Before starting any manufacturing process, it is very essential for the engineer to analyze the feasibility of the entire process by knowing the availability of manpower, machines and materials.
Also before the beginning of any manufacturing work, it is necessary to consider few things like yearly productions, lot size of the goods, cost of materials, wages of labour, cost volume analysis, etc.
The cost volume profit analysis uses the break even analysis which gives the clear idea about the quantity of the manufacturing or sales at which there is neither profit nor loss.
When the production is beyond the break even point, the industry makes profit. And if the production is less than the break even point, the industry suffers loss.
What is Break Even Analysis?
Break Even Analysis is a technique used by manufacturing industries which tells you exactly how much you must manufacture or sell at the present level of cost in order to avoid making a loss.
Break-even analysis is used regularly to check the progress of manufacturing industry by comparing the sales achieved for the particular product.
What is Break Even Point?
In break even analysis, it is important to understand the term “break even point”.
Break even point is a point at which the total cost of manufacturing and the total revenue are equal.
Break even analysis is a simple and effective technique that can be used to evaluate the relationship between sales volume, product cost and revenue generated.
Why is Break Even Analysis Important?
Break even analysis is very important management tool as it helps the management to take following decisions;
- Profitability of the present product line.
- How many units need to be sold to make the production profitable?
- How long can sales be declined before the loss occurs?
- The effect of reducing the selling price or the number of sales on the profitability of the production.
- What will be the effect on profitability if the overhead expenses increase?
- How much more products should be sold at the current price point?
Now, for the calculation of Break Even Point for any manufacturing business, three main data are needed.
- Fixed expenses
- Variable expenses and
- Sales units
Before further discussion of break even analysis, let me quickly explain the concept of fixed and variable expenses.
The expenses which are “fixed” do not vary with the total number of sales. While the expenses which are “variable” do vary with the number of sales.
1). Fixed costs includes those costs which a company will incur regardless of an increase or decrease in the number of sales.
Examples of fixed expenses are overhead expenses, administrative costs, salaries, rent, office expenses as well as depreciation costs.
2). Variable costs include those costs which vary with the increase or decrease in number of sales.
For example, let’s say a manufacturing company makes paper clips by bending pieces of wire.
As you sell more paper clips, you have to buy more wire.
Here the expense for the wire varies with the sales.
In other words, if the selling of paper clips is more, then the expenses for wire will be more. And if the selling of paper clip is less, then the expenses for wire will be less.
In short, the expenses for wire is dependent on the sales of the paper clip.
Hence it is termed as a variable expenses or variable cost.
Variable costs keep on changing depending upon the sales volume.
Once the fixed cost and the variable cost is known, the break even point is calculated using the below formula.
Break Even Point Formula
The formula of break even point in terms of physical units is given as;
- Break Even Point = (Fixed Cost) / (Selling Price – Variable Cost per unit)
The formula for break even point in terms of sales volume is given as;
- Break Even Point = (Fixed Cost) / (Contribution ratio)
Where, Contribution ratio = (Sales value – Variable costs) / (Sales value)
The formula for the sales at the break even point is given as;
- Sales at Break-Even point = Fixed expenses + Variable expenses (expressed as a % of sale)
- S = F + V
S = Number of unit sales during unit period of time
F = Fixed Cost incurred for the total units manufactured
V = Variable Cost
From the above formula of “sales at break even point“, you can see that the sales at break even point is equal to the total expenses spent by industry (i.e fixed expenses + variable expenses).
So at this condition, it can be said that there will be no profit and no loss.
If the sales increase beyond this number, the company will get the profits.
How to decide whether to make or buy, using Break Even Analysis?
Assume that the cost of purchase is directly proportional to the quantity of purchase.
For this situation, the break even point graph can be given as;
Let Q be the quantity of purchase at break even point.
Now, if our required quantity is less than Q, then it is cheaper to buy.
And if our required quantity is more than Q, then it is cheaper to make.
It can also be written as;
Q = Fixed Cost / (Purchase price – Variable cost)
In this way, break even analysis theory is helpful in solving many managerial problems of an industry such as minimum quantity to be manufactured to avoid losses, which machine will be profitable for production, etc.
How Break Even Analysis helps in managerial decision making?
Break even analysis helps managerial decision making in following ways.
- Break Even Analysis can be applied to solve the industrial problems such as minimum quantity of manufacturing to avoid losses, which machine will be profitable for a particular product, etc.
- It helps in deciding the unit cost incurred for the production of the product.
- It also helps in deciding the selling price of the product.
- It informs about the percentage financial yield for a project.
- Break Even analysis also informs that industry must run at its scheduled target capacity to get the advantages of the optimal cost of production per unit.
Break Even Analysis example problem
Example: The fixed costs for the financial year 2019-20 are $ 50000. The sales for this period are of $ 200000. The variable cost per unit is $ 3.5, selling price of each product is $ 13 and the number of units involved coincides with the expected volume of output.
Construct the break-even chart and determine:
(b) How many minimum products should be sold to earn profit?
(c) Profit earned at a turnover of $ 90000.
(d) Margin of safety.
(e) Angle of incidence.
Here Fixed cost F = $ 50,000
Variable cost V = $ 3.5 per unit
Selling price S = $ 13 per unit
Total sales = $ 2.00,000
No. of products sold = Total sales/selling price of one product = $ 2,00,000/13 = 15384 units.
Now draw the break-even chart, as described below.
(1) Draw on the graph paper fixed cost line AB at $ 50000.
(2) Total Variable cost = Number of product × variable cost/product = 15384 × 3.5 = $ 53,844
(3) Variable cost varies from 0 at 0 unit sale to $ 53844 at 15384 unit sale. Thus draw the variable cost line AC above the fixed cost line, as shown in the graph.
(4) Thus total cost = fixed cost + variable cost.
(5) Sales are zero at 0 units and is $ 2, 00,000 at 15384 units sales. Thus draw the sales line OD.
Total cost line and total sales line intersect at point E, which is known as Break-even-point on the break-even chart.
(a) Break-even-point is at 5268 units or $ 68493 sales.
(b) The firm should sell more than 5268 units to receive profit
(c) Profit at sales of $ 90000 is equal to $ 21515. And units are 1655 numbers.
(d) Margin of safety It is marked at 15384 units and is equal to; Total sales - sales at Break-even-point 200000 - 68493 = 131507 Percentage = 131507 / 200000 = 65%
(e) Angle of incidence Ø = 24° (by measurement)