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Break Even Analysis

It is a widely used technique to study the cost -volume profit relationship. The

narrower interpretation of term break even analysis refers to system of

determination of that level of activity where total cost equals total selling price. The

broader interpretation refers to that system of analysis which determines probableprofit at any level of activity. It portrays the relationship between the cost of

production, volume of production and sales value.

Break even analysis indicates the level of sales at which cost and revenue are in

equilibrium .The equilibrium point is commonly known as break even point, The

break even point is that point of sales volume at which total revenue is equal to total

cost.

Utility of Break Even Analysis:

It is the most useful technique of profit planning and control. It is a device to explain

the relationship between the cost volume profit .The utility of break even analysislies in the following advantages:

1) Provided detailed and understandable information:

Break even analysis is a simple concept to present and interpret accounting data.

Many business executives and other are unable to understand accounting data

contained in the financial statements and reports but break even charts visualizes

information very clearly and a look at a glance shall give a vivid picture of whole

affairs. The different elements of cost direct material, direct labour, overheads

(factory, office and selling etc) can be presented through an analytical break even

chart. Further the information is in a simple format therefore it is clearly

understandable even to layman.

2) Profitability of product and business can be known:

The profitability of different can be known with the help of break even chart,

besides the level no profit no loss .The problem of managerial decision regarding

temporary or permanent shutdown of business or continuation at a loss can be

solved by break even analysis .It is thus provides the basis information for profit

improvement studies and it is useful starting point for the detailed investigation.

3) Effects of changing of cost and sales price can be demonstrated:

The effect of changes of fixed and variable cost at different level of production on

profits can be demonstrated by graph legibly. In other words relationship of cost,

volume, profit at different level of activity and varying selling prices is shown

through chart. Thus it studied requisites for survival of the company.

4) Cost control can be analyzed:

The relative importance of fixed in the total cost of product can be analyzed and if

the total cost are high, they can be controlled by the management. Thus it is a

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managerial tool for control and reduction of cost, elimination of wastages and

achieving better efficiency.

5) Economy and efficiency can be affected:

The capacity can be utilized to fullest possible extent and economies of scale and

capacity utilization can be affected. Comparative plant efficiency can be studied onbreak even chart. The efficiency of output is indicated by the angle of incidence

formed at intersection of sales line and the variable cost.

6) Diagnostic tool:

It is useful diagnostic tool. It indicates to management the cause of increasing break

even point and falling profit the analysis of these causes will reveal that what action

should be taken. If break even point as a percentage of capacity is increasing, it

indicates the unfavorable condition and need immediate action .It is possible that

due to plant expansion absolute break even point may increase. This situation where

break even point as a percentage of capacity may does not increase, is not

unfavorable.

Limitation of break even analysis

Though break even analysis is a simple and useful concept but it is based on the

certain assumption which limits its utility and general applicability. However it

suffers from the following limitations:

1) Based on the false assumptions:

A) Cost segregation:

It is difficult to classified fixed and variable cost. However some of the can be easilyidentified as fixed such as rent of building, or variable such as direct material cost

but a large number of cost belong to mixed category .such cost known as semi-

variable cost consists of fixed as well as variable cost and are difficult to separate.

B) Fixed cost remains constant:

The assumption that fixed costs remain constant does not hold good. If a firm has

zero output some of fixed cost can certainly be reduced or eliminated. For example

some of the supervisors can be dismissed and the salaries can be reduced. On the

other hand if the company uses its ideal capacity additional fixed cost may be

incurred. Thus fixed costs are not constant and can change in the stepwise fashion.

C) Variable cost very proportionately:

The variable cost does not change in the same proportion as volume of production

or sales changes. for example if the company increases its production or sales it need

more workers who may be less efficient and less experienced or existing workers

need overtime and company have to pay for it. Similarly material cost will be less

due to purchase, discounts, if purchases in bulk. So lines drawn are not straight and

sometimes a curved line is obtained in respect of total cost.

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d) Change in selling price:

Similarly selling price may remain the constant under the perfect competition. But

in the real market situation of monopolistic completion or oligopoly selling price

have to be reduced to increase the sales volume. Thus sales revenue will not change

in the direct proportion with output.

e) Stock changes do not affect incomes:

The break even chart depicts volume of production or sales along x axis and thus

ignores the effect of changes in stock volume. As a matter of fact it is assumed that

stock changes will not affect income, but it is not true since the absorption of fixed

cost depends on the production and not on sales.

2) Limited information: can be presented in a single break even chart. If we have to

study changes of fixed cost, variable cost and selling prices, a number of charts will

have to be drawn up

Similarly when a number of products are manufactured it would a difficulttask to present information through single break even chart.

3)Short term focus: It is a short term technique of profit planning and can not be

used for the long term planning because it lead to long term decision. For example a

company wishes to increase his productive capacity and it may not yield enough

revenue in the first year. Thus in the term of break even analysis company may

drop idea of adding to productive capacity, but it may be beneficial over a long

period of time.

4) NO necessity: There is no necessity; of preparing the break even charts on

account of the following reasons:

A) Simple tabulation sufficient: because result of cost and sales can serve the

purpose which is served by break even chart. Hence the need of presentation

through chart and using mathematical tool of break even analysis does not arise.

b) Conclusive guidance not provided: No conclusive basis for action is provided to

management by technique of breakeven analysis,

c) Difficult to understand: The chart becomes very complicated and difficult to

understand particularly for the non technical man, if number of lines or curves

depicted on graph is large

d) No basis for comparative efficiency:

Charts do not provide any basis for the comparative efficiency between the different

units. In spite of all above limitation it remain an important tool for the profit

planning what is needed is that financial analyst should understand underlying

assumption and their corresponding limitation and adjust his data appropriately to

suits his needs.