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16.0 Objectives
16.1 Introduction
16.2 Break Even Analysis
16.3 Break Even Point
16.4 Impact of Changes in Sales Price, Volume, Variable Costs and Fixed Costs
on Profits
16.5 Required Sales for Desired Profit
16.6 Sales Volume Required to Earn a Desired Profit Per Unit
16.7 Sales Required to Maintain Present Profit
16.8 Margin of Safety
16.9 Angle of Incidence
16.10 Break Even Charts
16.11 Profit Volume Graph
16.12 Assumption in Break Even Analysis
16.13 Let Us Sum Up
16.14 Key Words
16.15 Answers to Check Your Progress
16.16 Terminal Questions
16.17 Further Readings
16.0 OBJECTIVES
After studying this unit you should be able to:
l understand the concept of break even analysis, impact of change in sales
volume, price, variable cost, fixed costs on profits;
l apply cost-volume profit relationship for profit planning;
l understand the concept of margin of safety, angle of incidence, and profit
volume ratio in decision making; and
l examine the assumptions and limitations of the break even analysis
16.1 INTRODUCTION
In this unit you will learn about the concept of break-event point and finding out of
break even point through mathematical equation and graphic representation You
will be acquainted with the relationship between Cost, Volume and Profit and its
impact on planning and evaluation of business operations. You will also study the
concepts of margin of safety, angle of incidence, limiting factor and profit volume
ratio in decision making. The unit also deals with the underlying assumptions of
32 break even analysis.
Break Even Analysis
16.2 BREAK EVEN ANALYSIS
The analysis of cost behaviour is necessary for planning, control and decision making.
Analysis of cost behaviour means analysis of variability of each cost element in
relation to the level of output. Every cost follows some definite behaviour pattern. For
example total variable costs varies in direct proportion to the volume of output but per
unit variable cost remains same. Examples of such costs are direct material, direct
labour, packaging expenses, selling commission etc. These costs are called product
costs and are controllable, as they incur only when production takes place. Whereas
fixed costs remains same irrespective to the level of output but per unit fixed cost goes
on decreasing with the increasing level of out put as fixed cost scattered over a large
number of units. Examples of such expenses are rent, rates and insurance, executives’
salary, audit fees etc. These costs are also called period costs and are uncontrollable.
The mixed costs or semi-variable costs have both the elements variable and fixed.
These costs also change in the same direction in which volume of output changes but
this change is less than proportionate change in output. Examples of such costs are
power, telephone, depreciation, etc. Thus the concept of break even analysis is a
logical extension of marginal costing. It is based on the same principle of classifying
the costs into fixed and variable.
The cost behaviour play a significant role in decision making. The relationships in
volume, cost and profit shows that if volume increase by 10 per cent (say), then cost
will not increase by 10 per cent. Because only variable cost will increase and fixed
costs remain same and unit fixed cost declines. Consequently, profit will not increase
by 10 per cent but more than that and vice versa. The level of production changes
due to many reasons, such as recession or boom, competition, introduction of new
product, increase in demand, scarce raw material etc. The management wants to
know the effect of these changes on profit. The break-even analysis helps the
management in decision making in these situations.
There are two methods of calculating break even point. Mathematical method and
Graphical method.
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Cost Volume Profit 16.3.1 Mathematical Method
Analysis
The break even point through mathematical method can be found out either by
i) Equation Method, or
ii ) Contribution Margin Technique.
Equation Method
We know,
Sales – Variable costs – Fixed cost = Profit (S --- VC – FC = P)
Sales – Variable costs = Fixed costs + Profit (S --- VC = FC + P)
Sales minus variable costs is called Contribution. (S --- VC = C)
Contribution = Fixed costs + Profit (C = FC + P)
At break even point, profit is zero.
Where, SP is selling price, VC is the variable costs, F is a fixed costs and Q is the
number of units produced and sold. Look at the following illustration how the break-
even point is to be calculated:
Illustration 1
Calculate the break even point from the following information :
Selling price = Rs. 3 per unit
Variable cost = Rs. 2 per unit
Fixed cost = Rs. 90,000
Estimated sales for the period = 100,000 units or Rs. 300,000
Suppose the units to be produced and sold at break even point is Q, then
When we produce and sell 90,000 units, then total sales revenue is Rs. 2,70,000
(90,000 units ´ Rs. 3 ) and total cost is Rs. 2,70,000, (VC Rs. 2 ´ 90000
units = 1,80,000 + F C Rs. 90,000)
Contribution Margins Technique
Contribution per unit means difference between selling price and variable costs
or
Contribution per unit = Selling price per unit – Variable Cost per unit
Break even point can be expressed in terms of units to be produced and sold or in
terms of value of goods. At break even point, we know
34
Break Even Point in Units Break Even Analysis
380 Profit
ne
zo
it
360
of
Pr
340 Angle of
incidence
Total cost
Costs/sales Revenues (in ’000 rupees)
320
Break even
point
300
280
Margin of
260 Safety
240
220
140
a
re
A
ss
Lo
40
20
0
10 20 30 40 50 60 70 80 90 100 110 120 130 140
Output Variable Cost Fixed Cost Total Cost Sale Rev. Contribution
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
0 0 90,000 90,000 0 0
80,000 1,60,000 90,000 2,50,000 2,40,000 80,000
90,000 1,80,000 90,000 2,70,000 2,70,000 90,000
1,00,000 2,00,000 90,000 2,90,000 3,00,000 1,00,000
1,10,000 2,20,000 90,000 3,10,000 3,30,000 1,10,000
1,20,000 2,40,000 90,000 3,30,000 3,60,000 1,20,000
39
Cost Volume Profit Contribution Break Even Chart
Analysis Y
Sales curve
Variable costs
Contribution curve
Profit area
Fixed cost
Loss BEP
Area
O Output X
15 0 %
= = 30 times
5%
Increase in sale price leads to higher contribution resulting in lower break even
point and vice versa. A lower number of units have to be sold in order to recover
the fixed cost.
Activity: 1 Try to draw the inferences from the above table and also prepare the
similar tables for increasing and decreasing the fixed costs and variable cost and study
42 the impact on profit, break even profit, P/V ratio etc.
Break Even Analysis
16.5 REQUIRED SALES FOR DESIRED PROFIT
Break even point equation can be extended to estimate the profit and loss at different
levels of production. At break even point, profit is zero but for calculating the sales
volume required to earn a desired profit, the profit value is put as desired profit. The
following equations can be derived for this purpose.
Solution
Fixed Costs
BEP (in units) =
Contribution Per Unit
Rs. 40,000
= = 10,000 units
Rs. 4
Fixed Costs
BEP (in value) =
P/V Ratio
Total Contribution
P/V Ratio =
Total Sales
Rs. 40,000
= = 0.40
Rs. 1,00,000
Rs. 1,00,000
= = 25,000 units
Rs. 4
Sales volume required to Fixed Costs + Desired Profit
earn desired profit (in value) = P/V Ratio
Rs. 40,000 + Rs. 60,000
= = Rs. 2,50,000
0. 40
In Units
Sales Volume Required
Fixed Cost
(in units) =
SP – (VC + DP)
Where DP is desired profit per unit
In Value
Fixed Cost
Sales Volume Required =
(in value) VC + P
1 -----
Selling Price
Fixed Cost
=
(VC + Desired Percentage of Profit on Sales)
1 -----
SP
Illustration 6
The cost information computed by the cost accountant is as follows :
Sales = 1,00,000 units
Selling Price = Rs. 10 per unit
Variable cost or out of pocket-costs = Rs. 6 per unit
Fixed costs or burden = Rs. 60,000 per annum
Compute the following :
a) Break even points in units and value
b) Make a profit of Rs. 40,000
c) Make a profit of Rs. 2 per unit
d) Make a profit of 30% on sales
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Solution Break Even Analysis
Fixed Costs
BEP in value =
P/V Ratio
Rs. 60,000
= = Rs. 1,50,000
0.40
b) Sales volume required to earn a profit of Rs. 40,000
In units
Fixed Costs + Desired Profit
=
Contribution per unit
Rs. 60,000 + Rs. 40,000
= = 25,000 units
Rs. 4
In Value
Fixed Costs + Desired Profit
=
P/V Ratio
Rs. 60,000 + Rs. 40,000
= = Rs. 2,50,000
0.40
c) Sales volume required to earn a profit of Rs. 2 per unit
In Unit
Fixed Costs
=
SP – (VC + P)
60,000
= = 30,000 units
Rs. 10 – (Rs. 6+Rs. 2)
In Value
Fixed Costs
=
1 – (VC +PD)/SP
60,000
=
1 – (6+2) / 10
60,000
= = Rs. 3,00,000
2/10 45
Cost Volume Profit d) Sales volume required to earn a profit of 30% on sales
Analysis
In unit Fixed Cost
=
SP – (VC + 30% of SP)
Rs. 60,000
= = 60,000 units
Rs. 10 – (6+3)
In Value
Fixed Costs
=
1 – (VC +30% of SP) / SP
60,000
= = Rs. 6,00,000
1 – (6+3) / 10
Calculations of selling price per unit for a particular break even point.
We know
Fixed Costs
BEP Units =
Contribution Per Unit
Fixed Costs
\ Contribution per unit =
BEP Units
Selling price per unit – Variable cost per unit = Contribution per unit
\ Selling price per unit = Contribution per unit + Variable Cost per unit
Thus
Selling Price per unit Fixed Costs
= + Variable Cost
Desired BEP
Illustration 7
Given Fixed Costs = Rs. 40,000
Selling Price Per Unit = Rs. 40
Variable Cost = Rs. 30
The break-even point in this case is
BEP Units Rs. 40,000 Rs. 40,000
= =
Rs. 40 – Rs. 30 Rs. 10
= 4000 units
What should be selling price per unit, if management wants to reduce the break-even
point from 4000 units to 2500 units?
Solution
Fixed Costs
Selling price per unit = + VC
Desired B E P
Rs. 40,000
= + Rs. 30
2500 units
= 1,02,857 units
48
In the second alternative, lesser units are required to be sold as compared to the first Break Even Analysis
alternative. Contribution margin is also high in second alternative. Hence second
alternative is better in comparison to the first alternative.
Calculating new sales volume or new selling price to offset the impact of
change in variable costs and fixed costs.
When a company introduces new production plans or improve the process, then
generally variable costs and fixed costs also change. In such situation, there are two
alternatives before the management to earn the same profits either to increase the
sales volume or increase the selling price when costs increases and vice versa. The
new sales volume needed to earn the same profit, when only variable costs changes,
then new contribution is calculated by changing the variable cost and break even
equation remains same. If management wants to change the selling price and volume
remains the same, then new selling price is :
New selling price = Old selling price + (new variable cost --- old variable cost)
When fixed cost changes, then fixed costs is replaced by a new fixed cost in the
equation and new volume of sales can be computed to earn the same profit. If
management thinks that selling price be changed and volume remain the same, then
new selling price is :
To earn the same amount of profit, management should either increase the production
to 40,000 units or increase the selling price to Rs. 12 per unit
Fn + DP
=
SP-VC
Fn is the new fixed costs
Rs. 40,000 + Rs. 50,000
= = 22,500 units
Rs. 10 --- Rs. 6
b) New selling price
Fn – Fo
= SPo +
Q
SPo is old selling price, Fn is new fixed cost and Fo is old fixed cost.
Rs. 40,000 – Rs. 30,000
= 10 + = Rs. 10.50
20,000 units
To earn the same amount of profit i.e. Rs. 50,000 management should either increase
the sales volume to 22,500 units or increase the selling price to Rs. 10.50.
iii) Variable cost increase by Rs. 1 per unit and fixed cost reduces by Rs. 10,000.
Fn + DP
=
SP - Vn
(VCn – VCo )
= SPo + + Fn – Fo
Q
Rs. 20,000 – Rs. 30,000
= Rs. 10 + + Rs. 7 --- Rs. 6
20,000 units
To earn the same profit i.e. Rs. 50,000 management should either increase the sales to
23,333 units or increase the selling price to Rs. 10.50.
50
Illustration 11 Break Even Analysis
Solution
When company is producing multi products, then for computing break even
equation in terms of value should be used.
The overall P/V ratio is 0.33 (P/V Ratio ´ % sales proceeds). P/V ratio can also be
computed as per preceding illustration.
Fixed Costs
\ Overall Break Even Point =
P/V ratio
Rs. 33000
=
0.33
52 = Rs. 1,00,000
The break up of total sales at Break Even Point will be: Break Even Analysis
Sales
C
Total cost
B
Angle of incidence
Fixed cost
O X
BEP
54 Output (in units)
Angle ABC is the angle of incidence. It reflects the responsiveness or sensitivity of Break Even Analysis
profit to variation in the volume sold. The higher the angle of incidence, the greater the
responsiveness of profits to variation in the sales volume and vice versa. In subsection
16.4 of this unit, we observed that small change in sales brings wide fluctuations in
profits.
Activity 2
During boom period high angle of incidence is better and in recession period low angle
of incidence is better? Comment.
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................
........................................................................................................................................
Profit after
change in price
New Old
Sales Line Profit before
Sales Line change in price
(R s)
BEP0
BEP1 Variable cost
Fixed cost
Total cost
New M/S
Old M/S
Output (units) 55
Cost Volume Profit 16.10.2 Effect of Change in Fixed Cost on Profit
Analysis
Increase in fixed cost leads to increase in break even point, lowers the margin of
safety and no impact on angle of incidence (Parallel lines)
Sales Line
New total cost
BEP1
BEP0
(Rs.)
Variable cost
Old M/S
New M/S
X
BEP0 BEP1 Actual Sales
Output (units)
16.10.3 Effect of Change in Variable Cost
Increase in variable costs leads to higher break even point, lowers the margin of safety
and reduces the angle of incidence.
New profit
Sales Line Old profit
New variable cost
BEP0
Fixed cost
Old M/S
New M/S
X
BEP0 BEP1 Actual Sales
56 Output (units)
Activity 3 Break Even Analysis
Try to find out the relationships between change in price, fixed cost, variable costs and
volume on profit, margin of safety and profit volume ratio through the following equations:
Fixed Cost
Break Even Point (in units) =
Sale Price – Variable Cost Per Unit
Fixed Costs
Break Even Point (in value) =
P/V Ratio
Margin of Safety = Actual Sales – Sales at BEP
Sales – Variable Costs Contribution
P/V Ratio = =
Sales Sales
Y
+100,000
0 Sales volume
X
Loss area BEP
200,000
-100,000
Fixed cost
57
Cost Volume Profit Better P/V ratio is an index of sound financial health. P/V ratio can be improved by
Analysis taking following steps:
z Increase in Sale Price
z Decrease in variable costs
z Change in sales mix, i.e. producing more of an item where P/V ratio is high along
with demand or droping or decrease the production of a products whose P/V ratio
is very low as per situation.
Illustration 14
ABC Ltd., a multi product company, furnishes the following data:
Particulars Period I Period II
Sales (Rs) 45,000 50,000
Total Cost (Rs) 40,000 43,000
Assuming that there is no change in price and variable costs. Fixed expenses are
incurred equally in the two periods. Calculate the following :
i) Profit volume ratio
ii) Fixed expenses
iii) Break even point
iv) Percentage M/S to sales in Period II
v) Sales required to earn profit of Rs. 1 0 , 0 0 0
vi) Profit when sales is Rs. 8 0 , 0 0 0 .
Solution
1) All costs can be segregated in two parts i.e., fixed and variable.
3) Variable costs changes directly with production. It means variable cost per unit
remains constant.
4) Selling price per unit remains constant at all various levels of activity.
5) Technological methods and efficiency of men and machines will not be changed.
6) Production and sales are perfectly synchronized i.e., no inventory exists in the
beginning or at the end of the period.
59
Cost Volume Profit 7) Either there is only one product or if several products are being produced and sold
Analysis then sales mix remains constant.
8) Break even analysis assumes linear relationship in total costs and total revenues.
The above assumptions are also the limitations of this analysis e.g. selling price per unit
and variable cost per unit remains constant at any level of activity. The production and
sales can be increased upto the maximum plant capacity so long as contribution is
positive. This assumption is valid if it is not necessary to reduce the selling price per unit
to increase the sales.
The variables cost per unit do not have a linear relationship with level of production
because of laws of return. In economic theory, initially total cost will increase at a
decreasing rate, then at a constant rate and finally at increasing rate.
Further production and sales are not perfectly synchronized as there will be some
opening and closing inventory. Technological methods and efficiency of men and
machines keeps changing. To increase the sales, price concessions are offered to the
customers. The break even chart, therefore becomes curve-linear having the following
shape.
Y
Sale Revenue
® Total Cost
Cost/Sales Revenue
BEP2
( Rs.)
®
BEP1
0
X
Sales Volume
In curve-linear model, the optimum production level is where the total revenue exceeds
the total cost by the largest amount. There are two break-even points, one at the lower
capacity level and other at the higher capacity level. No firm would like to operate at a
lower level then BEP1 as it is loss zone and beyond BEP2 point which is again a loss
zone. The economist’s model is valid over a range of activity and it allows production,
inputs costs, selling price to vary. The accountant model is valid only for a short relevant
range of activity where only quantity varies, price and cost structure is constant.
a) Profit/volume
b) Contribution/sales
c) Profit/contribution
d) Profit/sales
17) Profit - volume ratio is improved by reducing
a) Variable cost
b) Fixed cost
c) Both of them
d) None of them
18) The price reduction policy, ______ the P/V ratio and _______ the break even
point
a) Reduces, reduces
b) Reduces, increases
c) Increases, reduces
d) Increases, increases
19) Shut down point occurs when
a) Net profit is zero
b) Sale revenue - variable cost + fixed costs
c) Losses are greater than fixed cost
d) None of the above
20) The break even point and shut down point are
a) Synonymous
b) Anonymous
c) Different
d) Can’t say
21) The sales of a firm is Rs. 3,00,000, fixed cost is Rs. 90,000, and variable costs
are Rs. 2,00,000, the break even point will occur at
a) 2,70,000 units
b) Rs. 2,70,000
c) Rs. 3,25,000
d) 3,25,000 units
22) The financial accounts of a firm reveals the position at two time periods is as
follows:
Period Sales Rs. Profit Rs.
I 2,30,000 50,000
II 3,00,000 80,000
63
Cost Volume Profit The profit volume ratio for the firm will be
Analysis
a) 3/7
b) 5/8
c) 3/8
d) 13/53
23) The fixed cost of a firm is Rs. 90,000, variable cost per unit is Rs. 2 and sale
price is Rs. 3 per unit. The break even point will occur at
a) 30,000 units
b) 50,000 units
c) 90,000 units
d) Rs. 90,000
24) The sales volume in value required to earn the target profit, the formula is
25) The contribution per unit is Rs. 2 and fixed costs are Rs. 15,000 for earning a
profit of Rs. 50,000, the company must have sales of
a) Rs. 1,30,000
b) Rs. 1,00,000
c) 32,500 units
d) Rs. 32,500
d) Can’t say
64
28) The sale at a BEP for a firm is Rs. 4,80,000 and the actual sales made by the Break Even Analysis
firm Rs. 8,00,000, the margin of safety will be
a) Rs. 12,80,000
b) Rs. 3,20,000
c) Rs. 4 , 8 0 , 0 0 0 / 8 , 0 0 , 0 0 0
d) Rs. 800,000
29) The profit of a company is Rs. 30,000 by selling 10,000 units at a price of Rs.
10 per unit. The variable cost to sale ratio is 60 per cent. Find margin of safety
level.
a) Rs. 75,000
b) Rs. 30,000
c) Rs. 1,00,000
d) Rs. 12,000
a) Rs. 20,000
b) Rs. 25,000
c) Rs. 30,000
d) Rs. 4 0 , 0 0 0
i) Contribution is the difference between the total sales and fixed cost [ ]
3 b 9 c 15 d 21 b 27 c
4 c 10 b 16 b 22 a 28 b
5 b 11 a 17 a 23 c 29 a
6 b 12 b 18 b 24 d 30 b
B) i) False ii) True iii) True iv) True v) False vi) False vii) True viii) True
7) What are various ways to improve the margin of safety and P/V ratio?
8) ‘A 10 per cent increase in production and sales leads to more than 10 percent
increase in profit’ Explain
9) ABC Ltd. manufactures and sells four type of products under the brand names
of P, Q, R and S. The sale mix in value comprises of 34%, 40%, 16% and 10%
of P,Q, R and S respectively. The total budgeted sales (100%) are Rs. 60,000 per
month. Operating costs are:
P 60%
Q 65%
R 70%
S 40%
Fixed costs is Rs. 15,000 per month. Calculate the break even point for the
products on an overall basis. (Ans BEP Rs. 39062.50)
10) Explain from the following data, how the reduction in selling price would affect
the break even point and margin of safety.
Selling price per unit Rs. 20
Variable costs Material Rs. 6
Labour Rs. 4
Variable overheads Rs. 2
Fixed overheads is Rs. 8000. Full capacity of the plant is 5000 units. Reduced
selling price is Rs. 16 per unit.
[Ans. BEP increase by 1000 units and M/S decrease by Rs. 32000]
11) The sales manager of a company found that with fixed cost Rs. 50,000, sales
are increased from Rs. 30,000 to Rs. 4,00,000 and profit increased by Rs.
40,000. Compute the profit when sales is Rs. 5,00,000.
[Ans. Rs. 1 , 5 0 , 0 0 0 ]
12) ABC Ltd., has a margin of safety 37.5% with an overall contribution sale ratio
of 40%. The fixed cost is Rs. 5 lakhs.
Calculate the following:
i) Break even point
ii) Total Sales
iii) Total variables costs
iv) Profit
[Ans. (i) Rs. 12,50,000 (ii) Rs. 20,00,000 (iii) Rs. 12,00,000
(iv) Rs. 3,00,000]
13) The P/V ratio of a concern is 50% and margin of safety is 40%. Calculate the
net profit of the sales is Rs. 1,00,000.
[Ans. Profit Rs. 20,000] 67
Cost Volume Profit 14) X Ltd has earned a contribution of Rs. 2,00,000 and net profit of Rs. 1,50,000
Analysis on sales of Rs. 8,00,000. What is the break even point and margin of safety.
[Ans. Rs. 2 , 0 0 , 0 0 0 M/S is Rs. 6,00,000]
15) From the following cost information:
2001 2002
Sales (Rs) 1,50,000 2,00,000
Profit (Rs.) 30,000 50,000
Calculate:
i) P/ V ratio
ii) Break even point
iii) Sales required to earn a profit of Rs. 80,000
iv) Profit when sales is Rs. 2,50,000
[Ans. (i) 0.40) (ii) Rs. 75,000 (iii) Rs. 2,75,000 (iv) Rs. 70,000 ]
Note : These questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University.
These are for your practice only.
68