BREAK EVEN ANALYSIS

Breakeven analysis is a powerful management tool, and one that is critical in planning, decision-
making, and expense control. Breakeven analysis can be invaluable in determining whether to
buy or lease, expand into a new area, build a new plant, and many other such considerations.
Breakeven analysis can also show the impact on your business of changing your price structure.
As the price goes down (and so your gross margin goes down), breakeven shoots up - usually
very rapidly. Breakeven analysis will not force a decision, of course, but it will provide you with
additional insights into the effects of important business decisions on your bottom line.
Break-even analysis will provide a sales obective that can be expressed in either dollars or units
of production or sales, or whatever else is relevant. !f the breakeven
point is known, it can be a definite target to be reached and exceeded by carefully reasoned steps.
"nce you know the level of sales you have to reach before making a profit, you can evaluate the
reasonableness of this target. #hat are the odds of reaching this breakeven sales level$ "ne way
to test this is to convert the gross pound sales needed for breakeven into some other unit which
can then be compared against the capacity of the business or the si%e of the market. !f the
breakeven occurs at or near the capacity of the business, or if your analysis shows that you must
capture all (or more than all) of the available target market, the feasibility of your concept is
suspect, and the odds of business success are loaded against you.
Another way to use breakeven analysis is to change the variables in the e&uation. !f fixed or
variable expenses can be reduced, the breakeven point will go down. !f prices can be increased
without hurting sales (and without increasing costs), the breakeven point will go down. 'his is an
excellent way to experiment with different alternatives. (learly, this is a subective process - but
then, so is the rest of business analysis. 'he purpose is to make your business decision making as
reasonable as possible.
Costing Systems and techniques for engineering companies
'here are three maor types of costing they include)
1 Absorption (osting
2 *arginal (osting
3 Activity based costing
Absorption Costing;
!n product+service costing, an absorption costing system allocates or apportions a share of all
costs incurred by a business to each of its products+services. !n this way, it can be established
whether, in the long run, each product+service makes a profit. 'his can only be a guide. Arbitrary
assumptions have to be made about the apportionment of many of the costs which, given that
some costs will tend to remain fixed during a period, will also be dependent on the level of
activity.
An absorption costing system traditionally classifies costs by function. ,ales less production
costs (of sales) measures the gross profit (manufacturing profit) earned. -ross profit less costs
incurred in other business functions establishes the net profit (operating profit) earned.
.sing an absorption costing system, the profit reported for a manufacturing business for a period
will be influenced by the level of production as well as by the level of sales. 'his is because of
the absorption of fixed manufacturing overheads into the value of work-in-progress and finished
goods stocks. !f stocks remain at the end of an accounting period, then the fixed manufacturing
overhead costs included within the stock valuation will be transferred to the following period
"ne method of determining the total cost of a given product or service is that of adding the costs
of overheads to the direct costs by a process of allocation, appointment and absorption. ,ince
overheads (or indirect costs) can be allocated as whole items to production departments, it is
possible to arrive at a normal amount that must be added to the cost of each product in order to
cover the production overheads.
Advantages
1 #e cannot realistically produce unless fixed.
2 (osts are paid) therefore, they should be included in the production costs. ,elling can be
set.
3 /rices are based on total costs and in times of uncertain demand, it is better to consider
final profit and not ust contribution.
Disadvantages of Absorption Costing
'he following are the criticisms against absorption costing0
1 1ou might have observed that in absorption costing, a portion of fixed cost is carried over
to the subse&uent accounting period as part of closing stock. 'his is an unsound practice
because costs pertaining to a period should not be allowed to be vitiated by the inclusion
of costs pertaining to the previous period and vice versa.
2 Absorption costing makes no distinction between fixed and variable costs thus is not
suited for ((ost-volume-profit) (2/ analysis.
3 3urther, absorption costing is dependent on the levels of output which may vary from
period to period, and conse&uently cost per unit changes due to the existence of fixed
overhead. .nless fixed overhead rate is based on normal capacity, such changed costs are
not helpful for the purposes of comparison and control.
Marginal Costing;
!n product+service costing, a marginal costing system emphasises the behavioural, rather than the
functional, characteristics of costs. 'he focus is on separating costs into variable elements (where
the cost per unit remains the same with total cost varying in proportion to activity) and fixed
elements (where the total cost remains the same in each period regardless of the level of
activity). #hilst this is not easily achieved with accuracy, and is an oversimplification of reality,
marginal costing information can be very useful for short-term planning, control and decision-
making, especially in a multi-product business.
!n a marginal costing system, sales less variable costs (regardless of function) measures the
contribution that individual products+services make towards the total fixed costs incurred by the
business. 'he fixed costs (regardless of function) are treated as period costs and, as such, are
simply deducted from contribution in the period incurred to arrive at net profit.
The principles of marginal costing
'he principles of marginal costing are as follows.
3or any given period of time, fixed costs will be the same, for any volume of sales and
production (provided that the level of activity is within the 4relevant range5). 'herefore, by
selling an extra item of product or service the following will happen.
1 6evenue will increase by the sales value of the item sold.
2 (osts will increase by the variable cost per unit.
3 /rofit will increase by the amount of contribution earned from the extra item.
4 ,imilarly, if the volume of sales falls by one item, the profit will fall by the amount of
contribution earned from the item.
/rofit measurement should therefore be based on an analysis of total contribution. ,ince fixed
costs relate to a period of time, and do not change with increases or decreases in sales volume, it
is misleading to charge units of sale with a share of fixed costs. #hen a unit of product is made,
the extra costs incurred in its manufacture are the variable production costs. 3ixed costs are
unaffected, and no extra fixed costs are incurred when output is increased.
Features of Marginal Costing
'he main features of marginal costing are as follows0
Cost Classification
'he marginal costing techni&ue makes a sharp distinction between variable costs and fixed costs.
!t is the variable cost on the basis of which production and sales policies are designed by a firm
following the marginal costing techni&ue.
Stock/Inventory Valuation
.nder marginal costing, inventory+stock for profit measurement is valued at marginal cost. !t is
in sharp contrast to the total unit cost under absorption costing method.
Marginal Contriution
*arginal costing techni&ue makes use of marginal contribution for marking various decisions.
*arginal contribution is the difference between sales and marginal cost. !t forms the basis for
udging the profitability of different products or departments.
Advantages of Marginal Costing Technique
1 *arginal costing is simple to understand.
2 By not charging fixed overhead to cost of production, the effect of varying charges per
unit is avoided.
3 !t prevents the illogical carry forward in stock valuation of some proportion of current
year5s fixed overhead.
4 'he effects of alternative sales or production policies can be more readily available and
assessed, and decisions taken would yield the maximum return to business.
5 !t eliminates large balances left in overhead control accounts which indicate the difficulty
of ascertaining an accurate overhead recovery rate.
6 /ractical cost control is greatly facilitated. By avoiding arbitrary allocation of fixed
overhead, efforts can be concentrated on maintaining a uniform and consistent marginal
cost. !t is useful to various levels of management.
7 !t helps in short-term profit planning by breakeven and profitability analysis, both in
terms of &uantity and graphs. (omparative profitability and performance between two or
more products and divisions can easily be assessed and brought to the notice of
management for decision making.
Disadvantages
1 'he separation of costs into fixed and variable is difficult and sometimes gives
misleading results.
2 7ormal costing systems also apply overhead under normal operating volume and this
shows that no advantage is gained by marginal costing.
3 .nder marginal costing, stocks and work in progress are understated. 'he exclusion of
fixed costs from inventories affect profit, and true and fair view of financial affairs of an
organi%ation may not be clearly transparent.
4 2olume variance in standard costing also discloses the effect of fluctuating output on
fixed overhead. *arginal cost data becomes unrealistic in case of highly fluctuating
levels of production, e.g., in case of seasonal factories.
5 Application of fixed overhead depends on estimates and not on the actual figures and as
such there may be under or over absorption of the same.
6 (ontrol affected by means of budgetary control is also accepted by many. !n order to
know the net profit, we should not be satisfied with contribution and hence, fixed
overhead is also a valuable item. A system which ignores fixed costs is less effective
since a maor portion of fixed cost is not taken care of under marginal costing.
7 !n practice, sales price, fixed cost and variable cost per unit may vary. 'hus, the
assumptions underlying the theory of marginal costing sometimes becomes unrealistic.
3or long term profit planning, absorption costing is the only answer.
8 *arginal costing is not a method of costing but a techni&ue of presentation of sales and
cost data with a view to guide management in decision-making.
9 'he traditional techni&ue popularly known as total cost or absorption costing techni&ue
does not make any difference between variable and fixed cost in the calculation of profits.
But marginal cost statement very clearly indicates this difference in arriving at the net
operational results of a firm.
3ollowing presentation of two /erforma shows the difference between the presentation of
information according to absorption and marginal costing techni&ues0
Marginal Costing versus Absorption Costing
After knowing the two techni&ues of marginal costing and absorption costing, we have seen that
the net profits are not the same because of the following reasons0
"ver and .nder Absorbed "verheads
!n absorption costing, fixed overheads can never be absorbed exactly because of difficulty in
forecasting costs and volume of output. !f these balances of under or over absorbed+recovery are
not written off to costing profit and loss account, the actual amount incurred is not shown in it. !n
marginal costing, however, the actual fixed overhead incurred is wholly charged against
contribution and hence, there will be some difference in net profits.
COC!"S#O
*arginal cost is the cost management techni&ue for the analysis of cost and revenue information
and for the guidance of management. 'he presentation of information through marginal costing
statement is easily understood by all managers, even those who do not have preliminary
knowledge and implications of the subects of cost and management accounting.
Activity $ased Costing
Activity Based (osting is an accounting system that assigns costs to products based on the
resources they consume. 'he costs of all activities are traced to the product for which they are
performed. "verhead costs are also traced to a particular product rather than spread arbitrarily
across all product lines. 'he true cost of a product can be determined with much more fidelity
than was previously available with a traditional accounting system. An AB( system gives
visibility to how effectively resources are being used and how all activities contribute to the cost
of a product.
1. *ore accurate costing of products+services
2. Better understanding overhead
3. 8asier to understand for everyone
4. .tili%es unit cost rather than ust total cost
5. *akes visible waste and non-value added
6. ,upports performance management and scorecards
7. 8nables costing of processes, supply chains, and value streams
8. Activity Based (osting mirrors way work is done
9. 3acilitates benchmarking
Activity $ased Costing Disadvantages
*ore time consuming to collect data
(ost of buying, implementing and maintaining activity based system
*akes waste visible which some executives and managers don9t want their boss to see..
COC!"S#O
Absorption costing and marginal costing are two different techni&ues of cost accounting.
Absorption costing is widely used for cost control purpose whereas marginal costing is used for
managerial decision-making and control. 3or this reason, absorption costing and AB( are
appropriate costing techni&ues for engineering companies.
:owever, AB( is the most appropriate as provides managers with useful information they need
regarding the contribution that each customer makes to overall profitability. Also, AB( allows
managers to see how to maximise performance and implement sound profit-growth strategies.
Also, AB( also makes it very clear that integrated costs associated with the services that the
customer demands play a crucial role in determining each customer9s contribution to net profit.
AB( is nevertheless a form of absorption costing and the point of absorption costing is simply to
make sure that all costs are covered. !t is also a way of obtaining an accurate comparison with
outside alternative suppliers.