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# Business Economics 08 Breakeven Analysis

## by Uttam Satapathy, Student at National Institute of Industrial Management, Mumbai on Sep 13, 2011

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## Business Economics 08 Breakeven AnalysisPresentation Transcript

• Breakeven Analysis or Profit Contribution Analysis or Cost-volume-profit (CVP) Analysis
• Breakeven analysis – useful in planning, studies the relationship between TC, TR, total losses and profits over the whole range of output
• Linear cost and revenue functions
• TC = 100 + 10Q, TR = 15Q
• Breakeven Q (Qe) TR = TC 20
• or PQ=FC+Q.AVC
• or FC/P-AVC 20
• Operating losses (TC>TR)
• Operating profit (TR>TC )
• Profit contribution (P-AVC) - revenue on the sale of a unit of output after variable costs are covered represents a contribution towards profit
• Contribution margin ratio = P - AVC/P
• Criticism of linear functions- linear revenue and non linear cost functions
• Non linear costs and revenue functions TFC TVC TR TC  Q1 Q2 Q3 TC TR,TC,  A B a b C D losses profits
• Managerial uses of breakeven analysis
• Margin of safety – refers to the extent to which the firm can afford a decline in sales before it starts incurring losses.
• MS = S - BEP
• where MS = margin of safety,
• S = sales (planned), BEP = breakeven point
• It reflects resistance capacity to avoid losses
• Margin of safety
• Case -1
• MS = 8000 – 5000 = 3000 Q
• Or (S – BEP).100/S = 37.5%
• Case - 2
• MS = (4000 – 5000).100/4000 = 25%
• Required rate of profit (  R ) Q
•  R = PQ - [ (Q.AVC) + FC]
• Q = FC +  R /P – AVC = 100 + 200/15 – 10=60
• Change in price
• P contribution margin and vice versa
• P not always demand – it depends on E d
• Increasing sale price increases MS and vice versa
• Q n = FC +  / SP n – AVC
• Where Q n = new volume of sales, SP n = new selling price
• Case – 1
• 100 +200/15 – 10 = 60
• Price reduced to 13
• Q n = 100 + 200/13 – 10 = 100
• Case – 2
• If price increased to 17
• Q n = 100 + 200/17 – 10 = 44
• Change in cost
• High ratio of TFC to TC allows high profits with increasing sales
• Low ratio of TFC to TC has larger MS
• Change in fixed cost
• New output level
• Q n = Q + FC n – FC/P – AVC
• 60 + 150 – 100/15 – 10 = 70
• New selling price
• P n = P + FC n – FC/Q
• = 15 + 150 – 100/60
• = 16
• Change in variable costs
• New output level
• Q n = FC +  / P – VC n
• = 100 + 200/15 – 12 = 100
• The new selling price
• P n = P + (VC n + VC)
• = 15 + (12 – 10)
• =17
• Operating leverages
• A firm is said to be highly leveraged if fixed costs are large relative to variable costs and experiences more variation in profits for a given % ∆ Q than does a less leveraged firm.
• Leverage is analyzed using profit elasticity an indicator of risk
• Operating leverages
• If price is constant, E  depends on
• the level of output
• the level of TFC
• AVC
•  = PQ – (AVC) (Q) – TFC
• And ∆  = P (∆Q) – (AVC) (∆Q)
• Therefore
• E  = [P( ∆Q) – (AVC) ( ∆Q) ] / [PQ – (AVC)(Q) - TFC] / ∆Q/Q
• Or E  = Q(P – AVC)/ Q(P – AVC) - TFC
• Example Operating profit elasticity for two firms VG/lv/P-II-6 firm a firm b price = 10 price = 10 AVC = 5 AVC = 2 AFC = 1000 TFC = 4000 Output sale profit E  firm A firm B firm A firm B 1000 4000 4000 1.25 2.00 1500 6500 8000 1.15 1.50 2000 9000 12000 1.11 1.33 2500 11500 16000 1.09 1.25 3000 14000 20000 1.07 1.20
• Policy guidelines emanating from break even analysis
• A high BEP indicates vulnerability of the profit position of the firm
• The higher the contribution margin, the higher is the endurance of business and vice versa
• During boom, a firm with a higher percentage of fixed costs to sales earns higher profits as compared to a business with a higher percentage of variable expenses to sales. During depression. the leveraged firm suffers greater losses than others.
VG/lv/P-II-6