Break Even Analysis

Profit analysis

Profit in Business
According to Schumpeter, Profit reward for

innovation
Profit Reward for undertaking risk
Profit motive play a role in the efficient
allocation of resources In a bid to maximize
profit, all firms try to use its resources
efficiently when faced with tough competition
from the rival firms.

Profit Some Concepts

Business profits/Accounting profits

Total Revenue - Explicit Costs

Economic Profit = Business Profits Implicit
Costs
Implicit Costs include costs of entrepreneurial
ability and capital goods owned by the
company
Imp. Costs measured by opportunity costs

Break-even Analysis
Examines relation between Total Revenue, Total Cost

& Profit at different levels of output

Break-even between profit and loss=> No profit no
loss situation
Profit is defined as the difference between Total
Revenue and Total Cost
Break Even situation => Equality between Total
Revenue & Total Cost
Break Even A division between zone of profit and
zone of loss
Break Even output level is referred to that output
level where No profit No loss situation exists

Relevance of the study

A firm knowing its break even output can

target an output higher than it, to enjoy profit

and avoid operating in the loss zone
This helps to set a target of sales
To get an idea of the Contribution of the firm
to profit with each level of output, incremental
revenue and incremental cost
Fixing a profit margin and then targeting the
required sales to achieve the desired profit
level

Break-even Chart
Graphically representing the relation between

profit, revenue and costs in the form of a

break-even chart

Linear Representation of total revenue, total

cost, total fixed cost and Total variable costs

Graphical Representation of Break

Even
TR

TR,TC,TFC

it
Prof

TC

A
B

TFC

s
Los

Qo

Non-linear Break-even charts

TR, TC curves are non-linear following

diminishing marginal returns to a factor and

different price-elasticities.
Existence of multiple break-even points
Defined zones of profit unlike linear charts,

operating profit zones become closedbounded areas

Non-linear Graphical representation

TC

TR,TC,TFC

it
Prof

s
Los

TR

A
B

s
Los

Qo

TFC

Qo1

Break-even output & Contribution of a

firm
At, break-even point, TR=TC, therefore,

break-even output, QB = TFC/(P-AVC)

P-AVC, is the called the contribution margin
per unit, as it represents the portion of the
selling price that can be applied to cover the
fixed cost of a firm and to provide for profits
TR-TVC, thus signifies the total contribution
of the firm to cover its fixed cost and provide
for profits
At break-even profits are zero, TFC covered

Profit Planning by a firm

Once the contribution margin is known, it

becomes relatively easy for the firm to set an

output target, depending on the profit margin
they desire.
Let the profit desired by the firm be denoted
by , which has a 10% margin over the
Average cost.
Desired output level to achieve this profit ,
must have a total contribution of TFC+
Targeted output, QT=(TFC+)/(P-AVC)

Changes in price, AVC, TFC

The lower the break-even output, higher is

the operating profit zone & lower is the

operating loss zone
To achieve a lower break-even output, a firm
can operate by
Increasing the prices (TR curve shifts
upwards)
Decreasing fixed costs and variable costs
(TFC & TVC curves shift downward)

Changes in Break-even Output

TR1
TR

TR,TC,TFC

it
Prof

TC
TC1
TFC

TFC1
O

Qo1

Qo

Some observations on the linear

approach
Constant cost & prices This analysis holds

good under constant cost & prices or

constant mix of products assumptions,
otherwise break-even analysis difficult
Single product or constant product mix Over
time product mix may change, firms found it
difficult to allocate TFC among the products

Cost targets in break-even analysis

American Firms targeting price A new

model introduced is first designed, estimate

the cost and setting a desired profit, price is
determined
Japanese Cost Management Instead of
designing first, surveys the market first, set a
target price (acceptable to the consumers),
subtracts the desired profit margin to set the
targeted cost & then designs the new product

Example of NANO A Challenge

ahead
Targeted Cost Approach
Biggest challenge To achieve Break-even which is

already achieved in other models of TATA Motors by

cutting costs
Acc. to Ratan Tata, initially a high output target was
set to break-even which need a lot of high investment
Impossible target
Instead cost cutting to achieve low-cost, low breakeven by technological changes for e.g. Engine
designed to be placed under rear seat
*Source: Website of TATA Motors; interview with Ratan Tata

Reliance Retail almost achieved breakeven

Almost achieved break-even after first year of

operation
Loss less than one crore
Expected to achieve break-even after several
years of operations due to high capital
expenditure in retail industry
Reliance quite impressive as compared with
other established companies, which enjoy
very low profit margin of 1% or 2%
* Source: Mint dated 19th May, 2008

CASE STUDY on Lockheed Tri Star

& Europes Airbus Industry
1971- Lockheeds project L-1011 Tristar

commercial jet aircraft

Sought govt. guarantee for a bank loan to
complete the project
Proof of economically sound project framed
on the basis of break-even sales, was
forwarded by the company
Break-even 200 aircrafts at a price of $15.5
million

Case Study discussion

103 aircrafts already on demand, and options

of another 75 aircrafts shown.

Loan guarantee legislation was passed
Inclusion of fixed costs like development
costs of technology & construction facilities
actually doubles the break-even output,
therefore these were avoided by the firm
Given the market demand and tough
competition from McDonell-Douglas and
Boeing, a high break-even output difficult to
achieve, such costs were thus not included

 Outcome Sales of 250 aircrafts between

1971 & 1984 & phasing out of the plan due to

heavy losses
Implication In aircraft industry, the
development cost ( fixed cost) is high,
therefore break-even output is high
European Companies took 20 years to reach
break-even
*Source: Managerial Economics by Salvatore, 4th ed.,
Oxford

Preparation of Break even charts

Choice of Approach: Analytical or Statistical
Output Measurement : For multiple, non-

homogeneous products index method or

value of sales method
TR curve: two sets of data on revenue &
output required
Break-even point-Intersection of TR & TC
Margin of Safety difference between actual
sales or output and break-even sales or
output

Example
A coastal ship can carry a maximum of

1,00,000 passengers per month at a fare of

Rs. 850. Variable cost per passenger is Rs
100 while the fixed costs are Rs. 75,00,000
per month. Find the Break-even quantity and
sales for the ship and break-even percentage
capacity.
Suppose the management of shipping
company sets a profit target of Rs 75,00,000,
what level of output to be produced and at
what margin of safety?

Solution 1
1.

TFC
QB
10,000
P AVC

TFC
TFC
SB

Rs.85,00,000
1 ( AVC / P ) 1 (TVC / TR )

2.

3. Average % of seating capacity filled to achieve break-

even

QB
10,000
%B
100
100 10%
Qmax
1,00,000

Solution 2
1. Output to be targeted

TFC 75,00,000 75,00,000

QD

P AVC
550 100
20,000
% Capacity to be utilized

QD
20,000
%D
100
100 20%
Qmax
1,00,000

Margin of Safety
If a firm operates at a higher output level much

higher than the break-even output, a firm is

said to be operating safely in the profit zone.
Margin of Safety can be expressed as

Q A QB

100
QA
Solution 2. If targeted output is actually

produced & sold in the market, then Margin of

Safety = 50%

Break-Even Analysis of Hero Honda

Problem Continuous phenomenal growth &

a big jump in Jan, 2004, due to constant

innovations. But constant innovations had led
to higher costs. The time had arrived to look
into the relationship between cost, output and
profit more closely, to strengthen the
relationship with external stakeholders. It has
been the fixed cost that had shown an
increase. The problem was to identify the
impact of such changes in fixed cost on
commodity prices, output & profit.

Steps involved in Calculations of

Break-even point
Determined the variables like fixed costs,

selling prices and variable costs

Contribution Margin can be used in place of
selling price and variable costs where both
these variables are tough to separate
Selling Price defined as Total Sales Turnover
divided by total sales unit
Fixed and Variable Cost identified from
income data

Observations thro B.E. Analysis

Both Sales Turnover & Break-even have

increased
The gap between actual sales & break-even
sales have increased substantially indicating
high safety margin

Recommendations
Further cut in cost of production Adoption of

technologies like Chinese companies using

plastics, aluminium; employee value addition
Increase value to customer
Cutting overhead costs
60% capacity utilization may be increased
further by cutting costs, using resources
efficiently and optimally by more value
generation.