The Importance of understanding break even analysis

First of all, production managers and management accountants need to have a clear understanding of break-even analysis. This analysis is used as a general guideline for business decision making and is important for a number of reasons, including the ability to forecast the future cost and revenues and determine whether the business is making profit or loss, and also be able to develop a pricing strategy. The break-even analysis is based on marginal costing.

2008. Business Basics. 3rd edn. Essex: BPP publishing.

The total cost of manufacturing or producing products or services is divided into two main parts = fixed costs and variable costs. Fixed costs are not directly related to the volume of production and should remain broadly constant while variable costs vary directly with the production volume and change directly when the production volume changes. [WWW]. http://journal .au.edu/au-techno/2007/JUL07/auJourna/Tech_article.09.pdf (20 November 2008)

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The Break-even point (BEP) is the point at which income and expenditure are equal, and so neither a profit nor a loss is made. When calculating the break even point the total fixed costs are divided by the contribution per unit. The contribution is the difference between the sales revenues and the marginal cost of sales (variable costs).

2008. Business Basics. 3rd edn. Essex: BPP publishing.

Fixed Costs (FC) = Fixed production overheads + Fixed administration overheads + fixed distribution overheads

FC = 200000 + 180000 + 120000 = £500000

Variable costs (VC) = Direct materials + Direct wages + Variable production overheads

VC = 350000 +50000 + 200000 = £600000

VC per 1 unit = 600000 = £12

50000

SR =1000000 = £20

50000

Contribution = Sales revenue (SR) – Variable costs (VC)

Contribution = £20 – £12 = £8

Break even point (BEP) = Fixed costs (FC)

Contribution

BEP = 500000 = 62500 units

8

Margin of safety (%) = 50000 – 62500 100 = -25%

50000

The business is left with 25% of their sales.

Taking the role of the management accountant evaluate each of the four alternatives.

Pay Salespeople a 10 % commission, in anticipation of them selling more and the business reaching the break-even point.

FC = £500000

VC = £12 + £2 (10% commission of SR) = £14

SR = £20

Cont = £20 – £14 = £6

BEP = 500000 = 83334 units

6

The original sales = 50000 units

83334 – 50000= 33334 units

33334 100 = 66.7%

50000

By choosing this option sales production and sales would need to increase by 33334 units. This means that the business needs to sell 66.7% of products more than were the original sales to meet the break-even point. The business should consider that if they increase the production the additional warehouse may be needed so the stepped fixed costs will occur.

This idea may be considered as an unrealistic. Especially now, the economic crunch is affecting every kind of business and the companies need to be aware of what strategy are they going to use in order to increase their sales. The demand for products is decreasing because people are aware of this economic situation. They are loosing their confidence to buy products. They prefer to buy only necessities. And also the business needs to be aware of what the competitors will do and how they will undergo the present situation.

The management accountant should investigate some unpredictable situations.

How does the business know that by paying sales people a 10% commission, the business will reach break-even point? Is there a guarantee that the business will sell more?

How can we predict that the demand for the products will increase?

Reduce the selling price by 10% in anticipation of increasing sales by 30%.

Expected sales = 50000 + 30% (15000) = 65000 units

FC = £500000

VC = £12

SR = £20 – 20/10 = £18

Contribution = £18 – £12 = £6

BEP = 500000 = 83334 units

6

Profit/Loss = (65000 x 6) – 500000 = £110000 loss

Margin of safety (in units) = 65000 – 83334 = (18334) units

Margin of safety (%) = (Expected sales – breakeven sales) 100

Expected sales

Margin of safety (%) = (65000 – 83334) 100 = – 18334 100

65000 65000

Margin of safety (%) = -0.2821 100 = (28.21 %)

By reducing the selling price by 10% the sale should increase by 30%.

The break-even analysis presents that even if we sell 15000 units more the business would be left with 18334 units which represents 28.21 % of the production. Reducing the selling price by 10% may be a good pricing strategy that may increase customers’ demand for the product but even if we sell the expecting amount of units there will be a loss of £110000, and not just that a new warehouse may be needed because of the increased sales. The stepped fixed costs occur.

The management accountant needs to look for external factors which are affecting the demand for the product.

Will this pricing strategy lead customers to buy more products?

What the competitors will do? Will they decrease the selling price or will they invest money in improvements?

Increase direct wage rates from £4 to £5 per hour as part of a productivity/pay deal. It is hoped that this will increase production and sales by 20%, but advertising costs would increase by £50000.

Expected sales = 50000 + (20%) = 60000

Direct wages = £200000 : £4 = 50000 hours

New direct wages = £5 Ã- 50000 = £250000

FC = 250000 + 180000 +120000 = £550000

VC = (350000 + 250000 + 50000) = £13

50000

SR = £20

Contribution = £20 – £13 = £7

BEP = 550000 = 78572 units

7

Profit/Loss = (60000 x 7) – 550000 = £130000 loss

Margin of safety (in units) = 60000 – 78572 = (18572) units

Margin of safety (%) = (78572 – 60000) = 18572 x 100 = 31%

60000 60000

Increase of direct wages is a good motivation strategy which may increase the production by 20%. However this is not enough to cover the additional increase of wages and advertising costs. This scenario is clearly not a practicable option because the business will be left with 18572 units in the inventory and they will have a loss £130000 loss. In the present economic situation is very risky to invest in the advertising because there is no guarantee that the demand for the product will increase as people are buying the cheapest products and services.

In anticipation to produce and sell more a new warehouse may be needed. This means that the stepped fixed cost will occur.

Can the company deal with £130000 loss?

What will the competitors do? Will they invest in the advertising or they will reduce the selling price?

Increase sales by additional advertising of £300000, with an increased selling price of 20%, setting a profit margin of 10%.

FC = 500000 + 300000 = £800000

VC = £12

SR = £20 + (20/10) Ã- 2 = £24

Contribution = £24 – £12 = £12

BEP = 800000 = 66667 units

12

Margin of safety (%) = (73334 – 66667) 100 = 9.1%

73334

Sales Volume to achieve a target profit = Fixed cost + target profit

Contribution per unit

Sales Volume to achieve a target profit = 800000 + 80008 = 73334 units

12

73334 units need to be produced and sold in order to produce a profit of 10%.

This option can be considered as the most prosperous of all 4 options. However the business needs to deliberate that the increase of selling price by 20% is very unsecure. Particularly now the market is very unstable and the companies should try to sell everything they have. Producing more products is very risky. There is no guarantee that the sales would be made. Everything depends on customers. Many examples could be used from news. For instance, sales of cars fell by 23% and people are not going to the restaurant for their meal, they are saving their money and buying only necessaries. The business needs to be aware that the demand for the products is decreasing and not increasing.

Why they want to produce more products?

Also the business needs to be careful with the investment in adverting. The cost of advertising may be hard to cover.

A positive thing is that if the company orders more material to produce more products, the suppliers may offer a discount.

The business needs to take in consideration the competitors in the market and what they would do. Will they reduce the selling price or will they invest in advertising?

The management accountant should investigate all the factors that may affect the demand for the product and watch the economic situation.

What are the limitations of break-even analysis? Do these limitations invalidate it as a reliable business analytical tool?

The limitations of break-even analysis

The break-even analysis is based on forecasting and has a certain limitations which should be considered. It is not always possible to predict what will happen on the market.

The linear relationship is based on the presumption that costs remain constant. However this is not the case in practical market situations. The business may get some discount from its suppliers. Also the business can often reduce its selling price in order to increase its sales volume and this is an efficient strategy known as a non-linear relationship. Scarlett, R. 2007. Management Accounting – Performance evaluation. Butterworth-Heinemann

The business need to bear in mind that if a production increases or decreases it may result in expansion or reduction of capacity. If the Henllys scenario is used, in each case there is an anticipation of increased sales and production and this means that a new warehouse may be needed. The stepped fixed costs occur and this situation result in multiple break even points. Wood, F. & Sangster, A. Business Accounting 2, 2008, 11 edn. Essex: Pearson Education Limited. Pg. 656.

Apart from the situation described above the product mix need to be applied as well. Many organisations have more then one product or service and this can have an impact on the apportionment of fixed costs which can become arbitrary. Scarlett, R. 2007. Management Accounting – Performance evaluation. Butterworth-Heinemann

The break-even analysis is internal and it is not used to consider the things like competition or market demand which means that the business should use other analysis to watch what is happening on the market and what strategies are used by competitors.

These limitations explained above invalidate our break-even analysis as a reliable business analytical tool.