How To Use Break Even Point Analysis Accounting Essay

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The paper is discussion about the break even point analysis (BEA) as a tool for managing profitability of a business. Break even point is attained when the sales revenues are equal to the costs of a business. The two methods of BEA have been provided with provision of examples to explain the various aspects of the topic. The use of BEA at Apple Inc. has been discussed to show the real businesses applying the tool.

I. Introduction

Accounting for management (2010) defines break even point analysis (BEA) as the level where the profit of an organization is zero. At BEA, the sales are equal to the sum of the fixed costs and the variable costs. The total cost of an organization is composed of the fixed costs and the variable costs (Accounting for management 2010).

BEA sales = fixed cost + variable cost

The fixed costs are those costs which do not change irrespective of the quantity of commodities sold. Costs which are incurred when starting the business are fixed costs, for example, insurance, rent and computers. The business must incur such costs before it sells its first item. The variable costs recur and are absorbed by each item sold by the business. For example, when operating a tailor shop, you will buy cloths at a certain price, say $ 2 per square foot. The $2 will represent the variable cost. Other variable costs involved will be labor, other materials, and others (Richards, n.d.).

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Break even point analysis is used by the management to make decisions about the activities of the company. It provides the business with adequate information about the lowest level of operation where the business will achieve no profits. The management should avoid operating below the BEA point since this vindicates that the business is operating at a loss. Above the BEA, the business makes profits and can sustain all the costs incurred in the production of commodities (Gordon Bing, 1996).

Source: 12Manage (<http://www.12manage.com/images/picture_break_even_chart.gif>)

From the graph, the break even point is attained at a sales level of 3 units and $ 20. Below this point, the business incurs a loss as indicated on the graph. Above the BEA, the business makes a profit. The total revenue curve is above the total cost curve above the BEA point indicating that the business is making a profit. When losses are being incurred, the total revenue curve is below the total cost curve. The fixed costs are constant and do not change as the sales volume/value changes. The curves for variable costs and the fixed costs are below the total costs curve but when they are combined, they give the total costs curve. The total revenue curve and the variable costs curve begin at the zero mark indicating that there is a point where the company cannot incur variable costs or make any revenue at all. The fixed costs curve is above the origin. This suggests that the business must incur fixed costs at all times whether it is operating or not (Gordon Bing, 1996).

II. Objectives of Calculating the Break Even Point Analysis

The main objective of the break even analysis is to provide data which helps identify the minimum production level. Businesses are established to make profits. The BEA analysis indicates the sales level where the company is making profits or losses. A loss is made when the sales of the company are below the costs. This is a point below the BEA point. Profits are made when the sales level is above the BEA. At the BEA, the business is neither making a profit nor a loss (Frongello, n.d.).

III. Assumptions for Calculating the Break-Even Point

The analysis assumes that the average unit sales price is constant. There is an assumption that there are no discounts given to customers during the period. The selling process is assumed to be constant and they do not change with time. The sales forecast are believed to be accurate in estimating the price for products and any changes that may affect the prices in the market (Accounting for management 2010; Berry, 2003).

The variable costs per unit are assumed to be constant in the accounting period. The variable cost is the amount spent to buy goods for resale. In the sale of services, the variable cost is amount incurred to deliver the services (Berry, 2003).

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A condition where the fixed costs are constant is assumed to exist. Fixed costs are the expenses which must be incurred by the business even when it is not in operation. These are the basic costs which a business enterprise must incur to operate. The fixed costs do not change with changes in the sales volume. An increase or a decrease in the sales volume will not affect the fixed costs (Dennis, 1995).

A company producing a range of products combines the different prices to obtain a single price which reflects the overall price for all the products manufactured by the company. To obtain the BEA of the business is possible when using one price which provides an average for all the products of the company (Bauer & Dahlquist, 1999).

IV. Methods for Calculating the Break-Even Point

BEA is calculated using the equation method or the contribution margin method. The two methods give the same answer.

1. The Equation Method

This method is based on the contribution margin, that is, contribution margin is the difference between the sales and the variable costs (Wittwer, 2010).

Contribution margin = sales-variable costs

Therefore, at BEA, profits equal the contribution margin less the fixed costs

Profit at BEA = contribution margin-fixed costs

Or profit at BEA = [(sales-variable cost)-fixed cost]

When the equation is rearranged, the sales at BEA will be calculated as follows:

Sales at BEA = variable costs + fixed costs + profit

The definition of BEA provides that the profits made are zero at a given level of sales. Thus, the sales at BEA can be computed by evaluating the point where sales of the business equals the sum of the fixed cost, variable cost and zero profit.

Example (Accounting for management 2010):

Provided the following data, compute the BEA in sales volume and in sales value (dollar)

Unit selling price = $ 200

Unit variable cost = $ 100

Fixed costs = $ 30,000

Solution:

BEA sales volume (Q) = variable cost + fixed costs + profit

$ 200 Q = $ 100Q + $ 30,000 + $ 0

$ 100 Q = $ 30, 000

Q = $ 30,000 / $100

Q = 300 unit

Where Q is the quantity of units sold

To find the BEA sales in dollars, this can be done by multiplying the BEA sales units by the unit selling price.

300 units X $ 200 per unit = $ 60,000

2. Contribution Margin Method

This is a short cut to the calculation of the BEA using the equation method. The main concept is that the units sold provide a specific contribution margin that covers the fixed costs. Using this method, the units sold are obtained by dividing the total fixed costs by the contribution margin:

BEA sales units = fixed cost / unit contribution margin (Wittwer, 2010).

The difference between this method and the equation method is that it uses the contribution margin ratio. The equation method uses the unit contribution margin. Thus, the BEA sales in dollars equal the fixed cost / contribution margin ratio. The contribution margin method is used where a business has several product lines and wishes to calculate a single BEA for the entire business (Bauer, & Dahlquist, 1999).

BEA sales in dollars = [fixed cost / 1 â€" (variable cost / sales)] (Wittwer, 2010).

The answer will be the same when compared to the equation method, for example, using the data in the question for equation method (Accounting for management 2010).

BEA (dollars) = [$30,000 / 1 â€" (100 / 200)]

= $30,000 / 1 â€" 0.5

= $30,000 / 0.5

= $ 60,000

V. Advantages of Calculating the Break-Even Point

The BEA analysis is used for making decisions by the management. It is a tool used to indicate the minimum level of activity for the business to prevent losses in its operations. It provides a relationship between the cost, production, volume and returns. The managers can apply it to identify the changes in fixed costs, variable costs, prices for commodities and the revenues and their effect on the level of profit and the break even point. BEA analysis is most applicable in partial budgeting and capital budgeting methods of business analysis (Accounting for management 2010).

VI. Limitations for Calculating the Break-Even Point

The selling prices will always change over a given period of time. A situation where the prices are constant is an ideal situation and does not exist in the ordinary market place. Prices will be affected by inflation, bargaining power of customers, discounts offered to customers, and many other causes (Fuller, 1994). The changes in the selling prices of the products of a company will affect the break even point such that a constant value will not be obtained over a given period of time. Companies producing a range of products may find it difficult to get an average price to be used in the analysis of the BEA. A single price is required in the analysis (Frongello, n.d.).

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The variable costs changes with time and they are never constant. The costs of purchasing goods for resale will be determined by the current prices in the market. The cost of delivering services will change depending on the prevailing market conditions (Wittwer, 2010).

The fixed costs change in certain circumstances. They are not always constant. When the prices of the fixed costs change, this affects the break even point of a business. For example, the changes in the prices for electricity will affect the total costs (Guidry, Horrigan & Craycraft, 1998).

The combination of different prices of all the products of the company does not provide accurate data since different products will have different prices. The market for different products may be different and combining the prices will provide data which is misleading (Frongello, n.d.).

VII. Case Analysis

To maintain a competitive advantage in the market, a business should be able to access the BEA analysis to identify the strength of the business. To lower the break even point, the management can; lower the direct costs. This will be achieved through application of efficient technology, effective schedules to reduce costs and increase productivity of labor. The fixed costs must be put under control. The company can raise the prices of its products to increase the sales revenue (Kee, 2007).

Apple Company has been successful in the market due to the application of efficient technologies which lower the fixed and variable costs. However, due to the increasing competition in the market, the company has maintained low prices for its products. The company manufactures computer software, electronics and commercial servers. The software manufactured by the company includes Mac OS X operating system, iTunes, iLife, iWork, Aperture, Final Cut Studio, and Logic Studio. The computer hardware manufactured by the company includes iPod, iPhone, iPad and the Macintosh computers. Apple Inc was established in 1976 by Steve Jobs, Steve Wozniak and Ronald Wayne. Ronald Wayne later sold his shares to the other two partners and ceased to be a partner. During the foundation of the company, Mark Markkula provided funds and expertise. The headquarters of the company are based in Cupertino, California. (Linzmayer, 2009).

Several strategies have been adopted by the company to reduce the fixed and variable costs. The sales of the company have been increased by the use of technology in the marketing system. Apple has been able to maintain low prices for its supplies by bargaining with the suppliers of the materials used in the production. Some of the suppliers to the company are General Electric, Intel and others. The company has introduced retail stores and online stores as a strategy to increase its sales volume. The retail stores have been established in many parts of the country to make the products of the company accessible to many customers. Online stores have been used to enable many customers purchase the products through the internet. Most of the activities of the company are done above the break even point and this has created a competitive edge of the company. The major competitors of the company are Microsoft and IBM. Despite their large capital base compared to Apple, these companies have lost most of the market share to apple. To maintain a favorable BEA point, most of the costs are reduced to offer products at favorable prices. The company has maintained a favorable wage level for its employees (Linzmayer, 2009).

VIII. Conclusion

Break even point analysis is used to compute the level of sales where the profits of the business equals zero. It is a point where the total costs equals the revenues made by a business. The business neither makes a profit or a loss at the BEA point. All the costs are covered by the sales. The management of a business uses the break even analysis to identify the minimum level of activity the business can operate. The BEA analysis has several assumptions whereby the product prices, fixed costs and variable costs are assumed to be constant over the accounting period. The analysis has several limitations since the prices of products change with changes in the market conditions. The fixed costs as well as the variable costs are never constant and will change with time. Companies have applied the system of BEA in their systems to maintain a competitive edge in the market. The use of technology has been the major tool used by businesses to reduce the costs of production. Apple Inc has been successful in the market by applying technology and leadership in its activities to reduce costs of production and increase sales. This has brought about large profits to the company.