KHSS/ AL/ PA/ Costing (VI) Breakeven Analy.

/Oct03

Costing (VI) Breakeven Analysis

Part I : Background
1.1 Definition of Breakeven Analysis
Breakeven analysis is also known as cost-volume-profit analysis.
It is the study of the relationship between selling prices, sales volumes, fixed
costs, variable costs and profits at various levels of activity.
1.2 Application of breakeven analysis
Breakeven analysis can be used to determine a companys breakeven point
(BEP).
Breakeven point is a level of activity at which the total revenue is equal to the total
costs. At this level, the company makes no profit. With reference to the breakeven
point, the managers can set their sales goals and target profits.
1.3 Assumption of breakeven analysis
The model of breakeven analysis is developed on the following assumptions:
Relevance rangeIt is assumed that a company is operating within a
relevant range. The relevant range is the range of an activity over which the
fixed cost will remain fixed in total and the variable cost per unit will remain
constant.
Fixed costsTotal fixed costs are assumed to be constant in total. Fixed
costs per unit will decrease with the increasing number of units produced.
Variable costsVariable costs per unit are assumed to be constant. Total
variable costs will increase with the increasing number of units produced.
Sales revenue ---Sales revenue per unit is assumed to be constant and the
total revenue will increase with the increasing number of units produced.
These assumptions are illustrated in the following diagrams:
Costs ($)

Total Costs
Variable costs

Fixed costs

Sales (Units)
Total cost/ Revenue ($)

Sales Revenue
Profit
Total costs

Sales (units)
BEP
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Part II : Breakeven Analysis

2.1 Breakeven point
Breakeven point is the level of activity at which the company makes neither profit
nor loss.
It is also the activity level at which the total contribution is equal to the total fixed
costs. Contribution is defined as the excess of sales revenue over the variable
costs.
The following diagram illustrates the definition of contribution.
Profit
Sales
revenue

Contribution

Fixed costs

Variable costs

Formulas for breakeven analysis.

Breakeven point in units = Fixed costs / Contribution per unit

Breakeven point in units =

Contribution required to break even

Contribution per unit

Sales revenue at breakeven point =

Contribution required to break even X Selling price
Contribution per unit

Sales revenue at breakeven point =

Contribution required to break even
Contribution to sales ratio

2.2 Example 1
Selling price per unit-- $12
Variable cost per unit -- $3
Fixed costs-- $45,000
You are required to compute the breakeven point.
Breakeven point in units = Fixed costs / Contribution per unit
=
Sales revenue at breakeven point =

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Alternative method
Contribution to sales ratio =
Sales revenue at breakeven point =

Contribution required to break even

Contribution to sales ratio

=
Breakeven point units =

2.3 Target Profit

No. of units at target profit =

Fixed

costs
+
Target
Contribution per unit

Profit

2.3.1 Example 2
Selling price per unit --$12
Variable cost per unit -- $3
Fixed costs-- $45,000
Target profit-- $18,000
You are required to compute the sales volume required to achieve the target
profit.
Fixed
costs
+
Target
Profit
No. of units at target profit =
Contribution per unit

Required sales revenue =

Alternative method
Required sales revenue = Fixed costs+target profit/Contribution to sales
ratio
=
Units sold at target profit =
2.4 Margin of safety
Margin of safety is a measure of amount by which the sales may decrease before
a company suffers a loss. This can be expressed as a number of units or a
percentage of sales.
2.4.1 Example 3
The breakeven sales level is at 5,000 units. The company sets the target profit at
$18,000 and the budgeted sales level at 7,000 units.
You are required to calculate the margin of safety in units and express it as a
percentage of the budgeted sales revenue.
Margin of safety = Budgeted sales level breakeven sales level
=
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Margin of safety =
The margin of safety indicates that the actual sales can
______________units or __________ from the budgeted level before losses
are incurred.
2.5 Changes in components of breakeven analysis
The following example demonstrates the effects of the changes in different
components of breakeven analysis.
2.5.1 Example 4
Selling price per unit --$12
Variable cost per unit --$3
Fixed costs-- $45,000
Current profit-- $18,000
If the change in selling price is raised from $12 to $13, the minimum volume of
sales required to maintain the current profit will be:
(Fixed costs + Current profit) / Contribution per unit
=

If the fixed costs fall by $5,000 but the variable costs rise to $4 per unit, the
minimum volume of sales required to maintain the current profit will be:
(Fixed cost + Current profit)/ Contribution per unit
=

2.6 Limitations of breakeven analysis

Breakeven analysis assumes that fixed costs, variable costs and sales revenue
behave in a linear manner. However, some overhead costs may be stepped in
nature rather than remain constant. The previously straight sales revenue line and
total cost line tend to curve beyond a certain level of production. As a result, a
lower selling price is set to stimulate further sales and lower variable costs can be
obtained due to mass production.
It is assumed that all production is sold. The breakeven chart does not take the
changes in stock level into account.
Breakeven analysis can provide vital information for small and relatively simple
companies that produce large volume of the same product. It is not so useful for
the companies producing multiple products. Its applications tend to be limited
especially in those jobbing companies where each item produced is different.

Homework Exercises: Q.35-6A, Q.35-8A, Q.35-9A, Q.35-11A, Q.35-12A, Q.35-13A,

Q35-14A, Q.35-16A, Q.35-17A
Classwork Exercises: Q.35-5, Q.35-7, Q.35-10, Q.35-15, Q.35-18
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