ASSIGNMENT OF MANAGERIAL ECONOMICS

Topic:- Brreak-Even Analysis and Profit Planning

Submitted to:Mr.Ranjeev Handa (CT-IEMT) Shahpur

Submitted by:Ramandeep Kaur MBA-1st Sem.

Break Even Analysis

In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return. For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could: 1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) 2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier) 3. Increase the selling price of their tables. Any of these would reduce the break even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.

Computation of Break Even Analysis

In the linear Cost-Volume-Profit Analysis model,[2] the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.

The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs. The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation and multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin over Price) to compute it as: R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable Costs or Q * P(Price per unit) = TFC + Q * VC(Price per unit), Q * P - Q * VC = TFC, Q * (P - VC) = TFC, or, Break Even Analysis Q = TFC/c/s ratio=Break Even

Break Even Analysis

By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to

$2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.

[edit] Application
The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis.

Limitations

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.

It assumes that fixed costs (FC) are constant. Although, this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise. It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

Profit planning
Profit planning is simply the development of your operating plan for the coming period. Your plan is summarized in the form of an income statement that serves as your sales and profit objective and your budget for cost. How Is It Used? The profit plan is used in the following ways:

Evaluating operations. Each time you prepare an income statement, actual sales and costs are compared with those you projected in your original profit plan. This permits detection of areas of unsatisfactory performance so that corrective action can be taken. Determining the need for additional resources such as facilities or personnel. For example, the profit plan may show that a sharp increase in expected sales will overload the company's billing personnel. A decision can then be made to add additional invoicing personnel, to retain an EDP service, or to pursue some other alternative. Planning purchasing requirements. The volume of expected sales may be more than the business' usual suppliers can handle or expected sales may be sufficient to permit taking advantage of quantity discounts. In either case, advance knowledge of purchasing requirements will permit taking advantage of cost savings and ensure that purchased goods are readily available when needed. Anticipating any additional financing needs. With planning, the search for needed funds can begin as early as possible. In this way, financial crises are avoided and financing can be arranged on more favourable terms.

Advantages of Profit Planning Profit planning offers many advantages to your business. The modest investment in time required to develop and implement the plan will pay liberal dividends later. Among the benefits that your business can enjoy from profit planning are the following:

Performance evaluation. The profit plan provides a continuing standard against which sales performance and cost control can quickly be evaluated. Awareness of responsibilities. With the profit plan, personnel are readily aware of their responsibilities for meeting sales objectives, controlling costs, and the like. Cost consciousness. Since cost excesses can quickly be identified and planned, expenditures can be compared with budgets even before they are incurred, cost consciousness is increased, reducing unnecessary costs and overspending. Disciplined approach to problem-solving. The profit plan permits early detection of potential problems so that their nature and extent are known. With this information, alternate corrective actions can be more easily and accurately evaluated.

Thinking about the future. Too often, small businesses neglect to plan ahead: thinking about where they are today, where they will be next year, or the year after. As a result, opportunities are overlooked and crises occur that could have been avoided. Development of the profit plan requires thinking about the future so that many problems can be avoided before they arise. Financial planning. The profit plan serves as a basis for financial planning. With the information developed from the profit plan, you can anticipate the need for increased investment in receivables, inventory, or facilities as well as any need for additional capital. Confidence of lenders and investors. A realistic profit plan, supported by a description of specific steps proposed to achieve sales and profit objectives, will inspire the confidence of potential lenders and investors. This confidence will not only influence their judgment of you as a business manager, but also the prospects of your business' success and its worthiness for a loan or an investment.

Limitations of Profit Planning Profit plans are based upon estimates. Inevitably, many conditions you expected when the plan was prepared will change. Crystal balls are often cloudy. The further down the road one attempts to forecast, the cloudier they become. In a year, any number of factors can change, many of them beyond the control of the company. Customers' economic fortunes may decline, suppliers' prices may increase, or suppliers' inability to deliver may disrupt your plan. The profit plan requires the support of all responsible parties. Sales quotas must be agreed upon with those responsible for meeting them. Expense budgets must be agreed upon with the people who must live with them. Without mutual agreement on objectives and budgets, they will quickly be ignored and serve no useful purpose. Finally, profit plans must be changed from time to time to meet changing conditions. There is no point in trying to operate a business according to a plan that is no longer realistic because conditions have changed. Advantages vs. Disadvantages Despite the limitations of profit planning, the advantages far outweigh the disadvantages. A realistic plan, established yearly and re-evaluated as changing conditions require will provide performance guidelines that will help you control every aspect of your business with a minimum of analysis and digging for financial facts.

Profit Planning
Profit planning is the process of developing a plan of operation that makes it possible to determine how to arrange the operational budget so that the maximum amount of profit can be generated. There are several common uses for profit planning, with many of them focusing on the wise use of available resources. Along with the many benefits of this type of planning process, there are also a few limitations. The actual process of profit planning involves looking at several key factors relevant to operational expenses. Putting together effective profit plans or budgets requires looking closely at such expenses as labor, raw materials, facilities maintenance and upkeep, and the cost of sales and marketing efforts. By looking closely at each of these areas, it is possible to determine what is required to perform the tasks efficiently, generate the most units for sale, and thus increase the chances of earning decent profits during the period under consideration. Understanding the costs related to production and sales generation also makes it possible to assess current market conditions and design a price model that allows the products to be competitive in the marketplace, but still earn an equitable amount of profit on each unit sold. There are several advantages to engaging in profit planning. The most obvious is evaluating the overall operation for efficiency. If profits for the most recently completed period fall short of projections, this prompts an investigation into what led to the lower returns. Changes can then be made to the operation in order to increase the chances for higher profits in the next period. Necessary changes that may be uncovered as part of the profit planning process include increasing or decreasing the employee force, changing vendors of raw materials, or upgrading equipment and machinery that are key to the production of goods and services. In like manner, the need to restructure marketing campaigns so that more resources are directed toward strategies that are providing the greatest return, while minimizing or even eliminating allocations to strategies that are not producing significant results, may also become apparent as a result of this type of planning. Even issues such as changing shippers or making slight changes to packaging that trim expenses may be identified as part of the profit planning process. While profit planning is a useful process in any business setting, there are some limitations on what can be accomplished. The effectiveness of the planning is only as good as the data that is assembled for use in the process. Should the data be incorrect or incomplete, the results of the planning are highly unlikely to produce the desired results. In addition, if the findings of the process do not result in the implementation of procedures and changes in the relevant areas of the business, the time spent on the profit planning is essentially wasted. For this reason, profit planning should be seen as a starting point for operations and not simply recommendations of what should be done in order to increase profit margins.