Operations Management

with Total Quality

Management
Breakeven Analysis
INTRODUCTION
Break-even analysis is of vital importance in
determining the practical application of cost functions. It
is a function of three factors, i.e., sales volume, cost and
profit. It aims at classifying the dynamic relationship
existing between total cost and sale volume of a
company. Hence it is also known as “cost-volume-
profit analysis”. It helps to know the operating condition
that exists when a company ‘breaks-even’, that is when
sales reach a point equal to all expenses incurred in
attaining that level of sales.
OBEJCTIVES
At the end of this module, students are expected
to;
 Define break-even analysis.
 Understand the used and limitations of
break-even analysis
 Compute break-even and contribution
margin.
Breakeven Analysis Defined
 A break-even analysis is a financial tool
which helps a company to determine the stage
at which the company, or a new service or a
product, will be profitable.
 Breakeven analysis examines the short run
relationship between changes in volume and
changes in total sales revenue, expenses and net
profit
 Also known as C-V-P analysis (Cost Volume
Profit Analysis)
Uses of Breakeven Analysis
 C-V-P analysis is an important tool in terms
of short-term planning and decision making
 It looks at the relationship between costs,
revenue, output levels and profit
 Short run decisions where C-V-P is used
include choice of sales mix, pricing policy
etc.
Decision making and Breakeven
Analysis: Examples
 How many units must be sold to
breakeven?
 How many units must be sold to
achieve a target profit?
 Should a special order be accepted?
 How will profits be affected if we
introduce a new product or service?
Key Terminology: Breakeven
Analysis
 Break even point-the point at which a
company makes neither a profit or a loss.
 Contribution per unit-the sales price
minus the variable cost per unit. It
measures the contribution made by each
item of output to the fixed costs and
profit of the organisation.
Key Terminology ctd.
 Margin of safety-a measure in which the
budgeted volume of sales is compared with
the volume of sales required to break even
 Marginal Cost – cost of producing one extra
unit of output
Key Terminology ctd.
 Fixed Cost - are those business costs that are
not directly related to the level of production or
output.
 Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Key Terminology ctd.
 Variable costs are those costs which vary directly with the level of
output. They represent payment output-related inputs such as raw
materials, direct labour, fuel and revenue-related costs such as
commission.
 Direct variable costs are those which can be directly attributable
to the production of a particular product or service and
allocated to a particular cost center. Raw materials and the
wages those working on the production line are good examples.
 Indirect variable costs cannot be directly attributable to
production but they do vary with output. These include
depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.
Key Terminology ctd.
 Contribution margin is a product’s price minus all
associated variable costs, resulting in the incremental
profit earned for each unit sold. The total contribution
margin generated by an entity represents the total earnings
available to pay for fixed expenses and to generate a
profit.
 The contribution margin ratio is the difference between a
company's sales and variable expenses, expressed as a
percentage. The total margin generated by an entity
represents the total earnings available to pay for fixed
expenses and generate a profit.
Breakeven Chart
Breakeven Formula
Fixed Costs
*Contribution per unit

*Contribution per unit = Selling Price per unit – Variable Cost per unit
Margin of Safety
 The difference between budgeted or actual
sales and the breakeven point
 The margin of safety may be expressed in
units or revenue terms
 Shows the amount by which sales can drop
before a loss will be incurred
Example 1
Using the following data, calculate the
breakeven point and margin of safety in units:
 Selling Price = $50

 Variable Cost = $40

 Fixed Cost = $70,000

 Budgeted Sales = 7,500 units

Example 1: Solution
 Contribution = $50 - $40 = $10 per unit
 Breakeven point = $70,000/$10 = 7,000 units
 Margin of safety = 7500 – 7000 = 500 units
Target Profits
 What if a firm doesn’t just want to breakeven
– it requires a target profit
 Contribution per unit will need to cover profit
as well as fixed costs
 Required profit is treated as an addition to
Fixed Costs
Example 2
Using the following data, calculate the level of
sales required to generate a profit of $10,000:
 Selling Price = $35

 Variable Cost = $20

 Fixed Costs = $50,000

Example 2: Solution
 Contribution = $35 – $20 = $15
 Level of sales required to generate profit of
$10,000:
$50,000 + $10,000
$15
4000 units
Limitations of B/E analysis
 Costs are either fixed or variable
 Fixed and variable costs are clearly discernable over
the whole range of output
 Production = Sales
 One product/constant sales mix
 Selling price remains constant
 Efficiency remains unchanged
 Volume is the only factor affecting costs
Absorption and Marginal Costing
Compared
Absorption Marginal
 Fixed costs included in Product  Fixed costs not included in
Cost
Product Cost
 FC not treated as period cost –
closing/opening stock values  FC treated as period cost
 Under/over absorption of costs  No under/over absorption
 Complies with Financial of costs
Accounting standards  Does not comply with
Financial Accounting
standards
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