Break Even Analysis

The break even point for a product is the point where total revenue received equals the total costs associated with the sale of the
product (TR=TC). A break even point is typically calculated in order for businesses to determine if it would be profitable to sell a
proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break-Even Analysis can
also be used to analyze the potential profitability of an expenditure in a sales-based business.
==Margin of Safety==ok. In break even analysis, margin of safety is how much output or sales level can fall before a business reaches its
break even point (BEP).
Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing
production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed"
(costs not directly related to the volume of production).
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").
In unit sales
If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, a
loss. Break-even quantity is calculated by:
Total fixed costs / (selling price - average variable costs).
Explanation - in the denominator, "price minus average variable
cost" is the variable profit per unit, or contribution margin of
each unit that is sold. This relationship is derived from the
profit equation: Profit = Revenues - Costs where
Revenues = (selling price * quantity of product) and
Costs = (average variable costs * quantity) + total fixed costs. Therefore,
Profit=(selling price*quantity)-(average variable costs*quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero,
the quantity of product at breakeven is Total fixed costs / (selling price - average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products
that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product
looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product.
An example:
• Assume we are selling a product for $2 each.
• Assume that the variable cost associated with producing and selling the product is 60 cents.
• Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no
product is produced) is $1000.
• In this example, the firm would have to sell (1000/ (2.00 - 0.60) = 715) 715 units to break even. in that case the margin of
safety value of nil and the value of B.E.P. is not profitable or not gaining loss.
Break Even = FC / SP − VC
Where, FC is Fixed Cost, SP is selling Price and VC is Variable Cost
In Capital Budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables at which the
project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a
time.
The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely
to occur.
In using Break even analysis; it is important to remember the problem associated with Sensitivity analysis as well as some extension
specific to the method:
• Variables are often interdependent, which makes examining them each individually unrealistic.
• Often the assumptions upon which the analysis is based are made by using past experience/data which may not hold in the
future.
• Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until
reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be
invalid.
• Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project
analysis.
Limitations
• Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be
for the product at these various prices.
• It assumes that fixed costs (FC) are constant
 • It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales.
• It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of
goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).
• In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the
sales mix is constant).
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, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known
as the "break-even point" and 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 costs 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:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Costs
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.