improved.
Contribution can be improved by taking any of the following steps:
(a) Increase in selling price.
(b) Reduce marginal cost by efficient utilization of men, material and machines.
(c) Concentrate on the sale of products with relatively better P.V. ratio.

Limitations:

The following limitations are to be borne in mind while using P.V. ratios in break-
even analysis:
(a) P.V. ratio heavily leans on excess of revenues over variable costs.
(b) P.V. ratio fails to take into consideration the capital outlays required by the
additional productive capacity and the additional fixed costs that are added.
(c) It gives only an indication of relative profitability of product and product lines.
It will not help to take a final decision.
(d) The fundamental prerequisite for comparing profitability through P.V. ratio
is the proper segregation of costs into fixed and variable costs. Over
simplification may lead to erroneous conclusion.
(e) Higher P.V. ratio per unit of sales or per unit of production will indicate the
most profitable item only when other conditions are constant.

Illustration 1:
ABC Ltd. has provided the following information:
Sales (@ Rs. 5 p.u.) – 20,000 units
Variable cost p.u. – Rs. 3
Fixed cost – Rs.8,000 p.a.
Calculate the p.v.ratio and the break-even sales of the company.
Solution:

Illustration 2:
You are required to calculate the break-even point from the following
information:
Selling price p.u. Rs. 20 Fixed cost p.a. Rs. 80,000
Variable cost p.u. P.s. 4 Sales for the year Rs. 2,00,000
The number of units involved coincides with expected volume of output.
Solution:
Working notes:
(a) Selling price p.u. – Variable cost p.u. = Contribution p.u.
= Rs. 20-Rs. 4 = Rs. 16

Contribution p.u. Rs. 16

(b) P.V.ratio = Contribution p.u./Selling price p.u. x 100 = Rs.16/Rs.20 x 100 =
80% or 0.80

At break-even sales, there is no profit no loss.

Verification
Break-even sales – Variable cost – Fixed cost = 0
(5,000 units x Rs. 20) – (5,000 units x Rs. 4) – Rs. 80,000 = 0
Rs. 1,00,000 – Rs. 20,000 – Rs. 80,000 = 0

Margin of Safety:
The margin of safety refers to sales in excess of the break-even volume. It
represents the difference between sales at a given activity level and sales at
break-even point. It is important that there should be a reasonable margin of
safety to run the operations of the company in profitable position.
A low margin of safety usually indicates high fixed overheads so that profits are
not made until there is a high level of activity to absorb the fixed costs. A margin
of safety provides strength and stability to a concern.
The margin of safety is an important measure, especially in times of receding
sales, to know the real position to operate without incurring losses and to take
steps to increase the margin of safety to improve the profitability.
Margin of safety is calculated by using the following formulae:
How to Improve Margin of Safety?
The higher the margin of safety, the better profitability of the product/product
line.
The margin of safety can be improved by adopting any of the following steps:
(a) Keeping the break-even point at lowest level and try to maintain actual sales
at highest level.
(b) Increase in sales volume.
(c) Increase in selling price.
(d) Change in product mix increasing contribution.
(e) Lowering fixed cost.
(f) Lowering variable cost.
(g) Discontinuance of unprofitable products in sales mix.

Illustration 3:
You are given the data of XYZ Ltd. for the year ended 31st March, 2009
Sales (@ Rs. 10) – 1,00,000 units Variable cost p.u. – Rs. 6 Fixed cost p.a. – Rs.
3,00,000.Calculate the margin of safety.

Solution:
Break-even Sales = Fixed cost/Contribution p.u. = Rs. 3,00,000/Rs. 4 = 75,000
units
Margin of Safety =
= Actual sales – Break-even sales
= 1,00,000 units – 75,000 units = 25,000 units
= 25,000 units x Rs. 10 = Rs. 2,50,000

Angle of Incidence:
The angle which sales line makes with the total cost line is known as the ‘angle
of incidence’. The larger the angle of incidence indicates the higher the margin
of profit and vice versa. It is an indicator of profitability above the break-even
point.
If the margin of safety and angle of incidence considered and studied together
will provide significant information to the management about its profitability. A
high margin of safety with wider angle of incidence will represent the most
profitable position of the business concern and vice versa.

Relationship of BEP, Margin of Safety and Angle of Incidence:

The relationship among Break-even point, Margin of safety and Angle of
incidence is summarized as follows:
Break-Even Level:
It is the level of production or sales where there is no profit and no loss. At this
point of sales, total cost is exactly equal to sales, so that, there is no profit no
loss. The company starts earning profit only if actual sales are above break-even
sales. A company with a lower break-even point is considered better than a
company with a higher break-even point.

Angle of Incidence:
It is an angle formed by the intersection of total cost line and total revenue line
in a break-even chart. Larger angle of incidence is a sign of higher profitability
and a lower angle is a sign of lower profitability.
Margin of Safety:
It is the difference between actual sales and break-even point. Larger the margin
of safety, the more sound is the position of the business in respect of profit
earning. This means that larger margin of safety indicates larger amount of profit
and vice versa.

Impact of Selling Price, Fixed Cost and Variable Cost on BEP:

The selling price and variable cost has direct impact on the P.V. ratio, since P.V.
ratio being a function of contribution to sales.
The effects of changes in selling price, variable cost and fixed cost on P.V. ratio
are explained below:
(a) An increase in selling price increases the amount of contribution and
resulting in improvement in P.V. ratio.
(b) The decrease in selling price of a product, result in decrease in contribution
and lowering the P.V. ratio.
(c) The increase or decrease in fixed cost does not affect the P.V. ratio, even
though it may increase or decrease the total profit.
(d) The increase in variable cost per unit will reduce the contribution and result
in decrease of P.V. ratio.
(e) The decrease in variable cost per unit will result in improvement of
contribution and simultaneously, the P.V. ratio will also increase.
(f) The increase in P.V. ratio means lower break-even point and higher margin of
safety.
(g) The decrease in P.V. ratio result in increase of break-even point and lower
margin of safety

Problems on Break-Even Analysis (With Solution)

Break-Even Analysis: Problem with Solution # 1.

From the following particulars, calculate:
(i) Break-even point in terms of sales value and in units.
(ii) Number of units that must be sold to earn a profit of Rs. 90,000.

Solution:
Break-Even Analysis: Problem with Solution # 2.
From the following data, you are required to calculate:
(a) P/V ratio
(b) Break-even sales with the help of P/V ratio.
(c) Sales required to earn a profit of Rs. 4,50,000
Fixed Expenses = Rs. 90,000
Variable Cost per unit:
Direct Material = Rs. 5
irect Labour = Rs. 2
Direct Overheads = 100% of Direct Labour
Selling Price per unit = Rs. 12.
Solution:

Break-Even Analysis: Problem with Solution # 3.

From the following data, you are required to calculate break-even point and
net sales value at this point:
If sales are 10% and 25% above the break even volume, determine the net
profits.
Solution:

Break-Even Analysis: Problem with Solution # 4.

From the following particulars, find out the break-even-point:

What should be the selling price per unit, if the break-even point should be
brought down to 6,000 units?
Solution:
Break-Even Analysis: Problem with Solution # 5.
The fixed costs amount to Rs. 50,000 and the percentage of variable costs to
sales is given to be 66 ⅔%.
If 100% capacity sales are Rs. 3,00,000, find out the break-even point and the
percentage sales when it occurred. Determine profit at 80% capacity:
Solution:

Break-Even Analysis: Problem with Solution # 6

A company is making a loss of Rs. 40,000 and relevant information is as
follows:
Sales Rs. 1,20,000; Variable Costs Rs. 60,000; Fixed costs Rs. 1,00,000.

Loss can be made good either by increasing the sales price or by increasing sales
volume. What are Break even sales if

(a) Present sales level is maintained and the selling price is increased.

(b) If present selling price is maintained and the sales volume is increased. What
would be sales if a profit of Rs. 1,00,000 is required ?
Solution: