BREAK EVEN ANALYSIS

A great deal of importance is attached to cost-volume-profit relationship, which is

otherwise known as Break Even Analysis, in profit planning and appraisal of a project.
Break even analysis indicates the level of activity at which a unit neither earns profit
nor incurs loss. In a broader sense it refers to a system of analysis that can be used to
determine the probable profit at different levels of production.

ASSUMPTIONS:

Important assumptions underlying this analysis are:

1. The behaviour of costs is predictable. Costs can be divided into fixed and variable
costs and, variable costs are constant per unit of output.
2. Selling price per unit remain constant.
3. Sales mix of multi product firms remain constant.
4. It also assumes that the volume of output is equal to the volume of sales or the
variation in opening and closing inventories are insignificant.

CLASSIFICATION OF COSTS:

The cost of production can be broadly divided into fixed, variable and semi-variable
costs.

Fixed cost is the cost that has to be incurred by a unit irrespective of the volume of
production. It will not change with the change in the level of production.

Variable cost vary directly in relation to change in the level of production. It assumes
that the variable cost remains fixed per unit at any level of production.

Some of the items of cost neither remain fixed nor change in the same proportion in
which the level of production changes. These items are known as semi-variable costs.
Banker should follow a uniform policy for each industry in dividing these costs into
fixed and variable, so that a meaningful comparison can be made among the break
even points of several units in the same industry.

CONTRIBUTION

It is the difference between sales and variable cost. It is the amount left over after
recovering variable cost from sales. Contribution helps the unit to recover fixed cost.
CALCULATION OF BREAK EVEN POINT (BEP)

Break Even Point is that level of production where the total cost equals total revenue.
Break even point can be calculated basing on the figures of balance sheets to study the
past record and basing on the future projections submitted by the unit to study the
future. It is usually calculated on the basis of figures when the unit is likely to achieve
the normal level of production. It can be expressed in terms of volume of production or
percentage of installed capacity or amount of sales.

(1) BEP (in terms of volume of sales) =

Fixed cost
------------ X Estimated volume of sales
Contribution

(2) BEP (as a percentage of installed capacity) =

Fixed cost
------------------- X Estimated capacity utilisation
Contribution

(3) BEP (in terms of amount of sales) =

Fixed cost
----------------- X Estimated sales
Contribution

Thus the important factors involved in calculations of BEP are sales, fixed cost and
variable cost.

CASH BREAK EVEN:

It is calculated basing on the cash flows. Cost items not involving cash outflow will be
excluded from fixed cost whereas non cost item involving cash flow will be added to
the fixed cost. It can be calculated as per the above mentioned formulae without taking
depreciation and development rebate reserve as part of fixed cost. Cash break even
helps the banker in fixing the repayment schedule.

Fixed cost - Depreciation & Dev. rebate reserve

Cash BEP = ----------------------------------------------------------------
Contribution per unit.
INCOME BREAK EVEN:

It refers to the level of production, where the investor will be able to get the expected
dividend. Usually a merchant banker acting as underwriter calculates the income break
even to know the level of production where he can get the required dividend in case of
devolvement.

Fixed cost + earning required for the expected dividend

Income BEP = --------------------------------------------------------------
Contribution per unit.

MARGIN OF SAFETY:

Margin of safety refers to the difference between the actual volume of sales and the
break-even volume of sales. It can also be calculated in terms of capacity utilisation to
know the margin of safety in the capacity. Similarly margin of safety in amount of sales
can also be computed. Margin of safety indicates the magnitude by which the planned
activity level can fall before a loss is experienced. The higher the margin of safety, the
greater the protection against the risk of downside variation in sales.

BANKER AND BREAK EVEN :

Break-even analysis is one of the important tool in the hands of a banker or financial
institution in appraising the financial viability of a project. Banker can calculate the
profitability position of the unit and margin of safety available at various levels of
production and capacity utilisation. Break-even point should be low for units likely to
face difficulties in achieving full capacity utilisation and it can be high for units which
are likely to face difficulties in supply of raw materials, power, marketing etc.
Normally an entrepreneur prefers to close the unit when he is unable to recover even
the variable cost. i.e., if the contribution is negative. While considering proposals for
rehabilitations of sick units, Banker should ensure that the contribution is positive and
the unit is likely to achieve the break-even point within a reasonable period. Thus the
break-even analysis comes in handy for the banker in taking suitable lending decisions.

BREAK EVEN AND SENSITIVITY ANALYSIS:

As the break even analysis is based on projections, it is advisable to calculate the

probable break even point by assuming increase/decrease in sale price or variable cost
or fixed cost. Banker can find out the sensitivity of BEP to the probable changes in key
factors. Thus the banker assess the impact of possible variations in key factors viz., sale
price, variable cost, fixed cost on the Break even point, Margin of safety etc.,
LIMITATIONS:

Entire analysis is based on certain assumptions, hence the Break-even Analysis suffers
from some limitations.

1. Many items of cost cannot be classified as fixed or variable costs.

2. In case of multi product firms, the assumptions of constant mix and a single unit of
production are not practicable. Cost of allocation becomes very difficult.
3 Though the entire focus of analysis is on future basing on the projections, it ignores
the time value of money.
4. The per unit variable cost and unit sale price do not remain constant because of the
economies of scale and competition in the market.

CONCLUSION:

To overcome some of these limitations, costs and revenues can be expressed in present
value terms. In spite of these limitations Break-even analysis is still a useful tool in the
hands of banker and he can supplement this analysis with other tools of analysis while
taking lending decisions.