Limitations of breakeven analysis

Breakeven analysis is a useful tool for problem solving

and decision making, but some
of the limitations should be noted:
1 The breakeven analysis assumes that cost and revenue
behaviour patterns are
known and that the change in activity levels can be
represented by a straight line.
2 It may not always be feasible to split costs neatly
into variable and fixed categories.
Some costs show mixed behaviour.
3 The breakeven analysis assumes that fixed costs
remain constant over the volume
range under consideration. If that is not the case,
then the graph of total costs will
have a step in it where the fixed costs are expected to
increase.
4 Breakeven analysis, as described so far in this book,
assumes input and output
volumes are the same, so that there is no build-up of
stocks and work-in-progress.
5 Breakeven charts and simple analyses can only deal
with one product at a time.
6 It is assumed that cost behaviour depends entirely on
volume.

If the business is
operating at an activity level higher than the breakeven point, the distance between
these two points is called the margin of safety. The margin of safety indicates how
much activity has to fall from its present level before profit becomes zero.

Beyond the breakeven point

Beyond the breakeven point the fixed costs are covered and the sales of further
units are making a contribution to profit. The higher the contribution per unit, the
greater the profit from any particular level of activity.

Change in selling price

If the selling price per unit increases and costs remain constant, then the
contribution per unit will increase and the breakeven volume will be lower

Change in variable cost

The effect of a change in variable cost is very similar to the effect of a change in
selling price. If the variable cost per unit increases, then the contribution per unit will
decrease, with the result that more items will have to be sold in order to reach the
breakeven point. If it is possible to reduce variable costs, then the contribution per unit
will increase. The enterprise will reach the breakeven point at a lower level of activity
and will then be earning profits at a faster rate.

Change in fixed costs

If fixed costs increase, then more units have to be sold in order to reach the breakeven
point. Where the fixed costs of an operation are relatively high, there is a perception
of greater risk because a cutback in activity for any reason is more likely to lead to a
loss. Where an organisation has relatively low fixed costs, there may be less concern
about margins of safety because the breakeven point is correspondingly lower.
Cost behavior: is closely linked to
the concept of cost control. In the
short run, it is generally easier to
control variable costs than fixed
costs.

The High-Low Method : The is a common, three-step

approach to determining the variable and fixed components of a mixed cost. It
is based on the premise that only two data points are necessary to define a linear cost-volume
relationship. It is a relatively crude method since it uses only
the high and low data observations to predict cost behavior. The disadvantage
of this method is that if one or both data points are not representative of the
remaining data set, the estimate of variable and fixed costs may not be accurate. Its advantage is
that it can be used when only limited data are available.
The method involves three steps.

Statistical Methods : Statistical methods, such as ,

mathematically describe the relationship between costs and activities.
Because all data observations are used, the resulting linear equation is more
representative of cost behavior than either the high-low or scatter diagram
methods. Regression analysis can be performed using one or more activities to predict costs.

The Scatter Diagram Method :When there is doubt about the behavior pattern of a particular
cost, especially a mixed cost, it helps to plot past
costs and related measures of volume in a scatter diagram. A
is a chart of plotted points that helps determine whether a linear relationship
exists between a cost item and its related activity measure. It is a form of linear
approximation. If the diagram suggests a linear relationship, a cost line can be
imposed on the data by either visual means or statistical analysis.

assumptions are as follows:

1. The behavior of variable and fixed costs can be measured accurately.
2. Costs and revenues have a close linear approximation. For example, if
costs rise, revenues rise proportionately.
3. Efficiency and productivity hold steady within the relevant range of activity.
4. Cost and price variables also hold steady during the period being
planned.
5. The sales mix does not change during the period being planned.
6. Production and sales volume are roughly equal.
Margin of safety: The number of sales units or amount
of sales dollars by which actual sales can fall below
planned sales without resulting in a loss.