Break even Analysis

It is an important technique of profit planning. planning. This technique is made use of to study the relation b/w TC,TR, Total profit and loss at a given level of output. The output. objective of each firm is to earn profit. profit. Economic profit of the production of a commodity is the difference b/w its cost of prod n and the revenue earned by its sale.

Assumptions
     

Constancy of fixed costs Constant technology Constant returns to a factor Constant sales price Identity of output and sales Division of costs

Break even analysis refers to the technique of analysis by which the mutual relations b/w the volume of prod'n and cost of prod n, on the one hand and sale proceeds and profit, on the other are analyzed.  Total cost=Fixed cost + variable cost Break even point refer to that level of output at which the firm neither suffers any loss nor earns economic profit. Break Even Point=Total Revenue=Total cost


Methods of Break Even Analysis



Graphic method:-under this method break even method:point is explained with the help of break even chart. Break even chart is that graph which shows the extent of profit or loss to the firm at different levels of sales or production. The chart has been prepared on the assumption that the price of the commodity is Rs.3 per unit and variable cost is Rs. 2 per unit

O/p(00 TFC 0) 0 40 10 20 30 40 50 60 70 40 40 40 40 40 40 40

TVC 0*2=0 10*2=20 20*2=40 30*2=60 40*2=80

TC 40+0=40 40+20=60 40+40=80

TR0 0*3=0 10*3=30 20*3=60

40+60=100 30*3=90 40+80=120 40*3=120

50*2=100 40+100=14 50*3=150 0 60*2=120 40+120=16 60*3=180 0 70*2=140 40+140=18 70*3=210

2. Equation Method

Break Even Quantity=

Fixed Cost PricePrice-AC

Managerial applications of B.E.A

1.

Calculations of Volume of Sales to attain Target profit:profit: Break even analysis is used to know the volume of sales necessary to achieve a given profit.Required volume of sales is calculated with the help of following formula: Reqd vol of sales=fixed cost+profit target Cont n Margin per unit

2. Safety Margin:-It refers to a limit to which the sales may fall yet Margin: the firm may have no fear of loss.Safety margin is estimated by subtracting Break even Sales from Actual Sales. In other words, Safety Margin=Actual Sales-Break Even Sales SalesSafety Margin ratio is calculated by dividing Safety Margin by actual sales. Safety margin Ratio=Safety Margin *100 Actual sales

Contribution Margin Method



Contribution Margin is the excess of total revenue over total variable costs. For example, if the total sale proceeds of 5 units of a commodity is Rs.100 and total variable cost is Rs. 60, then the total margin is equal to the total fixed cost and total net profit.

3.Sales Required to offset Price Reduction:-If due 3.Sales Reduction: to certain reasons, a firm reduces its sales price then to avoid the resultant loss, the firm will have to raise the quantity of sales. The required increase in the quantity of sales can be determined with the help of following formula:formula:New Qty of Sales=Fixed cost+Profit Target New sales price-VC price4. Sales reqd to meet the proposed expenditure:expenditure:BEP also informs a firm how much increase in sales would be reqd to meet the proposed expenditure etc.It means proposed expenditure can be met by increasing the sales.

5. Change in variable Costs:- The firm may have to Costs:change the variable costs also for various reasons. Under the circumstances, it becomes necessary to effect change in the qty of sales or the sale price so as to maintain the existing level of profit. 6. Change in fixed costs:- Firm may stand in need of costs: new machines, modern equipments etc. in the long period. As a result of it, fixed costs will also change, as in the long run all costs become variable costs 7. Decision Regarding adding of new product or dropping of old one:- BEP enables a firm to arrive at a one: final decision whether to introduce ant new product or not. It also helps a firm to arrive at a final decision whether to continue the prod n of existing goods or to discontinue. 8. To produce or buy decisions:- Many a time a firm has decisions: to decide whether to manufacture itself, all the parts or to purchase the same from ancillary units.

Measure to improve profit performance

    

Reduction in fixed costs Reduction in per unit variable costs Increase in sales prices Increase in sales volume Efficient management

Advantages of BEA


     

Optimum level of profit:-with the help of BEA a profit:firm can find optimum level of prod n. prod n below the optimum level is not profitable for the firm. Target capacity:- To take advantage of minimum capacity:cost of prod n Minimum cost Self Prod n Expansion and contraction of plant Choice of projects Payment of dividend

Limitations of BEA


Ignores change in input prices:-since BEA is based prices: on past data it becomes necessary to adjust this data in context of changes in prices of inputs. However it is not so done. Ignores changes in product Prices:- Break even Prices: chart is prepared on the basis of current product prices. But in real life, product prices undergo change regularly. However in break even chart changes in product prices are not included because it becomes difficult to make the correct estimate of the qty of sale at different prices. Profit is not a function of o/p only:- In real life profit only: is the function of many other factors like technological changes, efficient mgt. etc. Limitations of a/c g data :- it suffers from all the limitations which a/c s data possess like calculating depreciation in an arbitrary manner etc

 

Unsuitable for long-term analysis:longanalysis:Ignores Selling Costs:- takes into a/c only Costs:prod n costs Unsuitable for multi-products:- BEA is multi-products:suitable for a few products. simultaneous analysis of several products, several plants and several deptts is very complex

Profit planning


Every mgt. is reqd to make profit planning. It needs depends upon the extent of the competition prevailing among the firms. It has not as much significance under the condition of monopoly as under monopolistic competition. it is so because the monopolist has full control over the price that under competition, the very existence of the firm depends on such efforts as yield profit in the long run.

Profit Planning means the projection of further earnings It involves analysis of actual and expected behavior of sales of the firm, prices of the commodity, fixed and variable costs, strategies of competing firms etc is through profit forecasting that the plan relating to improvement in profit can be chalked out.

With a view to enhancg its profit, a firm has to analyze the follg facts


Having analysed competitive conditions Ed of the product , the firm first of all makes an effort to increase the sales and get suitable price of the product. Having analyzed the costs of its different activities like R&D, Sales etc the firm decides how to reduce these costs. The firm decide its capital invt programme in such a manner as to reduce the high ROI, depreciation etc . The firm also makes an assessment of many other factors like most profitable rate of return , monitoring the implementation of selected alternative suggestion of invt.In short the main objective of Profit Planning is to enhance the quantum of profit planning.

Methods of Profit Planning



Spot Projection:-Forecast relating to volume of sales, Projection:price, cost etc is based on the basis of P&L statement. The demerit of this method is that project is treated as residue after dedicating all kinds of expenditure from the revenue. Environment based forecast:-PP is made on the forecast:basis of the external factors of the firms such as Govt policies etc . Forecasting with the help of BEA:-There are two BEA:methods under this: Sales revenue :Treating profit as the difference between sales revenue and cost On the basis of previous data concerning profit and output making profit planning with the regard to the planned level of output

Transfer Pricing


The large size firms divide their operations very often into product divisions or subsidiaries. Growing firms add new divisions or depts. to the existing ones. The firms then transfer some of their activities to other divisions. The goods and services produced by the new division are used by parent organization. In other words, the parent division buys the product of its subsidiaries. Such firms face the problem of determining an appropriate price for the product transferred

Conflicting problems in Transfer Pricing



Goal Congruence:- Problem of insuring that the Congruence:division mgt s goals coincide with those of firm. Incentive:Incentive:- this is the problem of providing division managers with the incentive to pursue the firm s goals rather than their own. Autonomy;Autonomy;- Problem of providing guidance with undermining the division managers authority and freedom to make independent decisions.

Transfer Pricing when there is no external market

In the absence of an external market, the correct transfer price is the marginal cost of the seller. Suppose a firm has two divisions. Div A manufactures a critical component for which there is no external market for the final product. Div. B completes assembly and packaging for the final product and markets it to public. Since ther is no external market for Div. A s product, Div. B must buy its entire supply from Div. A hence the prod n by Div. A is precisely equal to the demand by division B. Division A s marginal revenue will be the transfer price. Since division A seeks to maximize profit, the transfer price (which equals marginal revenue) must be equal to marginal cost of production.


Transfer price when an External market Exists



When there is an external mkt. for the selling division s product, the selling division may produce more or less than the buying division needs. If the selling division produces more than the buying division needs, the surplus can be sold in the external market. If the selling division produce less than the buying division needs, the buying division can obtain rest of its needs in the external market. Either way the selling division is free to pursue maximization of its own profit.

Pricing methods


Full Cost Pricing or Markup Pricing;Pricing;-

In setting price P, some firms intend to cover up their full costs of production and target profit. This is also termed cost plus or standard pricing . In establishing a full cost price for its products, 1. The firm first calculates expected prod n volume for the fiscal year or other suitable time period. 2. To compute the estimated capacity of the firm or plant. Capacity may be defined in terms of the level of o/p at which AC is minimum and designate this level of o/p as standard volume. 3. Average total costs is the standard cost which is defined as the pre-determined cost of each preoperation/product/process, intended to represent the value of direct material, direct Labour etc. Standard cost per unit of o/p=Total pre-determined costs preStandard volume

The final step is to add to this standard cost per unit of o/p, a given amt. of markmarkup over cost for profit so that we have the fullfull-cost price. The magnitude of mark-up markis decided by top mgt. it is because of this markmark-up that full-cost prices exceed avg fullcost prices. It is therefore known as markmarkup pricing. The mark-up may include mark(a) % addition to cover overheads (b) % addition for selling expenses a convention margin of profit.

Limitations of Full cost pricing



 

It ignores demand side of the product altogether. It fails to adequately reflect the competitive forces. It may be based on wrong conception of costs It overstates the ability of mgt. to allocate fixed costs precisely It is useless for industries whose products are perishable

Advantages of Full costs Pricing

 

    

It is very simple method. It is easy to calculate standard costs rather than marginal costs. Considering that full cost pricing furnishes a safe and secure methods, it reduces the costs of decision making. It enables the firm to make up price lists even before actual prod n begins It eliminates frequent price changes. It is particularly suitable for industries where price leadership. It is considered the logical methods to maximize longlong-run profits In practice businessmen are uncertain about the demand conditions for their product. So they use costcost-plus formula

Going Rate Pricing or Follow up



Some firms carefully examine the general pricing structure of the industry to which they belong and fix their respective price accordingly. Here the emphasis is on the prevailing market price rather than costs. In market where price leadership is well established, going-rate pricing goingis the only rational strategy which a follower firm can adopt, it may be less costly and less troublesome to the business, than the exact calculation of costs and market demand to set a price and then to face market risk and uncertainty .

Cont ..

Going rate pricing does not necessarily imply that a firm accepts a price impersonally set by a near perfect market. Rather it would seem that the firm has the option to set its own price, looking at the prevalent price. The firm can be a price maker provided it agrees to bear the consequences. Such a pricing method is not confined to small and medium businesses, sometimes even large business organizations also follow the going rate pricing policy. In a way, by adopting the going rate price, the firm avoids costs of collecting and processing information about the market conditions

Incremental or Direct cost Pricing



It simply means that the price of a product is based upon the incremental cost or direct cost or out of pocket costs. Not upon the average cost (fully distributed cost). In full cost and avg. cost pricing, both fixed and variable costs are taken care of while setting prices whereas in incremental cost pricing and marginal cost pricing only variable costs are considered.

Pricing Analysis ends here