CCP Break even analysis

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.