What are the Nature and Importance of break-even analysis?

(Finance, Accounting, Taxes & creative knowledge)

The nature and importance of break-even analysis   (Financial forecasts)

Break –even analysis

Break – even analysis calculates at what point the business ‘break even’: the point at which it is making neither a profit nor a loss. The break –even point for a business is therefore where total costs equal total revenues.  This point (of output) is important to a business because it is beyond this point that the business start to make a profit.

Break –even analysis uses fixed and variable costs to calculate the break –even point and to show it on a graph.

Constructing the break – even chart

To construct the chart (or graph) we need information on fixed cost, variable cost and selling price. We then plot the results on a graph that has Rs (costs and revenue) on the vertical (y) axis, and production / output (number made and sold) on the horizontal (x) axis.

For example, assume that a company is making a product. The selling price is Rs 3, fixed costs are Rs. 10000, variable costs are 50p per item, and 5000 product will be made and sold:

*Fixed cost (FC) line : the fixed cost line is plotted as a straight line that start at the rs 10000 point on the vertical axis and runs parallel to the horizontal axis (because fixed costs stay constant at Rs.10000) figure below, shows this break-even chart with the fixed cost line labelled .

*Variable cost (VC). If output is 5000, total variable costs are rs 2500 (5000*50p).

*Total cost (TC) line: total costs =fixed costs +variable costs. We plot the total cost line on the chart staring at where the fixed cost line meets the vertical axis: at this (zero) output there are no variable costs so total cost =fixed cost. At the other end of the line (the 5000 output point) the gap between total costs and fixed costs is rs.2500 (that is the total variable costs at this output).total costs at output of 5000 units are rs12500, i.e. rs 10000FC+rs 2500VC. The total cost line can now be drawn between the two output figures (zero and 5000) as shown in figure.

*Total revenue (TR) line. The TR line can be plotted. The selling price is rs 3 so the total revenue at the maximum output will be rs.15000 (rs3*5000). We can draw the TR line by A line drawn from this point down to the output axis shows that 4000 units signifies the break – even level of output. Selling over 4000 units will give a profit: the triangle below it, representing sales and output less than 4000, is the area of loss. *linking this point on the graph to the zero point where the two axes meet (because at an output of zero revenue Is also zero).

*Break-even point. The firm ‘s break-even point is where the TR and TC lines cross. A line drawn from this point down to the output axis shows that 4000 units represents the break – even level of output. Selling over 4000 units will give a profit: the triangle below it, representing sales and output under 4000, is the area of loss.

*Margin of safety. If 5000 units are sold , the margin of safety is between 5000 and the break-even point : the business knows that its sales can fall by 1000 (the margin of safety ) to 4000 before it starts to make a loss .

The profit or loss at all stages of output can be read from the chart. For example at output and sales of 4500, the TR line shows rs 13500 and the TC line reads rs.12250. the gap between these two lines-the profit , since TR is above TC- is rs.1250.