Cost of Production
6.5. BREAK EVEN ANALYSIS
Since making profits is one of the main objective of the firms involved in the production process. Profit planning is therefore the utmost importance to the company. Break even analysis is one such technique utilized by the firms for proper profit planning of the firms.
It reveals the relationship between the volume and cost of production on the one hand, and the revenue and profits obtained from the sales on the other. The break even point is that level of sales where the net income is equal to zero. It indicates a zone which shows no profit or loss. In fact the word 'break even'
AC
Output
symbolizes a point where the firm breaks even or equal where it faces no loss or no profit. It can also be said that it is a point where losses cease to occur while profits have not yet begun.
Break-Even Point
The break even point is that point of activity, where total revenues and total expenses are equal. It is that point where total cost equal to the total revenue. It also indicates a point where losses cease to occur while profits have begun to. The break-even point can be found in two ways.
1. The graphical method
2. The geometric method — here it may be calculated in terms of physical units, i.e., through volume of output or in terms of sales value.
Break-even chart: It may defined as 'an analysis in graphic form of the relationship of production, and sales to profit. It shows the extent of profit or loss to the firm at different levels of the activity.
It depicts profit-output relationship. The break-even point can be explained through a schedule.
Break even schedule :
Output Total Revenue TFC TVC TC
0 0 500 - 500
100 500 500 400 900
200 1000 500 800 1300
300 1500 500 1200 1600
400 2000 500 1500 2000
500 2500 500 1600 2100
600 3000 500 1750 2250
In the table above, when the output is zero, total fixed cost is Rs. 500, and total cost Rs. 500, the total variable cost is nil. When the output is 100, the revenue is Rs. 500 and the total cost incurred is Rs. 900 which is more than the revenue. When the output is 200 units the revenue is Rs. 1000 and the cost still high at Rs.
1300. This trend continues till the firm produces 400 units of output. When the firm produces 400 units its total revenue is equal to the total cost. This is the break-even point of the firm, where
BEP
when the producer is using a single unit. The BEP is the number of units of the commodity that should be sold to earn enough revenue just to cover all the expenses of production. Thus the BEP is a point where a sufficient number of units of output are produced so that its total contribution margin becomes equal to the total fixed cost. It can be calculated by using the formula :
BEP TFC P AVC
= − Where BEP = the break-even point
TFC = total fixed cost P = selling price
AVC = average variable cost.
Example: Suppose if the firm incurs Rs 10000, the selling price is Rs 4 per unit. And the average variable cost is Rs 2 per unit.
Find the BEP?
BEP TFC P AVC
= −
= 10000 / 4 – 2
= 5000.
Bep in terms of sales value: Bep in terms of physical output is suitable only in cost where single products are produced. If the firm is producing many products, the BEP can only be found in terms of sales value or in terms of total revenue. Here the contribution is a ratio to the sales.
BEP Total Fixed Cost Contribution ratio
=
Contribution ratio is measured as:
Contribution ratio (CR) = TR – TVC TR
Example: A firm incurs fixed cost of Rs 8000 and the variable cost is Rs. 12000. Its total sales receipt is Rs 30000 determine the Break even point.
CR 30000 120000 30000 3 / 5 BEP TFC / CR
3000 5 3 13333
= −
=
=
= ×
=
Assumptions of the Break even point
The break even analysis is based on certain assumptions. They include:
1. It assumes that costs can be classified into fixed and variable costs, thus ignoring semi-variable costs.
2. The selling price is assumed to be constant.
3. It assumes no change in technology, and labour efficiency.
4. It also assumes that production and sales almost remain fixed, in the sense there is no addition or subtraction to the inventory.
5. Factor prices are also assumed to remain constant.
6. The product mix is stable in the case of multi-product firm.
USES OF THE BREAK EVEN ANALYSIS
● It represents a microscopic picture of the business and it enables the management to find out the profitability region.
● It highlights the areas of economic strength and weakness of the firm.
● The BEA can be used to determine the 'safety margin'. The safety margin refers to a region where the firm can produce and sell without incurring loss. If the firm is working at loss, the safety margin helps in indicating a suitable increase in sales to reach the BEP and avoid losses. It can be found out by the following formula:
Safety Margin Sales BEP Sales 100
= − ×
● Target Profit: The break even analysis will help in finding out the level of output and sales in order to reach the target of profit fixed.
Target sales volume Fixed cost target profit Conbtribution margin %
= −
(Contribution margin = selling price – variable cost).
● Change in price: Many factors have to be considered before reducing the price of a product. Reduction in price need not necessarily result in increased sales, as it depends on the elasticity of demand.
New sales volume Total fixed cost total profit New selling price Average variable cost
= +
−
Thus the break even analysis serves as an important tool in helping entrepreneurs to take appropriate decisions, as far as pricing policy, sales projection and revenue of the firm is concerned.
The study on cost and cost concepts helps the entrepreneur in the hotel industry. Since this industry also strives to work for profit. An understanding of various cost concepts is needed not only to know the various type of expenditure involved in production process, but also helps to produce at the optimum level with the minimum cost. The relationship between revenue and cost which is well explained through the break even analysis, helps the industry to operate within the safe region of profit making, it helps to determine the level of output at which the industry can make profits or losses.
MODEL QUESTIONS Short Questions
1. Explain the term cost of production.
2. What is opportunity cost?
3. How is the marginal cost calculated?
4. What are selling costs?
5. Explain the relationship between cost, volume and output in the hotel industry.
6. Differenciate between fixed and variable cost.
7. What is social cost?
8. What is explicit cost?
9. When the advertisement cost appear in business?
Essay Questions
1. Give an imaginary cost schedule.
2. Why is the average revenue curve 'U' shaped? Explain.
3. How is the long run average revenue curve derived?
4. How is the break even analysis useful in business decisions?