Break-Even Point

What is Break-Even Point?
The Break-Even Point for a product is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). A break-even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break even analysis can also be used to analyse the potential profitability of an expenditure in a sales-based business

Introduction

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

Graphing the Break-Even Point
Break-even point can also be indicated by graphing. Figure 1 below is a sample graph for a business. To draw the graph, we should follow these steps:
1.Number of units produced is marked along the horizontal axis and the total revenue expressed in dollars is set on the vertical axis.
2.The sales line is drawn to indicate the sales at each level of production.
3.A horizontal line is drawn at the $12,000 level of sales to represent the fixed costs for our sample business.
4.A total cost line is drawn from the point of intersection of the fixed cost line and the vertical axis to the point of total costs as full capacity --$28,000.
5.The intersection of the total cost line with the sales line represents the break-even point, in this case $20,000. The dotted lines represent the level of production and the total costs at this level of operation.
6.Areas of net loss and of net profit are marked.

The break-even point graph helps the business owner determine the levels of production that will create profits for every level of sales. The business owner then works to increase profits without investing extra funds. To do this, he/she should study the following important points:
1.A possible increase in utilization of existing capacity through reduction of idle time.
2.Better repair and maintenance of equipment to reduce down time --time elapsed from the moment the machine breaks down to the time it gets back in service.
3.Improved working schedules and inventory levels.
4.Longer business hours.
5.Improved production control.
6.Markup policy.

Let us take a closer look at two of these points.

Markup Policy
Another item to study when considering ways to improve profit without increasing investment is the company's markup policy. Markup is the amount above cost that the business charges for an item. Too many business owners believe that the only way to larger profits is through higher markups. As a result, they tend to use either a fixed percentage of cost markup or some vague and arbitrary "rule of thumb" which multiples costs by some mystical figure in the manager's head to arrive at the selling price.

Actually, markup should be flexible. Break-even analysis allows studies to be made of volumes of sales at various price levels. It is often discovered that a lover markup will produce a higher volume of sales and increased profits.
If a customer feels costs are too high he/she will take their business elsewhere. Reduced turnover means slow sales. It also means that the business owner may have to raise prices to cover its inventory investment. This will drive more customers away.
An appreciation of the meanings of break-even analysis can prevent such a vicious cycle from even starting.

Margin of Safety
Margin of safety represents the strength of the business. It enables a business to know that what is the exact amount he/ she has gained or lost over or below the breakeven point).
Margin of safety = (sales - break-even sales) / sales) x 100% If P/V ratio is given then sales/pv ratio

Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

In Capital Budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time.
The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur.
In using break even analysis, it is important to remember the problem associated with sensitivity analysis as well as some extension specific to the method:
Variables are often interdependent, which makes examining them each individually unrealistic.
Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future.
Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the breakeven point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid.
Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis

Break-Even Point Calculation( BEP)
Calculation of the BEP can be done using the following formula:

BEP = TFC / (SUP - VCUP)

Where:
BEP = break-even point (units of production)
TFC = total fixed costs,
VCUP = variable costs per unit of production,
SUP = selling price per unit of production.

Benefits of Break-Even Analysis

The main advantage of break-even analysis is that it explains the relationship between cost, production volume and returns. It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques. The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.

Limitation of Break-Even Analysis

It is best suited to the analysis of one product at a time;
It may be difficult to classify a cost as all variable or all fixed; and
There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed.

Summary
Break-even analysis and techniques are the tools that finally tell the business owner or manager when he/she is making a profit. Break-even charts and analysis will be part of every budget the business owner put out. They enable he/she to gauge the business' production rate accurately. They will tell whether an increase or a slowdown in production is called for. They are a vital part of the business owner's life