BREAK EVEN ANALYSIS
Profit
Business
organisations have profit as their primary goal and various management
decisions
(such as product pricing, production levels, expansion, diversification, etc.)
are
aimed
at subserving this goal.
Profit, simplistically stated, is the
difference between sales realisations and the costs
incurred.
The profit and loss statements of organisations give details of sales
realisations
as well as costs.
In
other words, one could say, Profit = Sales - Costs
Profit
could, therefore, be increased by increasing sales and by taking steps to see
that
costs
do not increase, at least correspondingly.
Profit and Loss Account:
Profit,
however, is not directly related to the level of activity or volume of sales of
an
organisation.
Stated differently, profit does not necessarily increase or decrease directly
in
proportion to the volume of sales. This is because costs consist of various
components,
all of which do not vary proportionately with sales. There are some
components
of costs, which vary proportionately, but there are others, which are not
dependent
on the volume.
Types of costs
Broadly
speaking, costs could be divided into two categories -fixed costs arid variable
costs.
Fixed Costs
Fixed
Costs are those costs which tend to remain the same irrespective of the volume
of
output.
In other words, they do not vary when output changes. Factory rent, Managing
Director’s
salary etc. are all examples of Fixed Costs.
Fixed
Costs are, however, not truly fixed at all times but only over a comparatively
shorter
time period e.g. a quarter or even over a year. Over a very long period, fixed
costs
may undergo some changes.
Similarly fixed costs remain the same within a
well defined range of output, but once a
new
range is reached the costs change. For example one foreman may be adequate for
one
shift, but once the organisation decides to operate two shifts, one more
foreman
may
have to be employed and the fixed costs, representing the salary of foremen,
would
double.
Fixed costs are, therefore, referred to as “stepped costs” also in such cases.
Variable casts
40.1
Variable costs are those costs which do vary in relation to the output. As a
result, when
output
increases, variable costs go up proportionately. Raw materials consumed, stores
and
spares consumed etc., are examples of variable costs.
Semi-variable Casts:
There are some costs which are called
semi-variable costs or semi-fixed costs. These
are
hybrid costs made up of a fixed element and a fully variable element. There is
a
tendency
for the costs to vary with output, but the variation is irregular.
If costs could be segregated into fixed and
variable costs, it becomes easier to study the
behaviour
of profit in relation to volume. For a very broad understanding and use of
contribution
analysis, one could divide all costs into two categories only viz, fixed costs
and
variable costs. In other words, semi-fixed/semi variable costs could be treated
as
fixed.
If such broad analysis should indicate the need for deeper probe into the
profitplans,
an
in-depth study could be made by breaking up such semi-fixed/semi-variable
costs
into fixed and variable components.
Contribution
The difference between the sales price and the
variable costs is called Contribution. The
“contribution”
is the term used to describe this relationship between variable costs and
selling
price.
Contribution
= Sales - Variable Costs
In
view of the fact that variable costs by definition are directly related to
sales, the
contribution
will increase when sales increase and contribution will go down, when sales
go
down. The two important features of contribution are:
a)
Contribution increases directly in proportion to the volume i.e., there is a
linear
relationship
between the two and
b)
if nothing is produced and sold, the variable cost is nil and the loss incurred
is
equal
to fixed costs.
Importance of contribution in profit planning:
As stated earlier,
Profit
= Sales - Costs
In
view of the fact that we have now been able to identify that costs consist of
two
components
viz., fixed and variable, the above statement could be restated as under:
Profit
= Sales - (Variable Costs + Fixed Costs)
or
Profit =(Sales - Variable Costs)- Fixed Costs Where,
sales
– variable costs = contribution.
or
Profit = Contribution - Fixed Costs
In
view of the fact that contribution increases directly in relation to sales and
as fixed
costs
by definition remain the same, profit could be maximised by increasing
contribution.
In other words, organisations should have maximisation of contribution as
one
of their major goals and various management decisions must subserve this goal.
Profit Volume Ratio
The ratio of contribution to sales turnover is
called profit volume ratio (or P/ V ratio). The
P/
V ratio is a measure of the rate of contribution made by each rupee of sale out
of
which
fixed expenses must be met.
The profit volume ratio thus becomes an
important factor in taking various management
decisions.
If there are two alternatives open to the management as a result of which two
profit/volume
ratios would emerge, the management would prima facie choose the
alternative which
gives a higher profit volume ratio.
