An Assignment on

Basics of Economics(EFM RB21)

Assignment Title: Implementation of Break-Even

Analysis

Submitted to:
Prof. Vishwa Ballabh

Submitted by:
SOWHAM CHATTERJEE
RB21063
BATCH :- PGCBM-39

XLRI School of Management

 Application of Break Even Analysis (C-P-V analysis)
Break Even Point: The point at which total revenue of the firm is equal to its total
cost is called the Break Even Point. At this point total profit is zero as total
revenue equals total cost. We can determine break-even level of output as
follows.

Suppose, total revenue of the firm = R, price unit of output = p and the level of
output = x. Now, we know that R = px. On the other hand total cost = C, total
fixed cost = F and per unit variable cost = b. Then the total cost function is C= F
+ bx. Now, at the break-even point total revenue is equal to total cost, (R = C).

Break-Even analysis is used to give answers to questions such as “what is the

minimum level of sales that ensure the company will not experience loss” or “how
much can sales be decreased and the company still continues to be profitable”.
Break-even analysis is the analysis of the level of sales at which a company would
make zero profit. As its name implies, this approach determines the sales needed
to break even.

Break-Even point is determined as the point where total income from sales is
equal to total expenses. In other words, it is the point that corresponds to this level
of production capacity, under which the company operates at a loss. If all the
company’s expenses were variable, break-even analysis would not be relevant.
But, in practice, total costs can be significantly affected by long-term investments
that produce fixed costs. Therefore, a company in its effort to produce gains for
its shareholders has to estimate the level of goods sold that covers both fixed and
variable costs.

Break-even analysis is based on categorizing production costs between those

which are variable and those that are fixed. The distinction between fixed costs
and variable costs can easily be made, even though in some cases, such as plant
maintenance, costs of utilities and insurance associated with the factory and
production manager’s wages need special treatment. 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.
Application of Break-Even analysis
The break-even analysis has many uses.

1) This analysis may be applied for profit planning. From this analysis we can
know the volume of profit at different output levels. It helps to determine
the minimum volume of sales required to avoid losses. It can also be used
to determine the profit maximizing level of output and it is necessary to
know the relationship among cost, volume and profit in order to forecast
future profit.

2) The break-even analysis helps the management to take different decisions.

The analysis helps to resolve the following questions:-

i. Should emphasis be given on increasing the production & sales?

What will be the effect on profit if output rises?
ii. Would an increase in price of the product be desirable even if it leads
to a fall in sales?
iii. Should efforts be made to reduce costs, rather than increasing price
or sales? If costs are to be reduced, which type of costs should be
reduced fixed or variable cost?
iv. For a multiproduct firm, which is the most profitable product &
which is the least profitable product? What will be the effect on total
profit if the product mix changed?
v. Should the firm continue production in the short run even it is
losing?
3) We can determine the required sales value in order to earn a target level of
profit. This can be obtained from this relation:-
Required sales value =

4) The CVP analysis may be used for compare the financial position of
different firms. For example, a firm with a higher margin of safety will
have a better financial position. Again, a firm with a larger angle of
incidence will be able to earn profit more quickly than a firm with smaller
angle of incidence.
5) The break-even analysis helps to determine whether an expansion of
capacity is desirable or not. When a firm expands, its fixed cost rises. With
it, the level of output and variable cost also increase. The break-even output
also increase. To maintain the current rate of profit, sales are to be raised.
So, before taking any decision on expansion of capacity, the firm will have
to examine how these variables change. All these can be known from the
CVP analysis.

6) The CVP analysis can also be utilized to know whether it is profitable to

add a new product or to drop an existing product. The firm will have to see
whether profit rises or not if a new product is produced instead of an old
product. This can be seen from the CVP analysis.

7) Most often a firm has to decide whether certain inputs should be produced
by itself or bought from outside. The CVP analysis helps to take decision
in this case also.

8) The break-even analysis can also be utilized to determine the degree of

operating leverage of the firm.
The degree of operating leverage is defined as:-

(π)
( )
Example:-

Applying Break-Even Analysis in Service Industry

Break-even analysis can be used not only for companies that sell products, but
also for companies that offer services. The following example is taken from the
services sector and shows us the calculation that the finance department of
advertising ltd. has made in order to evaluate a future project. Specifically, the
Marketing department of advertising ltd. came up with the idea of “buying”
advertising space of urban buses in town Ville. They believe that many local
companies will be willing to be advertised in urban buses by having their logos
and various advertisements placed along buses sides. Also, they believe that
annual “bus rental” can be “sold” for 1500. Municipal Bus Line, during
negotiations with advertising ltd, made the following proposal: Fixed payment of
500 for each bus of its fleet and extra payment 200 for each bus that will be used
as for advertisement by advertising’s clients. Given that the agreement will be
valid for every single local bus of municipal lines (40 buses in total) the Finance
Department calculated, as follows, the break-even point:

∗ . .
B.E.P = = = = 154 buses
. . .

Break-Even Point Graph, Municipal Bus Line Proposal

The answer in this case is 154 buses, which is the target number, the expected
volume that covers both fixed and variable rental expenses of this new project.
The management of Advertising Ltd. considered that pre-start projections and
operating realities may be different and that the company may fall below the
break-even volume. Generally, there are three ways for a company to lower its
break-even volume, two of them involve cost controls:

 Lower direct costs (controlling inventory), which will raise the gross
margin,
 exercise cost controls on fixed expense (use of capital budgeting) and
 raise prices (not easy in a price-sensitive market).

Conclusion

Break-even analysis is useful as a first step in developing financial applications,

which can be used in invoicing and budgeting. The main purpose of this analysis
is to have some idea of how much to sell, before a profit will be made. Break-
even analysis is extremely important before starting a new business because it
gives answers to crucial questions such as “how sensitive is the profit of the
business to decreases in sales or increases in costs”. This analysis can be also
extended to early stage business in order to determine how accurate the first
predictions were and monitor whether the firm is on the right path or not. Even,
mature business must take into consideration their current B.E.P. and find ways
to lower that benchmark in order to increase profits.