Break-Even Analysis – Definition, Methods, Assumptions & Limitations
A break-even analysis is a financial tool that helps an organization or firm to determine the stage at which the company, or a new service or a product, will be profitable. In other words, it is a financial calculation for determining the number of products or services a company should sell or provide to cover its costs (particularly fixed costs).
What is Break-Even Analysis?
The break-even analysis represents the break-even point. Break-even point is the point at which a producer neither earns nor bears any loss i.e. the total revenue and total cost becomes equal to each other at the break-even point.
Every firm takes the decision of production quantity only after considering the break-even point because the production above this point provides profits to the firm and a firm and production below this point brings losses to the firm. Thus, normal profits are received by the firm at the break-even point.
What are the Assumptions of Break-Even Analysis
Assumptions: There are the following assumptions of the break-even analysis:
- All the components of the costs are divided into fixed and variable categories.
- The variable costs change at a fixed rate but the total variable cost changes proportionately with a change in the quantity of production.
- The fixed cost remains constant. These have to be paid even at zero production.
- The price of the product of the firm remains constant.
- The quantity of production is the only factor that affects the costs.
- Proper coordination is maintained between production and sale.
What are the Methods of Break-Even Analysis?
There are three methods to calculate Break-Even analysis. They are as follow:-
- Graphical Method
- Equational Method
- Contribution Analysis Method
1. Graphical Method of Break-Even Analysis
The graphical method shows a linear break-even analysis. When the price of a product remains the same, the organization expands its production, thus, total revenue is linear to the output. Let us learn this method through Figure-17:
As shown in Figure-17, TFC is equal to FE, which is a fixed cost line. The vertical distance between TC and TFC line equals TVC. As the quantity of output increases, the vertical distance between TC and TFC increases. This implies that TVC increases with change in TC and TFC.
Until Qb of the quantity is produced, the total cost exceeds the total revenue, which implies that an organization will suffer losses if it produces less than Qb. At Qb output level, total revenue equals total cost. At this point, an organization never makes a profit or loss implying that it is a break-even point. Thus, Qb is a break-even level of output. Producing more than Qb will be profitable for organizations as TR is greater than TC.
2. Equational Method of Break-Even Analysis
The equational method helps in the decision-making problems of the organization. We know that profit is equal to the difference between total revenue and total cost.
π = TR – TC
TR = P*Q
TC = TVC + TFC
TC = AVC*Q + TFC (TVC is the variable cost per unit multiplied by the output produced and sold)
Let Qb be the break-even quantity at which TR = TC.
TR = TC
P.Qb = TFC + AVC. Qb
P.Qb – AVC.Qb = TFC
(P – AVC)Qb = TFC
Qb = TFC/ (P-AVC)
Thus, from the above equation, it can be said that the break-even quantity of output is determined by TFC, price and variable cost per unit of output.
3. Contribution Analysis Method of Break-Even Analysis
The contribution analysis method of Break-Even Analysis refers to the analysis of incremental or additional revenue and costs of a business. Contribution is the difference between total revenue and variable costs. Let us discuss this through Figure-18:
Fixed costs are an addition to variable costs. Thus, the TC line is parallel to the variable costs line. In Figure-18, OQ is the break-even point. TC minus VC equals FC. Below OQ, the contribution is less than the fixed cost whereas, beyond OQ, the contribution exceeds faxed cost. The shaded portion between TR and VC is the contribution.
Profit Volume (PV) Ratio:
The profit volume (PV) ratio refers to another method to find the break-even point. The formula for profit volume ratio is:
PV Ratio = (S-V)/S* 100
S = Selling price
V = Variable costs
What are the Limitations of Break-Even Analysis?
Following are the limitations of Break-Even Analysis:-
Limitations of Break-Even Analysis
1. Suitable for Short-Term Only: Break-even analysis does not help in the long term because this analysis is based on such assumptions which are useful for the short term but are not possible in the long term period.
2. Division of Costs: In break-even analysis, there is a division of total cost into fixed and variable costs. Fixed cost remains unchanged and variable cost goes on changing due to changes in production but this division is not correct because none of the costs is completely fixed and none of the cost is completely variable.
3. Maximum & Optimum Production: Break-even analysis is based on the assumption that production should be maximum for maximum profits but in actual practice, decisions regarding optimum production are necessary instead of maximum production.
4. Based on Perfect Competition: This analysis assumes that a firm can sell any quantity of production at a single price. Thus, it is based on assumption that there is perfect competition but in actual practice, it is not possible.
5. Change in Ratio of Sales Mix: Break-even analysis is based on the assumption that there is no change in sales mix but a change in market performance also leads to a change in the sales-mix ratio.
6. Ignorance of Invested Capital: Capital investment is an important component. Break-even analysis suffers from ignorance of capital i.e. invested capital is ignored.
7. Not Suitable in Changing Conditions: Break-even analysis is not suitable for the changes in cost and sales price that occurred as a result of the changes in business conditions.
Also Read:
