Break-Even Analysis-Volume-Analysis is a systematic method of examining the relationship between changes in volume (that is output) and changes in Sales Revenue, Express and Net Profit. As a model of these relationships, Break-Even Analysis simpifies the real-world conditions which a firm will face.
The objective of Break-Even Analysis is to establish what will happen to the financial results if a specified level of activity or volume fluctuates. This information is vital to management, as one of the most important variables influencing total sales revenue, total costs and profits is output or volume.
Break-Even Analysis is based on the relationship between sales revenue, costs and profit in the short run. The short run being a period in which the output of the firm is restricted to that available from current operating capacity. In the short run, some inputs can be increased but others cannot. For example, additional supplies of materials and unskilled labour may be obtained at short notice, but it takes time to expand the capacity of the Plant and Machinery. Thus output is limited in the short run because Plant facilities cannot be expanded. It also takes time to reduce capacity, and therefore, in the short run, a firm must operate on a relative constant stock of production resources.
Break-Even Analysis Assumptions
It is essential that anyone preparing or interpreting Break-Even Analysis information is aware of the underlying assumptions on which the information has been prepared. The main assumptions are:
a. All other variables remain constant.
b. A single product or constant sales mix.
c. Profits are calculated on a variable-costing basis.
d. Total costs and total revenue are linear functions of output.
e. The analysis applies to the relevant range only.
f. Costs can be accurately divided into their fixed and variable elements.
Limitations of Break-Even Charts
1. As variable costs do not vary exactly in direct proportion to the volume of production or sales, it is false to show total cost as a straight line. The cost of additional direct materials may increase at a rate which is somewhat less than the increase in output or turnover on the other hand, direct materias, to meet a sudden increase in demand for the company’s products, may have to be purchased at a short notice from another supplier whose price may be higher. Similarly, the working of overtime is often necessary to produce more goods, and because ovetime rates are higher than normal rates, the variable costs may be higher on additional production.
Although increases in variable costs above the normal rates will, to some extent, be cancelled by increases below the normal rates, the straight line on the graph does not accurately indicate the real situation.
2. Likewise, to show sales as a straight line does not express the true situation. Revenue from sales does not increase absolutely in direct proportion to output. Additional sales may only be achieved if a quantity discount is given to those customers who buy in quantities. The top ofht sales line should, therefore, curve down slightly.
3. Where an organisation manufactures a variety of products, a single break-even chart has its limitations because the contribution per unit will be different for each product. Any major change in the product mix from one month to the next will completely invalidate the information provided by the chart. A way round this would be to prepare a breakeven chart for each individual product, but the problem would be how to apportion the fixed costs.
4. As fixed costs only remain fixed within certain output or turnover limits, the break-even chart cannot be used to provide information over a wide range of output. At higher activity levels, there may be well an increase in fixed costs.