Costing- Breakeven Analysis

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KHSS/ AL/ PA/ Costing (VI) Breakeven Analy./Oct03

Costing (VI) Breakeven AnalysisPart I : Background1.1 Definition of Breakeven Analysis Breakeven analysis is also known as cost-volume-profit analysis. It is the study of the relationship between selling prices, sales volumes, fixed

costs, variable costs and profits at various levels of activity.

1.2 Application of breakeven analysis Breakeven analysis can be used to determine a companys breakeven point

(BEP). Breakeven point is a level of activity at which the total revenue is equal to the total

costs. At this level, the company makes no profit. With reference to the breakevenpoint, the managers can set their sales goals and target profits.

1.3 Assumption of breakeven analysis

The model of breakeven analysis is developed on the following assumptions: Relevance rangeIt is assumed that a company is operating within a

relevant range. The relevant range is the range of an activity over which thefixed cost will remain fixed in total and the variable cost per unit will remainconstant.

Fixed costsTotal fixed costs are assumed to be constant in total. Fixedcosts per unit will decrease with the increasing number of units produced.

Variable costsVariable costs per unit are assumed to be constant. Totalvariable costs will increase with the increasing number of units produced.

Sales revenue ---Sales revenue per unit is assumed to be constant and thetotal revenue will increase with the increasing number of units produced.

These assumptions are illustrated in the following diagrams:

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Costs ($)

Sales (Units)

Fixed costs

Total Costs

Variable costs

Sales RevenueProfit

Total costs

Total cost/ Revenue ($)

Sales (units)

BEP


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Part II : Breakeven Analysis2.1 Breakeven point Breakeven point is the level of activity at which the company makes neither profit

nor loss.

It is also the activity level at which the total contribution is equal to the total fixedcosts. Contribution is defined as the excess of sales revenue over the variablecosts.

The following diagram illustrates the definition of contribution.

Formulas for breakeven analysis.

2.2 Example 1 Selling price per unit-- $12 Variable cost per unit -- $3 Fixed costs-- $45,000 You are required to compute the breakeven point.

Breakeven point in units = Fixed costs / Contribution per unit=

Sales revenue at breakeven point =

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Breakeven point in units = Fixed costs / Contribution per unit

Contribution required to break evenContribution per unit


Contribution required to break evenContribution per unit

Breakeven point in units =

X Selling price


Contribution required to break evenContribution to sales ratio

Contribution

Variable costs

Profit

Fixed costs

Salesrevenue


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Alternative methodContribution to sales ratio =

Contribution required to break evenContribution to sales ratio

=

Breakeven point units =

2.3 Target Profit

2.3.1 Example 2 Selling price per unit --$12 Variable cost per unit -- $3 Fixed costs-- $45,000 Target profit-- $18,000 You are required to compute the sales volume required to achieve the target

profit.

Required sales revenue =

Alternative methodRequired sales revenue = Fixed costs+target profit/Contribution to sales

ratio=

Units sold at target profit =

2.4 Margin of safety Margin of safety is a measure of amount by which the sales may decrease before

a company suffers a loss. This can be expressed as a number of units or apercentage of sales.

2.4.1 Example 3 The breakeven sales level is at 5,000 units. The company sets the target profit at

$18,000 and the budgeted sales level at 7,000 units. You are required to calculate the margin of safety in units and express it as a

percentage of the budgeted sales revenue.Margin of safety = Budgeted sales level breakeven sales level

=

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Fixed costs + Target ProfitContribution per unit

No. of units at target profit =

Fixed costs + Target ProfitContribution per unitNo. of units at target profit =


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Margin of safety =

The margin of safety indicates that the actual sales can______________units or __________ from the budgeted level before lossesare incurred.

2.5Changes in components of breakeven analysis The following example demonstrates the effects of the changes in different

components of breakeven analysis.

2.5.1 Example 4 Selling price per unit --$12 Variable cost per unit --$3 Fixed costs-- $45,000 Current profit-- $18,000

If the change in selling price is raised from $12 to $13, the minimum volume ofsales required to maintain the current profit will be:(Fixed costs + Current profit) / Contribution per unit=

If the fixed costs fall by $5,000 but the variable costs rise to $4 per unit, theminimum volume of sales required to maintain the current profit will be:(Fixed cost + Current profit)/ Contribution per unit

=

2.6 Limitations of breakeven analysis Breakeven analysis assumes that fixed costs, variable costs and sales revenue

behave in a linear manner. However, some overhead costs may be stepped innature rather than remain constant. The previously straight sales revenue line andtotal cost line tend to curve beyond a certain level of production. As a result, alower selling price is set to stimulate further sales and lower variable costs can beobtained due to mass production.

It is assumed that all production is sold. The breakeven chart does not take thechanges in stock level into account.

Breakeven analysis can provide vital information for small and relatively simplecompanies that produce large volume of the same product. It is not so useful forthe companies producing multiple products. Its applications tend to be limitedespecially in those jobbing companies where each item produced is different.

Homework Exercises: Q.35-6A, Q.35-8A, Q.35-9A, Q.35-11A, Q.35-12A, Q.35-13A,Q35-14A, Q.35-16A, Q.35-17A

Classwork Exercises: Q.35-5, Q.35-7, Q.35-10, Q.35-15, Q.35-18

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Costing- Breakeven Analysis