BREAKEVEN ANALYSIS NOTES FOR JKUAT

 Breakeven analysis is the study of the relationship between selling prices, sales volumes,
fixed costs, variable costs and profits at various levels of activity. It is also known as cost-
volume-profit analysis..
 It is a technique widely used by project management managers and management
accountants.
 It is based on categorizing production costs between those which are
 "variable" (costs that change when the production output changes)
 "fixed" (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of
activities, at which the project makes neither a profit nor a loss (the "break-even point").
Reasons for understanding costs

 When the Management contemplates on how to increase the production capacity of a

project they consider the cost implication of the project that they are operating in-terms
of efficiency
 Costs therefore enable the management to evaluate the profitability of the project that
they consider as a result of their decision making.
 Efficiency in a project is measured by taking into accounts the time spent and the
involved costs.

CLASSIFICATION OF COSTS

Fixed and variable costs

Fixed costs

These are costs that remain relatively the same at various levels of production.

 Fixed costs are those 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 projects.
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 centre
Examples
Raw materials and the wages those working on the production line are good examples.
 Indirect variable costs cannot be directly attributable to production but they do vary with
output.
Examples

 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 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" or complexity of the project. For example,
when a project has relatively low levels of output 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 project 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

Costs ($) Total Costs

Fixed costs

Sales (Units)
Direct and indirect costs

Direct

Direct cost is that cost that can be directly identified with the production of the specific
commodity

Indirect cost

Indirect costs are the expenses which cannot be pegged to the production of the particular
product and therefore they incurred incidentally as a result of the production process

Classification by function
Administration cost

These are costs that are involved in-directing:

 Controlling
 Planning
 Organizing
 Coordinating

The activities are in the production process and the above costs are essential since the production
process will not be complete without the above activities.

Selling and distribution cost

These are those costs incurred in promoting the sales and the delivery of the produced
commodities

These are the costs incurred after the production and therefore they are not relevant in decision
making.

OPPORTUNITY COST

This is the value of any opportunity ones gives up to engage in alternative activity to engage in
the best.

SUNK COST

These are costs relating to future opportunities that may have already been incurred and charged
in the earlier accounting period.

INCREMENTAL COST/MARGINAL COST

These are costs incurred by adding another unit, activity or department. They are also known as
marginal costs.

STEP COST
These consists of a series of fixed cost increment over a short range of production which
increases with time

BASIC TERMS USED IN COSTING

COST CENTRE

This is a segment project or a department to which costs are related. In general all departments
are cost centres

PROFIT CENTRE

This is a department which not only incurs costs (cost centre) but also generates revenue e.g
sales department

COST UNIT

This is an element or item to which project costs are directed. It’s the item product or the service
unit rendered by a project.

SERVICE CENTRE

This refers to a department of a project responsible for offering services to other departments e.g
the human resource department will be concerned with recruiting, remunerating and maintaining
employees who will work for the production departments.

COST BEHAVIOUR

This is the pattern of change on cost as a result of change in the level of activity or production.

COST VOLUME PROFIT ANALYSIS (CVP)

 This is a short term decision making process used by the managers to know how soon the
project will be able to break even.
 This point is important in decision making since it identifies the production level that will
enable a project to meet all their cost of production without realizing any profit .
  It’s worth noting that projects will still continue to be in operation at the break- even
point hoping that in the near future, they will begin to make profit.

ASSUMPTIONS OF/BREAK EVEN ANALYSIS /C.V.P

 The selling price per unit is known and will always remain constant
 Variable cost will increase with an increase in output
 Fixed cost will always remain constant irrespective of the level of output
 The technique of production will not change
 All unit produced are sold and therefore there’s no opening and closing stock
 In case of multiple products, the sales mix ratio will always be constant
 Variable costs and fixed costs are known with certainity
 All costs can clearly be divided into fixed or variable costs
 Output is the only factor that determines or affect cost and hence profit

The Break-Even Chart

Break-even chart is a graphical representation of costs at various levels of activity shown on the
same chart as the variation of 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:
Total cost/ Revenue ($)
Sales Revenue

Profit

Total costs

Sales (units)

BEP
  The Break Even Chart is used to show clearly s the relationship between the costs sales
and profits/loss at different specific levels of activities.
 Before the B.E.P the firm usually makes a loss and after the B.E.P the firm begins to
make a profit.
 At B.E.P point, the total cost curve intersects with the Total Revenue curve and forms an
angle of incidence.
 This angle indicates the rate of increase in profit after the break- even point, if this angle
is wider then profit will increase at a higher rate after the B.E.P and vice versa.

Assumptions of break -even chart

 Selling price and variable cost per unit remain the same at various levels of output
 Fixed costs remain unchanged at all levels of activity within the given range
 It’s possible to distinguish between fixed and variable costs
 The chart shows the relationship between cost and sales of a single product only.
 The production technique remains unchanged

Advantages of C.V.P

 .It enables the management to find the B.E.P and the specific profit/loss at a given level
of output
 It shows the behavior of cost and sales
 It establishes the relationship between costs sales and profits
 It indicates clearly the margin of safety i.e the difference between the actual/budgeted
activity level and the Break Even level of activity
 If the marginal safety is more than it means the firm can survive in difficult
circumstances

Limitations of Break- even chart

 The charts are only true within specific level of activity

 It assumes that the selling price is constant
 It assumes that fixed costs do not relate to the production
  The charts assume homogeneity
 Breakeven analysis assumes that fixed costs, variable costs and sales revenue behave in a
linear manner. However, some overhead costs may be stepped in nature rather than
remain constant. The previously straight sales revenue line and total cost line tend to
curve beyond a certain level of production. As a result, a lower selling price is set to
stimulate further sales and lower variable costs can be obtained due to mass production.
 It is assumed that all production is sold. The breakeven chart does not take the changes in
stock level into account.
 Breakeven analysis can provide vital information for small and relatively simple
companies that produce large volume of the same product. It is not so useful for the
companies producing multiple products. Its applications tend to be limited especially in
those jobbing companies where each item produced is different.

Application of breakeven analysis

Break-even analysis can be used to determine a project’s breakeven point (BEP).

Break-even point is a level of activity at which the total revenue is equal to the total costs.
At this level, the project makes no profit. With reference to the breakeven point, the managers
can set their sales goals and target profits.

Formulae applicable in C.V.P analysis

Total Revenue = Sell price x units sold

Total cost = Fixed cost + Total variable costs

Profit = T R – T C

Contribution = S.P – V.C

At B.E.P (Break Even Points); T C = T R

B E P (units) = Fixed costs

Contribution @ unit
 B E P (sales/value) = Fixed costs
Contribution @unit

Contribution margin ratio (C M R) = Contribution

S.P

Target sales = F C + desired profit

CMR

Target units = Desired profit

Contribution per unit

Average revenue = T. R = S.P per unit

No of units

Marginal safety = Budgeted output – B.E.P output

B.E.P in shs = Fixed cost

Contribution margin ratio


 Formulas for breakeven analysis.

Breakeven point in units = Fixed costs / Contribution per unit

B.E.P IN UNITS = F.C

CONTRIBUTION
= F.C
S.P.U—V.C.U

BREAKEVEN POINT IN SHILLINGS

Fixed cost X Selling price

Contribution per unit

Sales revenue at breakeven point =

Fixed costs

Contribution margin ratio

= F.C

C.M.R

EXAMPLES
 Selling price per unit-- $12
 Variable cost per unit -- $3
 Fixed costs-- $45,000
 You are required to compute the breakeven point.
 Breakeven point in units = Fixed costs / Contribution per unit
=
Break-even point in shillings =

2.3 Target Profit

Fixed costs + Target Profit

No. of units at target profit
Contribution per unit
=

2.3.1 Example 2
 Selling price per unit --$12
 Variable cost per unit -- $3
 Fixed costs-- $45,000
 Target profit-- $18,000

 You are required to compute the sales volume required to achieve the target profit.

No. of units at target profit Fixed costs + Target Profit

=
Contribution per unit

2.4 Margin of safety

 Margin of safety is a measure of amount by which the sales may decrease before a company
suffers a loss. This can be expressed as a number of units or a percentage of sales.

2.4.1 Example 3
 The breakeven sales level is at 5,000 units. The company sets the target profit at $18,000 and
the budgeted sales level at 7,000 units.
 You are required to calculate the margin of safety in units and express it as a percentage
of the budgeted sales revenue.
Margin of safety = Budgeted sales level – breakeven sales level
Example

(i) Bep = Fixed costs = 600 000

Selling price @ unit 200

Variable cost @ unit -100

Contribution @ unit

BEP in units = 600 00

100

= 6000 tickets

(ii) Target units = Fixed costs + Desired profits

Contribution @ unit

= 600 000 + 300 000

100

= 900 000 = 9 000 units

 100

(iii) Profit to be realized if 8000 – tickets were sold

Sales (8000 x 200) = 1600 000

Less: variable costs (8000 x 100) = (800 000)

Less: Fixed costs = 800 000

(600 000)
Profit 200 000

(iv) % age marginal safety

= Actual output – B.E.P output = 8000 – 6000

BEP Output 6000

= 2000 x 1000
6000

= 33.33%

(c) Circumstance under which production could continue even if sell price is low

 If the products are jointly produced

 If the contribution per unit is positive
 If they have been able to break even
 If they are optimistic that they will make more profit
 If the product is consumed within the organization i.e it’s meant to be an input in the next
process
  If it’s a by- product from the main process

Example 2

(a) The break even point will change with different sales mix because different products may
have different contributions which will make a firm to break even with lesser units if the
prioritized products with a higher contribution

Make or buy decisions

An organization would opt to make/produce when its cheaper to make or than to buy. The
reverse is true.

Illustration

Fixed costs = 768 000 per month

Selling price = 7200 per unit

Variable costs per unit

Materials 2800
Labour 720
Total 3520

Contribution per unit =Spu-Vcu (7200 - 3520) = 3680

Labour has 2 (Limiting factor)

Therefore contribution/hr = 3680 = 1840 per labour hour

2

(b) Buying price of specialized 36000

Making costs

Material costs 14,400

Labour cost (12 x 360) 4,320

 18,720

They should make the specialized component since they will save (36 000 – 18720) = 17 280

(c) Special offer/contract

Materials 136 800

Labour cost (20 x 360) 7 200

Cost of specialized component 18 720

Total cost (162720)

Selling price 648 000

Net contribution 485 280

Accept the special order because it has net contribution of 485 280

Decision on whether to drop a product from the existing alternatives

If a company has a range of products, and one is deemed to be unprofitable then the company
may consider droping the product and increase the production of the other profitable products.
Illustration

XYZ LTD produces three products with the following cost summary.

X Y Z

Sales 250 000 180 000 150 000

Total cost (200 000) (200 000) (120 000)

Profit/loss 50 000 (20 000) 30 000

The total cost comprises 75% variable and 25% fixed. The directors of the company are
acquiring that product Y should be discontinued. Do you agree with them.

Product X Y Z TOTAL

Sales 250 180 150 580

Less variable (150) (150) (90) (390)

Contribution 100 30 60 190

Less fixed (50) (50) (30) (130)

Net profit 50 (20) 30 60

If Y is excluded
Product Contribution

X 100

Z 60

Total cont. 160

Less fixed costs (130)

Net profit 30

Advice

I am not agreeing with directors since Net profit without Y will reduce to 30 from 60 with Y

Shut down problems

Shut down problems occurs at two main levels ie

 Whether a company should close one of its branches because it’s expensive to manage or
it’s making a loss
 Whether the closure should be permanent or temporary
 This problems usually require long term decisions, however they may be reduced to a
short term decisions by making the following assumptions.
The redundant costs will be negligible

Sell profit from fixed assets will reduce the redundancy costs.

Illustration
GTI LTD has three departments namely:

Accounting

Business courses

Computer classes

The following information is also provided

‘000’ ‘000’ ‘000’

Department Accounting Business Computer

Sales 50 40 60

Variable costs (30) (25) (35)

Contribution 20 15 25

Less Fixed Costs (17) (18) (20)

Net profit 3 (3) 5

The GTI is concerned with poor performance of the business department and they are
contemplating to stop

the department 5m shs are available to facilitate the stoppage process.

Required

(a) Advice the GTI whether the stoppage is economical

(b) If business is stopped the resources can be switched to a new department (medicine) with
expected sales of 50 m and variable cost of 30 m with an additional fixed cost of 5m.

Advice the GTI on whether they should substitute Business with the medicine department.

Accounting Business Computer classes

Contribution 20 15 25

Stoppage cost - (5) -

20 10 25

If business department is dropped

Accounting 20

Computer 25

45

Fixed cost (55)

Stoppage cost (15)

(a) It’s not economical to stop the business department

(b) If medicine department is introduced

 Contribution

Accounting 20

Computer 25

Med 20

Total contribution 65

Less: fixed costs 55

10

Additional fixed cost (5)