Break even analysis- A Comprehensive and Clear Description

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Break-even analysis is one of the most important concepts in management-accounting that enables the management to calculate production costs accurately and avoid wastage. It relates volume with profits at different levels and helps the company to fix price accordingly.

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Break even analysis- A Comprehensive and Clear Description

  1. 1. www.managementguru.net. For related presentations pl. contact: managementguru.net@gmail.cwww.managementguru.net. For related presentations pl. contact: managementguru.net@gmail.co11 Break-Even AnalysisBreak-Even Analysis Simplified for BetterSimplified for Better UnderstandingUnderstanding
  2. 2. 2www.managementguru.net. For related presentations pl. co Definition of Important factorsDefinition of Important factors Marginal Costing:Marginal Costing: Marginal costing necessiates analysis ofMarginal costing necessiates analysis of costs into fixed and variable. It has beencosts into fixed and variable. It has been designed to help the management to havedesigned to help the management to have a clear perspective on the effect of thesea clear perspective on the effect of these two types of costs on the profitabilitytwo types of costs on the profitability margin and sales volume .margin and sales volume .
  3. 3. 3www.managementguru.net. For related presentations pl. co Cost-Volume-Profit RelationshipCost-Volume-Profit Relationship This CVP( cost-volume-profit) analysisThis CVP( cost-volume-profit) analysis pertains to management accountingpertains to management accounting where the results can be interpreted towhere the results can be interpreted to know theknow the 1.1. Actual cost of production under differentActual cost of production under different circumstancescircumstances 2.2. What has to be the volume ofWhat has to be the volume of production?production? 3.3. What profit can be earned?What profit can be earned? 4.4. What is the difference between theWhat is the difference between the
  4. 4. 4www.managementguru.net. For related presentations pl. co ContributionContribution Contribution is the difference between sales andContribution is the difference between sales and the variable cost and referred to as “Grossthe variable cost and referred to as “Gross margin.”margin.” It is visualised as some sort of fund or pool outIt is visualised as some sort of fund or pool out of which all fixed costs are to be met and toof which all fixed costs are to be met and to which each product has to contribute its share.which each product has to contribute its share. The difference between contribution and fixedThe difference between contribution and fixed cost is either profit or loss as the case may be.cost is either profit or loss as the case may be.
  5. 5. 5www.managementguru.net. For related presentations pl. co Variable or Marginal CostVariable or Marginal Cost StatementStatement Sales-Variable cost=Sales-Variable cost= ContributionContribution Contribution-Fixed Cost=Contribution-Fixed Cost= ProfitProfit Variable Cost StatementVariable Cost Statement Sales RevenueSales Revenue xxxxxxxx Direct Materials xxxxDirect Materials xxxx Direct Labour xxxxDirect Labour xxxx Variable OverheadVariable Overhead xxxxxxxx Variable CostsVariable Costs ((xxxxxxxx)) ContributionContribution xxxxxxxx Fixed OverheadFixed Overhead (xxxx)(xxxx) ProfitProfit xxxxxxxx (- )Read as minus symbol(- )Read as minus symbol
  6. 6. 6www.managementguru.net. For related presentations pl. co Concept of ContributionConcept of Contribution The concept of contribution is useful inThe concept of contribution is useful in Fixation of selling pricesFixation of selling prices Determination of break-even pointDetermination of break-even point Selection of product-mix for profitSelection of product-mix for profit maximisationmaximisation Ascertainment of profitability of products,Ascertainment of profitability of products, departments etc.departments etc.
  7. 7. 7www.managementguru.net. For related presentations pl. co Contribution Margin RatioContribution Margin Ratio The contribution margin is also useful forThe contribution margin is also useful for determining the impact on profits of changes indetermining the impact on profits of changes in sales. In particular, it can be used to estimatesales. In particular, it can be used to estimate the decline in profits if sales drops, and so is athe decline in profits if sales drops, and so is a standard tool in the formulation of budgets.standard tool in the formulation of budgets. FormulaFormula: To calculate the contribution margin: To calculate the contribution margin ratio, divide the contribution margin by sales.ratio, divide the contribution margin by sales. The formula is:The formula is: Contribution marginContribution margin SalesSales
  8. 8. 8www.managementguru.net. For related presentations pl. co How to Calculate Con.MarginHow to Calculate Con.Margin Example:Example: Rs.Rs. Revenue 10,00,000Revenue 10,00,000 Variable expenses 4,00,000Variable expenses 4,00,000 -------------------------------- Contribution margin 6,00,000Contribution margin 6,00,000 Fixed expensesFixed expenses 6,60,0006,60,000 Net lossNet loss 60,00060,000
  9. 9. 9www.managementguru.net. For related presentations pl. co Break-Even AnalysisBreak-Even Analysis In itsIn its narrow sensenarrow sense, it is that point where, it is that point where Total Revenues=Total Expenses, i.e., theTotal Revenues=Total Expenses, i.e., the point of zero profit.point of zero profit. In aIn a broader sensebroader sense, it denotes a system of, it denotes a system of analysis that can be used to determine theanalysis that can be used to determine the probable profit at any level of operations.probable profit at any level of operations.
  10. 10. 10www.managementguru.net. For related presentations pl. co Definition of Break-Even PointDefinition of Break-Even Point At the breakeven point of a business,At the breakeven point of a business, income is equal to expense and thereforeincome is equal to expense and therefore there is no gain or loss.there is no gain or loss. It is the starting point from which anIt is the starting point from which an increase in sales or a reduction in costsincrease in sales or a reduction in costs generates a gain and a reduction in salesgenerates a gain and a reduction in sales or an increase in costs generates a loss.or an increase in costs generates a loss.
  11. 11. 11www.managementguru.net. For related presentations pl. co Why to calculate BE PointWhy to calculate BE Point The breakeven point is an important referenceThe breakeven point is an important reference point that enters into planning and carrying outpoint that enters into planning and carrying out business activities.business activities. A clear understanding of the level of salesA clear understanding of the level of sales needed to cover all costs helps you to knowneeded to cover all costs helps you to know 1.1. How many units you must produce in the caseHow many units you must produce in the case of a manufacturing businessof a manufacturing business 2.2. How many units you need to purchase and sell,How many units you need to purchase and sell, in the case of a merchandising business.in the case of a merchandising business. 3.3. In a services business, the breakeven pointIn a services business, the breakeven point indicates the number of billable hours you mustindicates the number of billable hours you must work in order to cover your costs.work in order to cover your costs.
  12. 12. 12www.managementguru.net. For related presentations pl. co Assumptions of CVP AnalysisAssumptions of CVP Analysis 1.1. Costs are differentiated into fixed andCosts are differentiated into fixed and variable components.variable components. 2.2. Fixed cost remains constant.Fixed cost remains constant. 3.3. Variable costs as the name indicatesVariable costs as the name indicates vary in proportion with the volume.vary in proportion with the volume. 4.4. Selling price does not change withSelling price does not change with volume.volume. 5.5. There is only one product or, in the caseThere is only one product or, in the case of multiple products, sales mix remainsof multiple products, sales mix remains constant.constant.
  13. 13. 13www.managementguru.net. For related presentations pl. co Assumptions of CVP AnalysisAssumptions of CVP Analysis 6. There will be no change in the general6. There will be no change in the general price level.price level. 7. Productivity per worker remains7. Productivity per worker remains unchanged.unchanged. 8. There is synchronisation between8. There is synchronisation between production and sales.production and sales. 9. The efficiency of plant can be predicted.9. The efficiency of plant can be predicted. 10. The principle of cost variability is valid.10. The principle of cost variability is valid.
  14. 14. 14www.managementguru.net. For related presentations pl. co What is fixed costWhat is fixed cost Fixed cost is invariable and has to be borne by the company regardless ofFixed cost is invariable and has to be borne by the company regardless of the level of sales.the level of sales. ExamplesExamples:: 1. The cost to rent an office, shop, warehouse, factory, or other facilities1. The cost to rent an office, shop, warehouse, factory, or other facilities 2. Base salaries and wages of employees; employee benefit plans,2. Base salaries and wages of employees; employee benefit plans, maintenance contracts; contracts for cleaning and security services;maintenance contracts; contracts for cleaning and security services; advertising contracts; insuranceadvertising contracts; insurance 3. Base costs of utilities such as electricity, gas, water, and sewage3. Base costs of utilities such as electricity, gas, water, and sewage 4. Base costs of telephone land lines or cellular telephone; Internet connection;4. Base costs of telephone land lines or cellular telephone; Internet connection; the monthly cost of a domain and website; real and personal property taxes;the monthly cost of a domain and website; real and personal property taxes; licenses and permits; depreciation and amortization; and interest and otherlicenses and permits; depreciation and amortization; and interest and other debt service expenses.debt service expenses.
  15. 15. 15www.managementguru.net. For related presentations pl. co What is variable costWhat is variable cost The costs that are incurred in proportion to the level ofThe costs that are incurred in proportion to the level of sales.sales. Examples:Examples: 1.1. Raw materials and suppliesRaw materials and supplies 2.2. FreightFreight 3.3. Rental of machinery, equipment, and tools for specificRental of machinery, equipment, and tools for specific jobsjobs 4.4. FuelFuel 5.5. Employee overtime pay; temporary contract labor;Employee overtime pay; temporary contract labor; repairs and maintenance; office supplies; telephonerepairs and maintenance; office supplies; telephone calls; travel expenses; and sales commissions.calls; travel expenses; and sales commissions.
  16. 16. 16www.managementguru.net. For related presentations pl. co What is Semi-variable costWhat is Semi-variable cost The costs that possess both theThe costs that possess both the characteristics of fixed and variable maycharacteristics of fixed and variable may be termed as semi-variable costs or semi-be termed as semi-variable costs or semi- variable over-heads.variable over-heads. For example electricity can be consideredFor example electricity can be considered as a fixed cost when it is utilised toas a fixed cost when it is utilised to illuminate all the facilities in a plant and itilluminate all the facilities in a plant and it also becomes variable when the level ofalso becomes variable when the level of operation increases to produce moreoperation increases to produce more units.units.
  17. 17. 17www.managementguru.net. For related presentations pl. co What is Angle of IncidenceWhat is Angle of Incidence The angle at which the sales line cuts theThe angle at which the sales line cuts the cost line.Any organisation would want thiscost line.Any organisation would want this angle to be wide and large as it indicatesangle to be wide and large as it indicates more quantum of profit where all the fixedmore quantum of profit where all the fixed over-heads are absorbed.over-heads are absorbed. A narrrow angle also covers the fixed-A narrrow angle also covers the fixed- over-heads but still the profit margin is lowover-heads but still the profit margin is low as compared to the former.as compared to the former.
  18. 18. 18www.managementguru.net. For related presentations pl. co What is Margin of SafetyWhat is Margin of Safety When the volume of sales exceeds theWhen the volume of sales exceeds the break-even point, that area is called thebreak-even point, that area is called the margin of safety.margin of safety. It is important that there should be aIt is important that there should be a reasonable margin of safety. A low marginreasonable margin of safety. A low margin indicates high fixed over-heads andindicates high fixed over-heads and reduced activity which is not enough toreduced activity which is not enough to absorb the fixed costs and accrue profit.absorb the fixed costs and accrue profit.
  19. 19. 19www.managementguru.net. For related presentations pl. co P/V Ratio or Profit-Volume RatioP/V Ratio or Profit-Volume Ratio P/V ratio plays a very important role in all break-even pointP/V ratio plays a very important role in all break-even point determination as it indicates the relationship between contributiondetermination as it indicates the relationship between contribution and turn-over.and turn-over. P/V ratio=P/V ratio= ContributionContribution SalesSales (or)(or) Sales - Variable costSales - Variable cost SalesSales (or)(or) Sales=Sales= ContributionContribution P/V ratioP/V ratio (or)(or) Contribution= Sales * P/V ratioContribution= Sales * P/V ratio This is basically expressed in percentage %This is basically expressed in percentage %
  20. 20. 20www.managementguru.net. For related presentations pl. co Calculation of BE pointCalculation of BE point Break-even point=Break-even point= Fixed costFixed cost P/V ratioP/V ratio This formula is derived from the basic formula of break-even pointThis formula is derived from the basic formula of break-even point which is:which is: 1.1. Fixed cost*SalesFixed cost*Sales Sales-Variable expenses (or)Sales-Variable expenses (or) 2. Fixed costs /2. Fixed costs / Sales-Variable expensesSales-Variable expenses Sales (or)Sales (or) 3. Fixed costs/ P/V ratio (or)3. Fixed costs/ P/V ratio (or) 4.4. Fixed costsFixed costs P/V ratio (or)P/V ratio (or) 5. Fixed Cots*5. Fixed Cots* 11 P/V ratioP/V ratio
  21. 21. 21www.managementguru.net. For related presentations pl. co Break Even GraphBreak Even Graph
  22. 22. 22www.managementguru.net. For related presentations pl. co Contribution GraphContribution Graph
  23. 23. 23www.managementguru.net. For related presentations pl. co Profit and LossProfit and Loss
  24. 24. 24www.managementguru.net. For related presentations pl. co PROBLEMSPROBLEMS 1. Find the BEP of production in terms of unit and in terms of value if the price of the product1. Find the BEP of production in terms of unit and in terms of value if the price of the product is Rs 250 per unit; variable cost is Rs 150 per unit and the fixed cost is Rs 1,50,000.is Rs 250 per unit; variable cost is Rs 150 per unit and the fixed cost is Rs 1,50,000. SolutionSolution In terms of unit:In terms of unit: BEP = FC/(SP – VC)BEP = FC/(SP – VC) = 1,50,000/(250 – 150) =1,500 units= 1,50,000/(250 – 150) =1,500 units In terms of value:In terms of value: BEP = FC/MC%BEP = FC/MC% MC% = (SP – VC)/SPMC% = (SP – VC)/SP = Rs (250 – 150)/ 250 = 0.40 = 40%= Rs (250 – 150)/ 250 = 0.40 = 40% = Rs 1,50,000/0.40 = Rs 3,75,000= Rs 1,50,000/0.40 = Rs 3,75,000 2. If the product’s demand is price-inelastic, the firm raises the price of the product from Rs2. If the product’s demand is price-inelastic, the firm raises the price of the product from Rs 250 to Rs 300 with the same variable cost of Rs 150 and the unchanged fixed cost of Rs250 to Rs 300 with the same variable cost of Rs 150 and the unchanged fixed cost of Rs 1,50,000. Will the BEP change from that when it remains unchanged?1,50,000. Will the BEP change from that when it remains unchanged? SolutionSolution BEP with an increase in SP:BEP with an increase in SP: Rs 1,50,000/(300 – 150) = 1,000 unitsRs 1,50,000/(300 – 150) = 1,000 units

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