Financial Management & Cost Accounting

Module 6. Working capital management

Lesson 36
DETERMINING BREAK EVEN POINTS, BREAK EVEN CHARTS, MARGIN OF SAFETY

36.1 Introduction

Usually, 'Break even analysis' is presented graphically as this method of, visual presentation is particularly well suited to the needs of business owing to the manager being able to appraise the situation at a glance. A visual representation of the relationship between costs- volume and profit is known as the break even chart. Such a chart not' only depicts the level of activity where there will be neither loss nor profit but also shows the profit or loss at various levels of activity. The break even chart means "a chart which shows profit or loss at various levels of activity, the level at which neither profit nor loss1s shown being termed the breakeven point". This may also take the form of a chart on which is plotted the relationship either of total cost of sales to sales or of fixed costs to contribution. Thus it is a graphical presentation of cost and revenue data so as to show their inter relationship at different levels of activity.

Break even charts are frequently used and needed where a business is new or where it is experiencing trade difficulties. In these cases the chart assists the management in considering the advantages and disadvantages of marginal sales. However in a highly profitable enterprise, there is little need of Weak even charts except when studying the implications of a major expansion scheme involving a heavy increase in fixed charges.

There are three methods of drawing a break even chart. These have been explained with the help of the following illustration:

36.2 Illustration

Calculate the Break Even Point and Profit if output is 50.000 units by drawing a break even chart.

Table 36.1 Break even charts

Production (units)	Fixed Expenses Rs.	Variable cost per unit Rs.	Selling price per unit Rs.	Total cost Rs.	Total sales Rs.
0 10,000 20,000 30,000 40,000 50,000 60,000	1,50,000 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000	10 10 10 10 10 10 10	15 15 15 15 15 15 15	1,50,000 2,50,000 3,50,000 4,50,000 5,50,000 6,50,000 7,50,000	--- 1,50,000 3,00,000 4,50,000 6,00,000 7,50,000 9,00,000

Solution

36.2.1 First method

On the X axis of the graph is plotted the number of units produced, sold and on the Y axis are shown costs and sales revenues.

The fixed cost line is drawn parallel to X axis. This line indicates that fixed expenses remain the same with any volume of production. The variable costs for different levels of activity are plotted over the fixed cost line at zero volume of production. This line can also be regarded as the total cost line because it starts from the point where fixed cost has been incurred and variable cost is zero. Sales values at various levels of output are plotted joined and the resultant line is the sales line. The sales line will cut the total cost line at a point where the total costs are equal to the total revenues and this point of intersection of two lines is known as breakeven point - the point of no profit no loss. The number of units to be produced at the breakeven point is determined by drawing a perpendicular line to the X axis from the point of intersection and measuring the horizontal distance from the zero point to the point at which the perpendicular line is drawn- The sales value at the breakeven point is determined by drawing a perpendicular line to the Y axis from the point of intersection and measuring the vertical distance from the zero point to the point at which the perpendicular line is drawn. Loss and profit are as have been shown in the chart which shows that if production is less than the breakeven point, the business shall be running at a loss and if the production is more than the breakeven level, profit shall result.

36.2.2 Second method

Another method of drawing a break even chart is showing the variable cost line first and thereafter drawing the fixed cost line above the variable cost line. The latter line is the total cost line because it is drawn over the variable cost line and represents the total cost (variable and fixed) at various levels of output. The difference under this method from the first method is that the fixed cost line shown above the variable cost line shall be parallel to the latter whereas under the first method, the fixed cost line is parallel to the X. axis. The sales line is drawn as usual and therefore the added advantage, of this method is that 'Contributions' at varying levels of output are automatically depicted in the chart. The breakeven point is indicated by the Intersection of the total cost line and the sales line. The break even chart on the basis of the data given in the illustration will appear as given below according to this method.

36.2.3 Third method

Under this method, fixed cost line is drawn parallel to the X- axis. The contribution line is drawn from the origin and this line goes up with increase in output. The sales line is plotted as usual. The question of interactions of sales line with cost line does not arise because the total cost line is not drawn in this method. In this method, breakeven point is that point where the contribution line cuts the fixed or loss. If the contribution is more than the fixed expenses, profit shall arise and if the contribution is less than the fixed expenses loss shall arise. The graphical presentation of the given data according to this method is given in the previous page.

36.3 Cash Break-Even Chart

Though break even charts are generally based on profit and loss data and are used to estimate earnings most likely to result from given scale of operations such charts can also be made to yield information regarding the effect of changes in the scale of operations upon the cash situations of a business. However this requires a slight rearrangement and a few adjustments in the basic approach to the graphical representation of break even analysis.

Following points have to be kept on view in connection with the construction of cash break even charts:

i. Fixed expenses are to be divided into those that involve cash payments and those that do not involve cash payments, like depreciation.

ii. In view of the fact that cash break even chart is designed to show actual payments, and not expenses incurred, any lag in the payment of the items of variable cost must be taken into account.

iii. Consideration has also to be given to the period of credit allowed to debtors for arriving at cash to be received from them.

36.4 Illustration

From the following data, plot a Cash Break Even Chart.

Output and sales 1000units

Selling price per unit Rs. 15

Fixed costs Rs. 5,000

(Including depreciation Rs. 1000)

Variable cost per unit

Assume there is no lag in payments. Rs. 5

Solution

Table 36.2 Cash break even points

Output (Units)	Variable Costs Rs.	Cash Fixed costs Rs.	Total Cash costs Rs.	Sales Rs.
200 400 600 800 1000	1000 2000 3000 4000 5000	4000 4000 4000 4000 4000	5000 6000 7000 8000 9000	3000 6000 9000 12000 15000

Cash Break Even Point = Cash Fixed Cost/ Cash Contribution per unit

= Rs. 4000/10 = 400 units.

36.5 Angle of Incidence

This is the angle formed the breakeven point at which the sales line cuts the cost line. This angle indicates rate at which profits are being made. Large angle of incidence is an indication that profits are being made at a high rate. On the other hand, a small angle indicates a low rate of profit and suggests that variable costs form a major part of cost of production. A large angle of incidence with a high, margin of safety indicates the most favorable position of a business and even the existence of monopoly conditions.

Margin of safety represents the amount by whici1 the actual volume of sales exceeds those at the breakeven point. It is important that, there should be a reasonable margin of safety; otherwise a produced level of activity may prove disastrous. A low margin usually indicates high fixed costs so that profits ~re not made until there is high level of activity to absorb fixed costs.