Definition of Break-Even Analysis:

Break-even analysis refers to ‘ascertainment of level of operations

where total revenue equals to total costs’. It is an analysis used to
determine the probable profit or loss at any level of operations.
Break-even analysis is a method of studying the relationship among
sales revenue, variable cost and fixed cost to determine the level of
operation at which all the costs are equal to its sales revenue and it
is the no profit no loss situation.

This is an important technique used in profit planning and

managerial decision making. Break-even analysis is made through
graphical charts. Break-even chart indicates approximate profit or
loss at different levels of sales volume within a limited range. The
break-even charts show fixed and variable costs and sales revenue
so that profit or loss at any given level of production or sales can be
ascertained.

Steps in Construction of Break-Even Chart:

The following steps are involved in construction of a
break-even chart:

Step 1:
Select a scale for sales (units) on horizontal axis.

Step 2:
Select a scale for costs and revenues on vertical axis.

Step 3:
Draw the fixed cost line parallel to the horizontal axis.

Step 4:
Draw the total cost line, starting from the point on the vertical axis
which represents fixed costs.

Step 5:
Draw the sales line, starting from the point of origin (zero) and
finishing at point of maximum sales.

Step 6:
The sales line will cut the total cost line at the point where the total
cost equal to total revenues.

Step 7:
The point of intersection of two lines is called ‘break-even point’ i.e.
the point of no profit no loss.

Step 8:
The lines drawn from intersection to horizontal axis and vertical
axis give the sales value and number of units produced at break-
even point.

Step 9:
The loss is shown if the production is less than the break-even point
and profit is shown if the production is more than the break-even
point.

Step 10:
The total sales minus break-even sales represent the margin of
safety.
Step 11:
The angle which the sales line makes with total cost line, while
intersecting it at breakeven point is called ‘angle of incidence’.
Break-even point helps in assessing the viability of the organization
and to take decisions in profit planning and cost control. Break-
even point is the point of zero net income i.e. the level of sales is just
equal to its costs. Costs include both fixed and variable costs.

It is used as a useful tool in financial planning to recover costs and

to maximize profits. The changes in operating condition such as,
selling price, variable cost and fixed cost will change the break-even
point. For calculation of break-even point, the costs need to be
segregated into fixed cost and variable costs.

The basic assumption in ascertainment of break-even point is that

the selling price per unit and variable cost per unit are constant and
the fixed costs, in total, are constant. Break-even point indicates the
level of operating capacity and sales to be achieved to recover all
costs. Any further activity or sales beyond break-even point will lead
to earn profit for the concern.

Formulae for Break-Even Analysis:

Assumptions and Limitations of Break-Even Analysis:

The following assumptions and limitations are important
considerations in break-even analysis:
(a) The break-even analysis requires that all costs should be
segregated into fixed and variable components. There is difficulty in
segregation of semi-variable expenses into variable and fixed
elements of costs accurately.
(b) It is assumed that all fixed costs remain constant at various
levels of activity. But in practice, it may not be fixed in the long-run.

(c) Another assumption is that variable costs are really variable and
changes in direct proportion to the volume of output. It means that
variable cost per unit of product remains constant. In practice
variable costs are not necessarily strictly variable with output.

(d) In break-even analysis, it is assumed that production units and

sales units are equal and no inventory exists in the beginning or at
the end of the period for which analysis is made. In practice there
will always be existence of inventory.

(e) There will be no change in selling price and it remains constant

at all levels of output and further assumed that there is no change in
sales mix. In the real world situation, to increase the sales, it may
necessitate to frequently change the selling prices and sales mix of
the products.

(f) It is assumed that productivity, operating efficiency, product

specifications and methods of manufacture and sale will not
undergo any change. In actual situation, the operating efficiency
and productivity depends upon the manpower, it is impractical to
assume that these factors remain constant.

(g) A break-even chart can depict the position of only one product
and fails to present various products in the sales mix in one chart
and different charts are required to be drawn for different products.

(h) Break-even analysis ignores the capital employed in business,

which is one of the important facts in determination of profitability
of the company and its products.

(i) The break-even charts assumes that total cost and total revenue
can be represented in straight lines. In practice, the function of
costs and revenue are curvilinear in nature.

 Profit-Volume Ratio:
Profit-Volume Ratio (P/V) reveals the rate of contribution per
product as a percentage of turnover. It indicates the relationship of
the contribution to sales. It helps in knowing the profitability of
business.

This ratio is calculated as:

P/V Ratio = Contribution/Sales x 100

How to Improve P.V. Ratio?

Better P.V. ratio is an index of sound financial health of company’s
product. P.V. ratio can be improved, if contribution is improved.

Contribution can be improved by taking any of the

following steps:
(a) Increase in selling price.

(b) Reduce marginal cost by efficient utilization of men, material

and machines.

(c) Concentrate on the sale of products with relatively better P.V.

ratio.

Limitations:
The following limitations are to be borne in mind while
using P.V. ratios in break-even analysis:
(a) P.V. ratio heavily leans on excess of revenues over variable costs.

(b) P.V. ratio fails to take into consideration the capital outlays
required by the additional productive capacity and the additional
fixed costs that are added.

(c) It gives only an indication of relative profitability of product and

product lines. It will not help to take a final decision.

(d) The fundamental prerequisite for comparing profitability

through P.V. ratio is the proper segregation of costs into fixed and
variable costs. Over simplification may lead to erroneous
conclusion.

(e) Higher P.V. ratio per unit of sales or per unit of production will
indicate the most profitable item only when other conditions are
constant.
Illustration 1:
ABC Ltd. has provided the following information:
Sales (@ Rs. 5 p.u.) – 20,000 units

Variable cost p.u. – Rs. 3

Fixed cost – Rs.8,000 p.a.

Calculate the p.v.ratio and the break-even sales of the company.

Solution:

Illustration 2:
You are required to calculate the break-even point from
the following information:
Selling price p.u. Rs. 20 Fixed cost p.a. Rs. 80,000

Variable cost p.u. P.s. 4 Sales for the year Rs. 2,00,000

The number of units involved coincides with expected volume of

output.

Solution:

Working notes:
(a) Selling price p.u. – Variable cost p.u. = Contribution p.u.

= Rs. 20-Rs. 4 = Rs. 16

Contribution p.u. Rs. 16

(b) P.V.ratio = Contribution p.u./Selling price p.u. x 100 =

Rs.16/Rs.20 x 100 = 80% or 0.80

At break-even sales, there is no profit no loss.

Verification

Break-even sales – Variable cost – Fixed cost = 0

(5,000 units x Rs. 20) – (5,000 units x Rs. 4) – Rs. 80,000 = 0

Rs. 1,00,000 – Rs. 20,000 – Rs. 80,000 = 0

Margin of Safety:
The margin of safety refers to sales in excess of the break-even
volume. It represents the difference between sales at a given activity
level and sales at break-even point. It is important that there should
be a reasonable margin of safety to run the operations of the
company in profitable position.

A low margin of safety usually indicates high fixed overheads so that

profits are not made until there is a high level of activity to absorb
the fixed costs. A margin of safety provides strength and stability to
a concern.

The margin of safety is an important measure, especially in times of

receding sales, to know the real position to operate without
incurring losses and to take steps to increase the margin of safety to
improve the profitability.

Margin of safety is calculated by using the following

formulae:

How to Improve Margin of Safety?

The higher the margin of safety, the better profitability of the
product/product line.

The margin of safety can be improved by adopting any of

the following steps:
(a) Keeping the break-even point at lowest level and try to maintain
actual sales at highest level.

(b) Increase in sales volume.

(c) Increase in selling price.

(d) Change in product mix increasing contribution.

(e) Lowering fixed cost.

(f) Lowering variable cost.

(g) Discontinuance of unprofitable products in sales mix.

Illustration 3:
You are given the data of XYZ Ltd. for the year ended 31st March,
2009

Sales (@ Rs. 10) – 1,00,000 units Variable cost p.u. – Rs. 6 Fixed
cost p.a. – Rs. 3,00,000

Calculate the margin of safety.

Solution:
Break-even Sales = Fixed cost/Contribution p.u. = Rs. 3,00,000/Rs.
4 = 75,000 units

Margin of Safety =

= Actual sales – Break-even sales

= 1,00,000 units – 75,000 units = 25,000 units

= 25,000 units x Rs. 10 = Rs. 2,50,000

Angle of Incidence:
The angle which sales line makes with the total cost line is known as
the ‘angle of incidence’. The larger the angle of incidence indicates
the higher the margin of profit and vice versa. It is an indicator of
profitability above the break-even point.
If the margin of safety and angle of incidence considered and
studied together will provide significant information to the
management about its profitability. A high margin of safety with
wider angle of incidence will represent the most profitable position
of the business concern and vice versa.

Relationship of BEP, Margin of Safety and Angle of

Incidence:
The relationship among Break-even point, Margin of
safety and Angle of incidence is summarized as follows:
Break-Even Level:
It is the level of production or sales where there is no profit and no
loss. At this point of sales, total cost is exactly equal to sales, so that,
there is no profit no loss. The company starts earning profit only if
actual sales are above break-even sales. A company with a lower
break-even point is considered better than a company with a higher
break-even point.

Angle of Incidence:
It is an angle formed by the intersection of total cost line and total
revenue line in a break-even chart. Larger angle of incidence is a
sign of higher profitability and a lower angle is a sign of lower
profitability.

Margin of Safety:
It is the difference between actual sales and break-even point.
Larger the margin of safety, the more sound is the position of the
business in respect of profit earning. This means that larger margin
of safety indicates larger amount of profit and vice versa.

Impact of Selling Price, Fixed Cost and Variable Cost on

BEP:
The selling price and variable cost has direct impact on the P.V.
ratio, since P.V. ratio being a function of contribution to sales.

The effects of changes in selling price, variable cost and

fixed cost on P.V. ratio are explained below:
(a) An increase in selling price increases the amount of contribution
and resulting in improvement in P.V. ratio.
(b) The decrease in selling price of a product, result in decrease in
contribution and lowering the P.V. ratio.

(c) The increase or decrease in fixed cost does not affect the P.V.
ratio, even though it may increase or decrease the total profit.

(d) The increase in variable cost per unit will reduce the
contribution and result in decrease of P.V. ratio.

(e) The decrease in variable cost per unit will result in improvement
of contribution and simultaneously, the P.V. ratio will also increase.

(f) The increase in P.V. ratio means lower break-even point and
higher margin of safety.

(g) The decrease in P.V. ratio result in increase of break-even point

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