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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
CLASSIFICATION OF 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
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
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.
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.
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
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.
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.
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
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.
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
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.
Profit = T R – T C
Formulas for breakeven analysis.
= 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 =
2.3.1 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.
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
Contribution @ unit
= 6000 tickets
(600 000)
Profit 200 000
= 2000 x 1000
6000
= 33.33%
(c) Circumstance under which production could continue even if sell price is low
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
An organization would opt to make/produce when its cheaper to make or than to buy. The
reverse is true.
Illustration
Materials 2800
Labour 720
Total 3520
Making costs
They should make the specialized component since they will save (36 000 – 18720) = 17 280
Accept the special order because it has net contribution of 485 280
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
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
If Y is excluded
Product Contribution
X 100
Z 60
Advice
I am not agreeing with directors since Net profit without Y will reduce to 30 from 60 with Y
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
Sales 50 40 60
Contribution 20 15 25
The GTI is concerned with poor performance of the business department and they are
contemplating to stop
Required
Advice the GTI on whether they should substitute Business with the medicine department.
Contribution 20 15 25
20 10 25
Accounting 20
Computer 25
45
Accounting 20
Computer 25
Med 20
Total contribution 65
10