Break-Even Analysis

(Main Part of Marginal Costing Accounting Techniques))

Theory of costs has an important implication in the decision making
of the firm regarding the level of output at which it will break-even,
that is, at which its total revenue will equal total cost and therefore it
will attain no profit, no loss position. Break-even analysis is also
called profit contribution analysis.

Break-even analysis is also applied to determine the quantity of

output sold at which the firm will realise its target level of profit.

Break-even analysis can be made by assuming linear cost output and

revenue-output relationships or by assuming non-linear cost and
revenue function.

Break-even analysis can be either made through graphical method or

algebraic method.
Assumptions of Break-even Analysis (Linear Relationship)

(i) All costs whether they relate to production, or to administration, or to

selling activities, they can be segregated into fixed and variable cost.

(ii) Irrespective of the volume of production, there will be no variation in per

unit variable cost, for total variable costs are assumed to change with the
volume of production at fixed proportion.

(iii) At all production levels selling price remains constant.

(iv) Fixed costs remain unchanged at all levels of production

(v) Production costs depends only on volume of output.

(vi) Fixed costs should be recovered only out of the selling prices of products
sold

(vii) Sales synchronise with production. Stock in hand, if any, should be valued
only at marginal cost
 Break-Even Analysis

TR (p = £2)
Costs/Revenue TC
Profit VC

Loss
FC

Q1 Output/Sales
 Break-Even Analysis Margin
safety
of
shows
how far sales can
fall before losses
made. If Q1 =
TR (p = £3) TR (p = £2)
TC 1000 and Q2 =
Costs/Revenue
1800, sales could
VC fall by 800 units
Assume
before a loss
current
would be sales
made
at Q2
A higher
price would
lower the
break even
point and the
Margin of Safety margin of
safety would
FC widen

Q3 Q1 Q2 Output/Sales
 Some Concepts

Contribution

It refers to excess of sales over variable costs. Again excess of this contribution over
fixed cost is regarded as profit, and the deficit of the same is treated as loss. Hence it
may be noticed that profit enhances with increase in contribution because the fixed
cost remains constant.

Contribution originates from the difference between the selling price and the
marginal cost.

There is a distinction between Total Contribution and Per Unit Contribution. Unit
contribution should be multiplied by the number of units sold to have a measure of
Total Contribution.
Example

If a cup of tea sells at Rupee 1, and variable costs per cup for tea, sugar, and milk,
etc., is 60 paisa, contribution per cup is 40 paisa. Suppose 2000 cups of tea are sold
per month, total contribution amounts to Rs.800 (40 paisa × 2000).

Alternatively, if total variable costs Rs.1200 (60 Paisa × 2000) is deducted from the
monthly sales of Rs.2000 (Re.1 × 2000), the Total contribution becomes Rs.800.

If Rs.300 are spent for fuel, salary, and other monthly fixed expenses, the Net Profit
comes to Rs.500 (Rs.800-Rs.300).

The relation between Sales, Marginal Cost (or Variable Cost), and Fixed Cost is
given below:

Contribution = Sales Variable Cost or Marginal Cost

Contribution (Per Unit) = Selling Price Per Unit – Variable Cost Per Unit

Contribution (In Aggregate) = Fixed cost ± Profit/Loss

Marginal Costing Technique centres around the concept of Contribution. The
relation among sales, marginal Costs, Fixed costs, and Profit can be shown with
the help of some equations.

Contribution = Sales – Marginal Cost / Variable

or, Sales = Marginal Cost + Contribution

Again we know from the previous slide that

Contribution = Fixed Cost ± Profit/Loss

So,
Sales = Marginal Cost/ Variable Cost + Fixed Cost ± Profit/Loss

So, S – V = F ± P/L, Where, S = Sales

V= Marginal Cost/Variable Cost
F = Fixed Cost
P/L = Profit/Loss
Since four factors are involved in the above equation, any one of them can be
derived if information on other three are available. All the equations are based on
aggregate figures of Sales, Marginal Cost, Fixed cost and Profit/Loss. But barring
the fixed cost, the other items are based on unit prices. Relation among them based
on unit prices may be analysed as below.

Sales = p×q
Marginal Cost = m×q, where, p = Selling Price Per Unit
m = Marginal Cost Per Unit
q = Quantity of Goods produced and sold
Now,
Contribution = Sales - Marginal Cost
= pq – mq
Hence it is evident that it is the excess
= q(p – m) of Selling price over per unit Marginal
So Cost which represents contribution per
Unit. More the excess, more the
Contribution Per Unit = [q(p – m)]/q
profitability of the firm.
=p-m
Profit/Volume Ration or P/V Ratio

This ratio is called the “Contribution Ratio” or “Marginal Ratio”. It reveals

the relation between contribution and sales. From the marginal cost
equation we can derive figures on sales, profit, and fixed cost. But cannot
depict the relative position of the items. Knowledge on profitability is
more useful than the absolute figure on profit.

The ration provides information on contribution per rupee of sales. Here

profit refers to contribution and volume refers to sales. This contribution
and sales may be expressed either in aggregate or in per unit of sales. The
results will be the same irrespective of the way of expression.

It may be expressed in fractions or in percentage term and can the stated in

four ways shown in the next slide.
P/V Ratio = Contribution/Sales ……………(1)
Since Contribution = S – V = F ± P/L, the above equation can be written in
another way

P/V Ratio = [Sales – Variable Cost]/Sales

= [S – V]/S ……………………...(2)

P/V Ratio = [Fixed Costs ± Profit/Loss]/Sales

= [F + P]/S……………………….(3)

P/V Ratio = Change in Contribution or Profit/Change in Sales……(4)

It may appear that this equation is not based on Marginal Cost Equations.
But it is not so. This formula is most useful in solving problems in
examinations.
Higher the P/V Ratio, higher the profitability and higher the sustaining
capacity of the firm to stay in the competitive market. It assists in
determining the volume of production required for earning desired profit.
This is management aims at enhancing the ratio.

Desired profit may differ from present profit, but P/V Ratio and Fixed Cost
usually remain constant. This is why sales necessary to earn desired profit
can be determined with the help of P/V Ratio.

P/V Ratio = [Fixed Cost + Profit/Loss]/Sales

So
Sales = [Fixed Cost + Profit/Loss]/P/V Ratio

If we replace the Profit in the above equation by the desired profit, we can
get the required volume of sales.
 Cost-Volume-Profit Analysis and Break-Even Analysis

P/V ratio indicates how much of sales is used for paying variable costs. In other
words, it speaks of the interrelations among sales, variable cost and profit. But
relations among fixed costs and these items cannot be revealed with the ratio. But a
complete picture of profitability requires an analysis of the relation among cost,
volume of sales, and profit.
Such as analysis is called Cost-Volume-Profit (C-V-P) analysis. It is done basically
with the information on P/V ratio and fixed costs.

Surplus of each rupee of sales over related variable cost is used first to recover a
portion of the fixed costs. But the question is: how many units must be sold to
recover the fixed cost completely? In other words, at what point of sales does
aggregate of fixed and variable costs equal sales?

So we are to determine the level of sales where there is neither profit, nor loss. It
may be solved either mathematically or graphically. When it is done arithmetically,
it is called break-even analysis, and when it is solved graphically, the graph or chart
is called Break-even Chart.
In most cases C-V-P Analysis and Break-Even Analysis are used
interchangeably. It is so because BE technique is used in most cases for C-
V-P analysis. BE technique is used in both restricted and wide sense.

In wide sense, BE analysis means an enquiry about interdependence

among cost, volume of sales and profit at different levels of production.

In restricted sense, it is a technique with which we can determine the level

of production and sales where total of fixed and variable costs equals sales,
i.e., the point of sales where there is neither profit nor loss.
 Break-Even Point
It refers to the point in the chart where the total cost line and sales line intersect. At
this point two lines break and become equal. It indicates the level of production and
sales where there is neither profit, nor loss because here contribution just equals
fixed cost. This is why this point is also called critical point, or, equilibrium point,
or, balancing point. If sales exceed this level, profit begins to grow, and if it does
not, the firm suffers loss.

Formulae for Determining BE Point

The basic idea behind the formulae is that BE sales in units should be calculated by
dividing fixed cost by contribution per unit of sales. Several formulae are used for
this purpose. They may appear different, but a little observation reveals that they are
based on this basic principle.
For example, if variable cost per unit and selling cost per unit are Rs.6 and Rs.8
respectively, and fixed costs are Rs.5000, contribution per unit will be Rs.4 (Rs.10 –
Rs.6). Hence the firm is to produce and sell (Rs.5000 ÷ Rs.4) = 1250 units to
recover its fixed cost. At this level of production its sales will be (Rs.10 × 1250) =
Rs. 12500 and its Total cost, (Rs. 6 × 1250 + Rs.5000) = Rs.12500. I may be stated
in the formula in the next slide.
Break-Even Sales (in units) = [Fixed Cost]/[Selling Price Per Unit – Variable Cost per unit]
= Fixed Cost/Contribution Per Unit………………….(1)

Formula for Finding out BE Sales in volumes

Break-Even Sales (In values) = [Fixed Cost/Contribution per unit]/Selling Price…..(2)

Other Formula

BE Sales (In value) = Fixed Cost × [Total sales/ Total Contribution]………………..(3)

= Fixed Cost × [1/PV Ratio]………………………………………(4)