Break Even Analysis

Introduction

Break-even analysis is a technique far and wide used by production management and
management accountants. It is based on categorizing production costs between those which are
"variable" that means, costs that change when the production output changes and those that are
"fixed" that means, costs not directly related to the volume of production.

A break-even analysis is the most important part of any good business plan. It can also be helpful
even before you decide to put in writing a business plan, when you are trying to figure out if an
idea is worth pursuing. Long after your company is positive and running, it can remain helpful as
a way to figure out the best pricing structure for your products.

It seems to be a bit complicated, but it is not. Basically, a break-even analysis lets you know how
many units of possessions, say, how many sandwiches, or mobile phones, or hours of consulting
service, you must sell in order to cover your costs.

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").

Break even analysis is a calculation of the sales volume which is given in units required to just
wrap costs. A lower sales volume would not be making money and a higher volume would be
money-spinning. Break-even analysis focuses on the relationship between fixed cost, variable
cost also known as cost per unit, and selling price also known as selling price per unit.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income or sales or revenue with the same
variation in activity. The point at which neither profit nor loss is achieved is known as the
"break-even point".

Break Even Point

It is the sales volume which is usually expressed as units sold, at which the company breaks
even. Profits are 0 at the break-even point. The break-even point is calculated by the following
formula:

Break Even Point = Fixed Costs / (selling price-variable costs).

Time Period

 The fixed costs are summarized for a specific time period.

 Per unit variable cost is not dependant on a specific period of time.
  Per unit selling price is not dependant on a specific period of time.
 The Break-Even Point is expressed as the number of units, over a particular time period
that must be sold to obtain a Net Profit of 0. The time period the units must be sold is
always the same as the time period of the fixed costs.

Characteristically the time period is monthly; however it could be yearly or even hourly. For
example, a farmer seeking the break even on an annual corn crop would choose a yearly time
period. The farmer would add up the fixed costs for the whole year and the break even sales
volume would be expressed as a yearly sales volume.

Break-even point is the number of units that must be sold in order to produce a profit of zero, but
will recover all associated costs. In other words, the break-even point is the point at which your
product stops costing you money to produce and sell, and starts to generate a profit for your
company.

Graphic Method of Break-Even Analysis

The graphic method of analysis given below helps you in understanding the concept of the
break-even point. On the other hand, the break-even point is found faster and more accurately
with the following formula:

Q = FC / (UP - VC)
where:

Q = Break-even Point, i.e., Units of production (Q),

FC = Fixed Costs,

VC = Variable Costs per Unit

UP = Unit Price

Therefore, Break-Even Point Q = Fixed Cost / (Unit Price - Variable Unit Cost)

This method is further divided into two parts:

1. Linear Break-Even Analysis:

It has been pointed out that the most important deficiency of these descriptions is their
disappointment to reveal and demonstrate in what state of affairs linear break-even analysis
is appropriate for a business and in what state of affairs it is inappropriate. It suggests that
such analysis cannot be applied to perfectly competitive firms. On the other hand, in special
circumstances, it might be appropriate to a purely competitive firm. It is highly significant for
businesses operating in oligopolistic conditions where the famous kinked demand curve
applies. In addition to this, it is applicable if imperfectly competitive firms follow fixed price
rules. On the other hand, if imperfect competitive firms, such as monopolists, agree to
 flexible pricing, for example, prices to clear no matter what quantity of product they have
supplied to the market, the linearity supposition involved in this type of break-even analysis
will, as a rule, be dishonored. This is so because the total revenue of the firm will be a non-
linear function of the quantity of the product supplied by the firm to the market. All the same,
because fixed price behaviour by businesses may be common, as well as constant average
variable costs of production over a considerable range of output, linear break-even analyses
has a considerable range of application to business

The Linear Break-even point is represented on the chart below by the intersection of the two
lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.

Fixed Costs

Fixed Cost is a cost that does not change when production or sales levels do change, such as rent,
property tax, insurance, or interest expense. The fixed costs are summarized for a specific time
period (generally one month). These 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:

1. Rent and rates

2. Depreciation
3. Research and development
4. Marketing costs (non- revenue related)
5. Administration costs

Variable Costs

Variable costs are costs directly related to production units. The variable cost times the number
of units sold will equal the Total Variable Cost. Total Variable costs plus fixed costs make up the
total cost of production. 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.

Selling Price (per unit price)

Selling price is the price that a unit is sold for. Sales Tax is not included in the selling price and
sales tax paid is not included as a cost. The Selling Price times the number of units sold equals
the Total Sales.
 2. Non-Linear Break-even analysis:

The graph for the analysis of Break-even point in case of Non-Linear TR and TC curves is given
below:
In the market forms of monopoly and imperfect competition such as monopolistic competition
and oligopoly revenue output relationship is non-linear. In such market forms, Total Revenue
i.e., TR curve increases at a diminishing rate. On the contrary, short run Total Cost i.e., TC curve
first rises at a diminishing rate and then it starts rising at an increasing rate. In the graph TR
represents Total Revenue Curve. This curve is increasing at a diminishing rate. The reason for
this is that for a firm working under monopoly or imperfect competition, price of its product falls
as it sells more and Marginal Revenue i.e., MR is less that price. However, it is seen that TC
starts from point F which lies above the origin. It means OF is fixed cost FC which the firm has
to incur even if it stops production in the short run, for example, bills, taxes, etc., such costs goes
on even if the production stops. Thus, total short run cost curve increases at a decreasing rate and
then after a point it increases at an increasing rate. For this reason, we see, that the TC curve is
approximately ‘U’ shaped. Total profit can be measured as the vertical distance between TR and
TC.

Now, equal to the level of output OQB, TC lies above TR curve showing that as the firm raises
its output in the initial stages TC is greater than TR and the firm is suffering from loss. When it
produces OQB level of output, TR = TC.

Consequently, we get Break-even point, which means no profit no loss point.

When the firm increases its output beyond OQB, TR becomes larger than TC and profits begin to
accrue to the firm. Here, we see that the profits are increasing as the firm increases production to
output OQP, since the distance between TR and TC is expanding. At OQP level of output, the
distance between TR and TC is the largest and therefore maximum will be the profit. If the firm
expands output beyond QP, the gap between TR and TC curves goes on narrowing down and
therefore, the total profits will turn down. Consequently, at QP, TR exceeds TC by the largest
amount profit of the firm is maximum.

At the output level QX, TR=TC at K. Consequently, K is the upper break-even point. This point
K is not of much significance as it lies beyond firm’s profit maximizing level and may actually
lie beyond the capacity of the firm to produce. It is the first break-even point or QB at which TR
just covers TC so that its economic profit is zero.

In the lower panel of the graph, the profit curve has been drawn which measures the distance
between TR and TC. Profit curve lies below the X-axis which is equal to the output level QB,
showing loss if it produces less than QB. At QB, profit is zero because here TR covers TC of
production. Therefore, QB = Break-even point. Beyond QB, profit curve is rising until it reaches
at its maximum point corresponding to the level of output QP. Beyond QP, profit curve slopes
downward indicating that profit is declining. Thus, at QP, the firm maximizes its profit. At a
higher output level QX, net profits are again zero indicating upper break-even point.

Algebraic method of Break-even analysis

Let us assume that:

P is the price per unit of commodity sold.
Q is the quantity produced and sold

We know that
TFC = Total Fixed Cost
AVC = Average Variable Cost
Π = Profit
Profit = TR-TC
TR = P x Q = PQ ……………1
TC = TVC + TFC
TC = AVC x Q + TFC ……… 2

Break-even quantity of output produced and sold occurs at the level at which TR = TC.

Let QB indicates the break-even quantity.

Therefore, from 1 and 2, we get-

TR = TC

P x QB = TFC + AVC x QB

P x QB - AVC x QB = TFC

(P – AVC) x QB = TFC

QB = TFC/ (P – AVC) ………….3

Equation 3 clarifies that break-even quantity of output produced and sold is determined by TFC,
P and AVC. Change in any of these variables will cause a change in the break-even quantity. The
denominator in the above equation is the profit contribution per unit.