Brek-even Analysis

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Prof. T.R.Panigrahi

A firm Breaks Even if it doesnt http://www.bized.ac.uk make a profit or a loss

In other words Profit = 0 Business must make a profit to survive. To make profit income must be higher than the expenditure. To get break-even the total revenue (TR) must be equal to the total cost (TC). In other words the money coming into the business is the same as the money leaving the business. (TR = TC)

Total Revenue (TR) & Total Cost

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TR = Price per Unit x No. Of Units Sold = P.Q TC = Total Fixed Cost + total variable cost = TFC + TVC For the quantity where TC=TR, the AC=AR TC/Q = AC. & TR/Q = AR

Definition: Break-even Output

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The quantity of output in which the total revenue is equal to total cost such that a firm earns exactly a normal profit, but no economic profit. Breakeven output can be identified by the intersection of the total revenue curve and total cost curve, or by the intersection of the average total cost curve and average revenue curve. The most straightforward way of noting breakeven output, however, is with the profit curve. For a perfectly competitive firm breakeven output occurs where price is equal to average total cost.

http://www.bized.ac.uk Importance of Break-Even Analysis

Break-Even Analysis is used to

predict future profits/losses predict results eg produce Product A or Product B

Break-Even Point is when Sales Revenue equals Total Costs at this point no profit or loss is incurred the firm merely covers its total costs Break-Even Point can be shown in graph form or by use of formulae

Importance of Break-Even Analysis http://www.bized.ac.uk It examines the interaction of fixed costs, variable costs, price, and unit volume to help the manager in determining what combination of elements are necessary to break even. The analysis is also useful for showing a prospective financing source that you are aware of how much money you need to get your company going, or to keep it going. It can also be used to chart positive cash flow for a planned new product or service.

http://www.bized.ac.uk Break-Even Analysis

TOTAL COSTS
Total Costs is simply Fixed Costs and Variable Costs added together.

TC = FC + VC
As Total Costs include some of the Variable Costs then Total Costs will also change with any changes in output/sales. If output/sales rise then so will Total Costs. If output/sales fall then so will Total Costs.

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Assumptions
Price & AVC do not change with the change in output level

Break-Even Analysis

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Break-even sales Revenue

If Break-even is not attained..!

it falls below the Total cost
1. Reduce fixed costs

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Three Methods to increase the TR if

2. Reduce the variable cost per unit

3. Increase revenue per unit ie, Price. If not possible then Quit.

Break-Even Analysis
Fixed Costs: Rent: Rs.400 Helper (Wages): Rs.200 Variable Costs: Flowers: Rs.0.50 per bunch Selling Price: Flowers: Rs.2 per bunch So we know that: Total Fixed Costs = Rs.600 Variable Cost per Unit = Rs.0.50 Selling Price per Unit = Rs.2.00

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Break-Even Analysis

SP = Rs.2.00
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We must firstly calculate how much income from FC = Rs.600 each bunch of flowers can go towards covering the Fixed Costs. This is called the Unit Contribution. Selling Price Variable Costs = Unit Contribution Rs.2.00 - Rs.0.50 = Rs.1.50 For every bunch of flowers sold Rs.1.50 can go towards covering Fixed Costs

VC = Rs.0.50

Break-Even Analysis
Now to calculate how many units must be sold to cover Total Costs (FC + VC)

SP = Rs.2.00
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VC = Rs.0.50 Unit cont = Rs.1.50

FC = Rs.600

This is called the Break Even Point Break Even Point = Fixed Costs Unit Contribution Rs.600 Rs.1.50 = 400 Units Therefore 400 bunches of flowers must be sold to Break Even at this the point the business is not making a Profit nor incurring a Loss it is merely covering its Total Costs

Break-Even Analysis

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Lets try another example: Selling Price per unit = Rs.5 Variable Cost per unit = Rs.2 Fixed Costs = Rs.300 How many units must be sold in order to Break Even?

Break-Even Analysis

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SP = Rs.5.00

First calculate the Unit Contribution SP VC = Unit Contribution Rs.5.00 - Rs.2.00 = Rs.3.00

VC = Rs.2.00

FC = Rs.300

Now calculate Break Even point by using the formula Fixed Costs Unit Contribution Rs.300 Rs.3.00 = 100 units Therefore 100 units must be sold in order to Break Even

Break-Even Analysis

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Lets try another example: A firm has Fixed Costs of Rs.1,200. The Selling Price is Rs.6 per unit and the Variable Costs are Rs.3 per unit. How many units must be sold in order to Break Even?

Break-Even Analysis

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SP = Rs.6.00

First calculate the Unit Contribution SP VC = Unit Contribution Rs.6.00 - Rs.3.00 = Rs.3.00

VC = Rs.3.00

FC = Rs.1,200

Now calculate Break Even point by using the formula Fixed Costs Unit Contribution Rs.1,200 Rs.3.00 = 400 units Therefore 400 units must be sold in order to Break Even

Break-Even Analysis

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Break Even can also be used to calculate Profit (or Loss) at a given level of output For example: J Bannerman sells Golf Clubs. How much profit/loss is made when 5000 golf clubs are sold? Each Golf Club is sold for Rs.20 Variable Costs per golf club are Rs.10 Fixed Costs total Rs.24,000

Break-Even Analysis

SP = Rs.20.00
http://www.bized.ac.uk VC = Rs.10.00

Firstly, calculate Unit Contribution FC = Rs.24,000 SP VC = Unit Contribution Sales = 5,000 units Rs.20.00 - Rs.10.00 = Rs.10.00 Now calculate Total Contribution when 5,000 golf clubs are sold Unit Contribution x no of units = Total Contribution Rs.10.00 x 5,000 = Rs.50,000 Now calculate Net Profit at 5,000 units Total Contribution Fixed Costs = Net Profit Rs.50,000 - Rs.24,000 = Rs.26,000

So: Analysis Break-Even

SP = Rs.2.50 Fixed Costs =

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Lets try another example.

SP = Rs.2.50 VC = Rs.1.50

Rent Rs.1,050 Insurance Rs.200 Total FC Rs.1,250 Variable Costs = Flowers Rs.1.49 Paper Rs.0.01 (Rs.3/300) Total VC Rs.1.50

FC = Rs.1,250

Caroline Wilson owns a florist shop. She buys each bunch of flowers for Rs.1.49 and special wrapping paper for Rs.3 per roll. Each roll of wrapping paper will wrap 300 bunches of flowers. Rent of her premises is

Break-Even Analysis

SP = Rs.2.50
http://www.bized.ac.uk VC = Rs.1.50

FC = Rs.1,250 Calculate Carolines Break Even Point and also how much Profit would she make if she sold 2,000 bunches of flowers?

Firstly, calculate Unit Contribution SP VC = Unit Contribution Rs.2.50 - Rs.1.50 = Rs.1.00 Now calculate Break Even Fixed Costs Unit Contribution Rs.1,250 Rs.1.00 = 1,250 units

Break-Even Analysis
How much Profit would she make if she sold 2,000 bunches of flowers?

SP = Rs.2.50
http://www.bized.ac.uk VC = Rs.1.50

FC = Rs.1,250 Unit Cont = Rs.1.00

Now, calculate the profit at 2,000 bunches of flowers Unit Contribution x No of Units = Total contribution Rs.1.00 2,000 units = Rs.2,000 Total Contribution Fixed Costs = Net Profit Rs.2,000 - Rs.1,250 = Rs.750

Break-Even Analysis
Another Example

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Calculate how many units need to be produced in order to achieve a Net Profit of Rs.25,000 given the following information

Fixed Costs Rs.30,000 Contribution per unit Rs.10

Answer

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Net Profit = Total Contribution Fixed Cost Rs.25,000 = Total Contribution - Rs.30,000 therefore Total Contribution = Rs.55,000

If unit contribution is Rs.10 then 5,500 units will have to be produced in order to achieve a Total Contribution of Rs.55,000.
Therefore the number of units required to achieve a Net Profit of Rs.25,000 is 5,500 units

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Break-Even Analysis
The formulae used so far assumes that Unit Costs are known ie Unit Selling Price and Unit Variable Cost
When no unit costs are known, the Profit/Volume Ratio should be used instead

Profit Volume Ratio

P/V Ratio (Profit/Volume Ratio) = Total Contribution / Sales x 100

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If asked to calculate the volume of sales needed to Break-Even (when no unit costs are given) the following formula should be used:
Sales at BEP = Fixed Costs / Profit/Volume Ratio

Profit/Volume Ratio
For Example

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Sales Rs.60,000 Variable Costs Rs.24,000 Fixed Costs Rs.14,000

Calculate the P/V Ratio and the BEP

Answer

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Sales Variable Costs = Total Contribution Rs.60,000 - Rs.24,000 = Rs.36,000

Total Contribution / Sales = P/V Ratio (Rs.36,000 / Rs.60,000) x 100 = 60% Fixed Costs / P/V Ratio = Sales at BEP Rs.14,000 / 60% = Rs.23,333 Therefore Rs.23,333 of Sales are necessary in order to Break-Even

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Costs/Revenue

Break-Even Chart
TR TC VC

The Break-even point occurs where total revenue equals total costs the firm, in this example would have to sell Q1 to generate sufficient revenue (income) to cover its total costs.

BEP FC

Q1

Output/Sales

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Costs/Revenue

Break-Even Chart
TR (p = Rs.3)
TR (p = Rs.2)

TC

VC

If the firm chose At present, this to set price higher firms sells each than Rs.2 (say unit for Rs.2 Rs.3) the TR Break Even point curve would be is at Q1 steeper they would not have to sell as many units to break even

BEP

BEP

FC

Q2

Q1

Output/Sales

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Break-Even Chart
Costs/Revenue
TR (p = Rs.1)
TR (p = Rs.2)

TC BEP

VC

If the firm chose to set prices lower (say Rs.1) it would need to sell more units before covering its costs

BEP

FC

Q1

Q3

Output/Sales

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Break-Even Chart
Costs/Revenue
TR (p = Rs.2)

TC VC

Profit

If you sell sold fewer Any units units than theEven above Break Breakrepresents Even Point, Point a a loss is incurred Profit

BEP Loss FC

Q1

Output/Sales

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Break-Even Chart
Costs/Revenue
TR (p = Rs.3)
TR (p = Rs.2)

TC VC

BEP Margin of Safety

Margin of If we sell safety shows A higher price Break Even how farlower sales more than would can fall before Point is Q1 Break Even the break losses are made. Point ie Q2 even If Q1 point = 1000 we startand to units sold and the Q2 = 1800, make a sales margin of could fall by 800 Profit safety would units before a widen loss would be made

FC

Q3

Q1

Q2

Output/Sales

LIMITING FACTORS

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Under normal circumstances, the bestpaying product is that which shows the highest contribution per Rs. of sales Certain circumstances make this inappropriate eg a factory producing a particular range of products may depend on a highly skilled labour force If skilled labour is in short supply in the locality of the factory, then labour is termed a limiting, or key, factor

LIMITING FACTORS

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The most important criterion now will be the optimum use of labour This is expressed by the contribution per labour hour Direct labour is only one example of a limiting factor Other examples could be
direct materials machine hours factory capacity

For Example

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In a situation where labour is scarce (ie direct labour = limiting factor), advise management which of Products X and Y is more profitable Product X Product Y Selling Price Rs.100 Rs.100 Contribution % (P/V Ratio) 35% 30% Direct Labour Hours per unit 25 hours 20 hours

Answer

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Under normal circumstances Product X would be the better paying product because of its higher P/V Ratio However, when the limiting factor is labour, Product Y becomes the better paying product:
Contribution Per Direct Labour Hour Product X 35% x Rs.100 25 = Rs.1.40 Product Y 30% x Rs.100 20 = Rs.1.50

PRODUCT MIX

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A business may produce a number of products but at the same time be unable to meet total demand for all products due to a limiting factor eg machine hours or labour hours. In this case the business would decide on the optimum use of the limited resource by producing all of the demand for the product which yields the highest contribution per the limiting factor. Having produced all of the demand from that product, the business would produce the next highest contribution per the limiting factor and so on until full capacity is reached.

For example
A
Contribution per labour hour Labour hours per unit Total demand in units Rs.2 4 5,000

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A business can produce Products A, B and C.

B
Rs.1 4 5,000

C
Rs.3 3 10,000

The factory is limited to 60,000 labour hours.

How many units of each Product should be produced to maximise profit?

Answer

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Produce in the order of the highest Contribution per Labour Hour ie C then A then B Demand Labour hrs/unit Total lab hrs C 10,000 3 30,000 A 5,000 4 20,000

Total labour hours required to produce all demand for C then A = 50,000 labour hours.

Answer

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If Total Labour hours available equals 60,000 and 50,000 is used producing Products C and A, then 10,000 labour hours are left to produce as many units as possible for Product B Product B uses 4 labour hours per unit, therefore only 2,500 units of Product B can be produced within the available 60,000 labour hours

Assumptions of Break Even Analysis

All Fixed and Variable costs can be identified
Variable costs are assumed to vary directly with output Fixed costs will remain constant

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Selling prices are assumed to remain constant for all levels of output

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Assumptions Continued
The sales mix of products will remain constant break even charts cannot handle multi-product situations It is assumed that all production will be sold
The volume of activity is the only relevant factor which will affect costs

Limitations of Break Even Analysis

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Some costs cannot be identified as precisely Fixed or Variable Semi-variable costs cannot be easily accommodated in break-even analysis

Costs and revenues tend not to be constant

With Fixed costs the assumption that they are constant over the whole range of output from zero to maximum capacity is unrealistic

Limitations Continued

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Price reduction may be necessary to protect sales in the face of increased competition The sales mix may change with changes in tastes and fashions Productivity may be affected by strikes and absenteeism The balance between Fixed and Variable costs may be altered by new technology

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