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Break Even Analysis Essay Sample

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Break Even Analysis Essay Sample

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”). Some Related Definitions:

Break Even Analysis:
An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Break Even Point:
An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Break Even Price:
The amount of money for which a product or service must be sold to cover the costs of manufacturing or providing it.

Fixed Cost:
A cost that remains constant, regardless of any change in a company’s activity.

Variable Cost:
A cost that changes in proportion to a change in a company’s activity or business.

Contribution Margin:
A cost accounting concept that allows a company to determine the profitability of individual products.

It is calculated as follows:

Product Revenue – Product Variable Costs Product Revenue

The phrase “contribution margin” can also refer to a per unit measure of a product’s gross operating margin, calculated simply as the product’s price minus its total variable costs.

Margin of Safety:
Margin of safety is how much output or sales level can fall before a business reaches its breakeven point.

Break Even Chart:
Chart where sales revenue, variable costs, and fixed costs are plotted on the vertical axis while volume is plotted on the horizontal axis. The break-even point is the point where the total sales revenue line intersects the total cost line.

Uses of Break Even Point:
oHelpful in deciding the minimum quantity of sales
oHelpful in the determination of tender price
oHelpful in examining effects upon organization’s profitability oHelpful in deciding about the substitution of new plants
oHelpful in sales price and quantity
oHelpful in determining marginal cost
Limitations of Break Even Point:
oBreak-even analysis is only a supply side (costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product
at these various prices. oIt assumes that fixed costs (FC) are constant

oIt assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. oIt 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. oIn multi-product companies, it assumes that the relative proportions of each product sold and produced are constant.

Problem on Break Even Analysis and Break Even Chart:

Problem – 1
Sales of Keya Company for the year 2007 were Tk. 4,00,000. Fixed expenses was Tk. 90,000 and variable expenses totaled Tk. 2,20,000. Contribution margin Tk. 180,000.

Required:
(i)Contribution Margin Ratio.
(ii)The Break-even point in Taka.
(iii)Margin of safety Sale.
(iv)Margin of safety Ratio.
(v)Profit for the year 2007.

Solution:

Contribution
(i) Contribution Margin Ratio = ——————- × 100
Sales
1,80,000
= ——————- × 100
4,00,000
= 45%

Fixed Cost
(ii) Break-even point in (Tk.) = ———————-
C/M Radio
90,000
= ———————-
45%
= Tk. 2,00,000

(iii) Margin of safety Sales = Total sale – Break-even Sales
= Tk. 4,00,000 – 2,00,000
= Tk. 2,00,000

Margin of safety sales
(iv) Margin of safety Ratio= —————————- × 100
Total Sales
Tk. 2,00,000
= ———————— × 100
Tk. 4,00,000
=50%

(v) Profit for the year= Margin of safety sales × C/M Ratio.
= Tk. 2,00,000 × 45%
= Tk. 90,000.

Problem – 2
Webb Company has used direct costing in preparing the following income statement:
Tk.
Total Sales 5,00,000
Less: Variable Cost 3,00,000
Contribution Margin 2,00,000
Less: Fixed cost 1,60,000
Profit 40,000
—————-
Here, total units = 5000
Required: Contrast a break even chart from this data and identify the break
event point on the chart.

Solution:

Here,
Total Contribution
Contribution per Unit = ———————–
Total Units
200,000 = ———————–
5,000
= Tk. 40

Contribution
(i) Contribution Margin Ratio = ——————- × 100
Sales
2,00,000
= ——————- × 100
5,00,000
= 40%

Fixed Cost
(ii) Break-even point in (Tk.) = ———————-
C/M Ratio
160,000
= ———————-
40%
= Tk. 4,00,000

Fixed Cost
(iii) Break-even point in (Tk.) = —————————
Contribution per unit
160,000
= ———————-
40
= 4,000 Units (iv) Margin of safety Sales = Total sale – Break-even Sales
= Tk. 5,00,000 – 4,00,000
= Tk. 1,00,000

Margin of safety sales
(iv) Margin of safety Ratio= —————————- × 100
Total Sales
Tk. 1,00,000
= ———————— × 100
Tk. 5,00,000
= 20%

(v) Profit for the year= Margin of safety sales × C/M Radio.
= Tk. 1,00,000 × 40%

= Tk. 40,000.

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 business (or launching a new product) 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 (the one that leads to profits) or not.

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