Break-even Analysis

The Meaning of Break-even Analysis:

Break-even analysis seeks to investigate the interrelationships among a firm’s sales revenue or total
turnover, cost, and profits as they relate to alternate levels of output. A profit-maximizing firm’s
initial objective is to cover all costs, and thus to reach the break-even point, and make net profit
thereafter. The break-even point refers to the level of output at which total revenue equals total
cost.

Therefore, the primary objective of using break-even charts as an analytical device is to study the
effects of changes in output and sales on total revenue, total cost, and ultimately on total profit.
Break-even analysis is a very generalized approach for dealing with a wide variety of questions
associated with profit planning and forecasting.

Break-even Chart:

Break-Even charts are being used in recent years by the managerial economists, company executives
and government agencies in order to find out the break-even point. In the break-even charts, the
concepts like total fixed cost, total variable cost, and the total cost and total revenue are shown
separately. The break even chart shows the extent of profit or loss to the firm at different levels of
activity. The following Figure illustrates the typical break-even chart.

In this diagram output is shown on the horizontal axis and costs and revenue on vertical axis. Total
revenue (TR) curve is shown as linear, as it is assumed that the price is constant, irrespective of the
output. This assumption is appropriate only if the firm is operating under perfectly competitive
conditions. Linearity of the total cost (TC) curve results from the assumption of constant variable
cost.

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It should also be noted that the TR curve is drawn as a straight line through the origin (i.e., every unit
of the output contributes a constant amount to total revenue), while the TC curve is a straight line
originating from the vertical axis because total cost comprises constant / fixed cost plus variable cost
which rise linearly. In this Figure, the point at which TR equals TC, point QA, is the break-even
level of output. The area between TR curve and TC curves depicts the profit function . It
follows that the firm incurs loss, when it produces output below QA level. QA level of output is at
break-even point of no profit, no loss. When it expands further output, it makes profit.

As seen above, when total revenue and total cost curves are linear, both TR and TC, and hence the
total profit are monotonically increasing functions of output. Under such a situation, the profit
maximizing or sales maximizing output is thus indeterminate. Linearity in the case of the total cost
curve implies that the firm can expand output without changing its variable cost per unit very much.
For a relatively narrow output range, this is no doubt a reasonable assumption. Moreover, we make
this linearity assumption to make our analysis simple, and thus to provide management with general
profit guidelines, not to suggest exact answers to certain problems.

In a situation of non-linear revenue and cost curves, neither TR nor the profit function is a
monotonically increasing function and thus the price-output determination under varying objectives
is of great significance. Following Figure presents the most common graphical representation of
break-even analysis. The horizontal axis measures the rate of output, and revenues and costs,
measured in rupees, are shown on the vertical axis. Figure combines an inverted U-shaped total
revenue (TR) curve and the familiar S-shaped short run total cost curve (TC).

The curvilinear shape of the total revenue curve follows from the assumption that the firm faces a
downward-sloping demand curve and must reduce its price to be able to sell more. The law of
diminishing returns accounts for the curvilinear shape of the total cost curve.

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The vertical distance between TR and TC measures the profit or loss associated with any specific
level of output. To the left of Qa and to the right of Qb total costs exceed total revenues, and there
are losses. So there are two break-even points. Between these two points, profits are positive
because TR exceeds TC. The point at which profits are maximized (that is, the point at which the
vertical distance between TR and TC is the largest) is shown as Qc.
The break-even point is the point where total revenue = total cost, or price per unit = cost per unit.
In Figure the firm breaks even at two different points B and B’. At both the points there is neither
profit nor loss.

ВЕР in terms of Physical Units:

Viewing in terms of per unit cost and revenue, the break-even point is located at that level of output
at which the price or average revenue is equal to the average cost. Thus, the selling price should
cover the average variable cost in full as well as a part of the fixed cost. The price of the excess other
(AVC) is regarded as contribution margin per unit, which contributes towards the fixed cost. Thus,
the BEP is spotted at a point where a sufficient number of units of output produced so that its total
contribution margin becomes equal to the total fixed cost. Hence, we may give the formula as under:

BEP = TFC/P – AVC

Where,

BEP = break-even point

TFC = total fixed cost

P = price

AVC = average variable cost

(P – AVC measures the contribution margin per unit)

Example: If the price = Rs. 4 per unit, TFC = 150, AVC = Rs. 3 per unit then calculate BEP.

BEP = TFC/P – AVC

BEP = 150/4-3 = 150

At the level of output 150 units, the total revenue is equal to the total cost. At this level, the
firm is working at a point where there is no profit or loss.

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The break-even analysis can be used for the following purposes:
(i) Safety Margin:
The break-even chart helps the management to know at a glance the profits generated
at the various levels of sales. The safety margin refers to the extent to which the firm
can afford a decline before it starts incurring losses.

The formula to determine the sales safety margin is:

Safety Margin= (Sales – BEP)/ Sales x 100

From the numerical example at the level of 250 units of output and sales, the firm is
earning profit, the safety margin can be found out by applying the formula

Safety Margin = 250- 150 / 250 x 100 =40%

This means that the firm which is now selling 250 units of the product can afford to
decline sales upto 40 per cent. The margin of safety may be negative as well, if the firm
is incurring any loss. In that case, the percentage tells the extent of sales that should
be increased in order to reach the point where there will be no loss.

(ii) Target Profit:

The break-even analysis can be utilized for the purpose of calculating the volume of
sales necessary to achieve a target profit.

When a firm has some target profit, this analysis will help in finding out the extent of
increase in sales by using the following formula:
Target Sales Volume = Fixed Cost + Target Profit / Contribution Margin per unit

By way of illustration, we can take Table 1 given above. Suppose the firm fixes the
profit as Rs. 100, then the volume of output and sales should be 250 units. Only at this
level, it gets a profit of Rs. 100. By using the formula, the same result will be obtained.

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