3.

3 Break-even analysis
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1.1.1 My Introduction to business management
Break- even analysis is an important topic from the examination point of view. Therefore, students are suggested to
cover this topic thoroughly. We will start with a hypothetical case study so that the basic concepts are understood
clearly and you can analyze its implications for a business.

CASE STUDY
Pinnacle Notebook Ltd. is a notebook manufacturing company based out of Pune. It manufactures different types of
notebooks for students. The company incurs fixed costs such as rent of the premises, lease payments of assets, etc.
The variable costs such as electricity bill, wages of the workers are also incurred. Pinnacle Notebook manufactures
20,000 units of notebook and charges Rs. 120 per notebook on an average in a month. The expected fixed costs for
the next few months are Rs. 1,80,000 per week and the variable cost is expected to be around Rs. 10 per notebook,
per week. The expected demand for the notebooks is same as the output i.e. 20,000 units per month.

CONTRIBUTION
Contribution refers to the amount of money that remains after the total variable costs associated with the production
are deducted from the total sales revenue.

Total Contribution = Total Revenue – TVC

AVC = Average variable cost
 Total Contribution = (P – AVC) × Q
P = Price of the product
Therefore, Contribution per unit = P – AVC
Q = Quantity sold
And Profit = Total contribution – TFC TFC = Total fixed cost

For Pinnacle Notebook Ltd, let us try to calculate the month’s profit.
TVC = (10 × 20,000 × 4) = 8,00,000
AVC = TVC/ Q = 8,00,000/ 20000 = 40
Contribution per unit = P – AVC = 120 – 40 = 80
Total contribution = 80 × 20000 = 16,00,000
Profit = Total contribution – TFC = 16,00,000 – (1,80,000 × 4) = 16,00,000 – 7,20,000 = 8,80,000

There are three ways in which a business organization can increase the profits. These are:
(1) By increasing the sales revenue to increase the total contribution.
(2) By decreasing the variable costs incurred.
(3) By decreasing the fixed costs by exercising cost control.

Importance of contribution analysis:

(1) Contribution analysis helps a business organization to set the correct prices of the product to ensure that there
is sufficient contribution towards the payment of FC.
(2) It helps the management to decide which products are to be given precedence in terms of investment. The ones
with the higher contribution are given priority in general.
(3) Contribution analysis helps in proper allocation of the costs to the cost and profit centres.

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(4) This analysis is also helpful in taking make-or-buy decisions. The decision is made after comparing the unit
contribution of buying and making the product.

(5) Contribution analysis is vitally important to perform break-even analysis. Break- even is a point where TR = TC
(no profit, no loss). For newly established businesses, attaining the break- even point is necessary to move
towards stability and profitability in the long run.

Common mistake:
BREAK- EVEN ANALYSIS Students generally suggest that if a
product is making minimal
Break-even analysis is a management decision-making tool drawn on contribution, its production must be
the basis of expected sales and cost. It helps the managers to decide discontinued. But that is not a correct
whether the particular product is feasible for production or not, what option. From a firm’s point of view, that
would be the expected profits, and at which point will the firm break- small contribution is also helpful in
even. It is essential for the new enterprises to reach break-even point paying towards the fixed costs. If we
to ensure their sustainability and profitability in the long-term. discontinue its production, we would
be at no profit since the same amount
In general, a business can be at any of the three situations at any point of FC will be incurred continually.
of time:
a. At Loss- When TC > TR
b. At profit- When TR > TC
c. At Break-even- When TR = TC

Steps in performing break-even analysis:

I. Calculation of break-even point and break-even quantity
Three ways to ascertain break-even point (the point at which the costs are
equal to the revenue i.e. there is no profit no loss). Lower BEQ shows that
firm will be able to operate at profit in the next few years and vice-versa.
a) TR = TC rule
BEQ (Break-even quantity) = The quantity at which TR = TC. Break-even quantity refers to
If, TR = TC the level of output (Q) at which
 P ×Q = TFC + TVC the total cost is equal to the
 120Q = 7,20,000 + 40Q total revenue which means
 80Q = 7,20,000 that there is no profit =/ loss.
(Since TVC = Rs. 10 per notebook per week, therefore, TVC for the
month = 10Q × 4 = 40Q)
 Q = 7,20,000/ 80 = 9,000 Exam tip:
If the BEQ is a decimal number
Therefore, BEQ for Pinnacle Notebook Ltd. = 9,000 units of notebook
(for instance - 173.56), then it
is rounded up to 174.
b) Contribution per unit rule
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This rule says that,
BEQ = FC/ Contribution per unit
Using the figures of above case study,

BEQ = 7,20,000/ 80 = 9,000 units.

It is easier and quicker to calculate BEQ with this method.

Now, what is break-even revenue?

The amount of revenue at which the fixed and variable costs of the business would be covered for the firm to break-
even.
𝐅𝐂 𝐅𝐂 𝐅𝐂 𝐅𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭𝐬
BER = BEQ × P = ×P= ×P= 𝐕𝐂 =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐩𝐞𝐫 𝐮𝐧𝐢𝐭 𝐏−𝐀𝐕𝐂 𝟏−( ) 𝟏−(𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭𝐬/𝐩𝐫𝐢𝐜𝐞)
𝐏

c) Break-even chart/ Graphical method

The break-even chart drawn beside shows the break-
Costs and revenues (Rs.)
even point and the break-even quantity. Break-even
point = Rs. 3,60,000. And break-even quantity = 9000 TR
units.
TC = Total cost = TVC + TFC
TR = Total Revenue Break-even
Profit =
point
Rs.8,80,000
Well, it is particularly important to construct the
break-even chart carefully and properly. The steps TC
involved in doing so are:
3,60,000
• x and y axes are plotted. x-axis being the level of
output (units) any y-axis being costs and revenues Loss
(monetary unit).
• The TC line is drawn and labelled, where TC = TFC 9,000 Output
+ TVC. Remember, since TFC is incurred even (No. of notebooks
Break-even quantity
when the output is zero unlike TVC, therefore, TC per month)
line would always start at same level as TFC.
• TR line is drawn and labelled, and the TR line starts from origin since sales revenue is zero when the level of
output is zero.
• Now the break-even point is marked at the intersection of TC and TR lines. And the break-even quantity is the
level of output at which TC and TR lines intersect. (TR = TC).

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II. Calculation of the margin of safety
Common mistake:
The margin of safety (MOS) is the difference between the firm’s sales
Students generally express the margin
volume and the break-even quantity.
of safety as the monetary value. The
A firm must have a positive MOS to be able to make profits.
students should make sure that MOS is
When sales volume > BEQ, MOS is positive => Profit
measured in terms of the level of
When sales volume < BEQ, MOS is negative => Loss
output which is measured in units.

In the above case study, Pinnacle Notebook Ltd. produces and sells 20,000 notebooks per month while the quantity
needed to break-even is 9000 units.
Thus, MOS = 20,000 – 9000 = 11,000 units (which is positive).

Inferences/ implications of break-even analysis of Pinnacle Notebook Ltd.:

• The break-even point of Pinnacle Notebook Ltd. suggests that the company is breaking even at an output of 9000
units and the company’s output is 20,000 units. Hence, there is a positive MOS and the management of the company
can look forward to continuing with the production of notebooks.
• A positive MOS indicates profit. The profits can be increased more by increasing the production or minimizing the
costs (by optimum utilization of resources and avoiding wastage).

Common mistake:
Costs and revenues

Students seem to think that

TR
calculating the break-even
point will actually ensure
Break-even
Profit = the firm covers its costs and
point
Rs.8,80,000 makes profit. Calculating
(Rs.)

the BEQ does not mean the

TC firm has actually sold
3,60,000 anything. Break-even
analysis is performed on the
Loss MOS basis of expected revenues
and costs.
9,000 Output
BEQ (No. of
notebooks per
month)

The break-even point in the diagram is based on expected costs and revenues. The actual break even, profits and
losses might differ from the predicted figures due to few reasons which are:
➢ The short and long-term profits generally differ. In the short run, to attract the customers, the price of the
product is reduced leading to higher BEQ but in the long run, the prices might be raised up once customers
become loyal. This reduces demand and hence BEQ.
➢ The change in demand because of the different factors that affect demand.
➢ Innovation and introduction of new technologies can lead to the production of better products. This might gear
sales and profits and the values would surpass the original forecasts.
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 Benefits of BEA Limitations of BEA
It is a useful decision-making tool that helps the BEA is based on some assumptions that seem to be
management to make realistic predictions about profits unrealistic from the business’s perspective. The
and losses of the business. assumptions are mentioned in the box below.

This tool can be used to improve the profit graph of the It is a static tool / model and hence, not of much use in a
business in the coming years. dynamic business environment.
BEA performed with the help of break-even chart BEA’s results solely depend on the data. The data needs
makes it convenient to draw interpretations and to be authentic to avoid wrong results.
conclusions. The charts are relatively easy to construct
and interpret.
Calculating the margin of safety through BEA helps the BEA is only suitable for single product firms that can
managers to assess the risk involved in producing the sell all of their output.
project.

FEW UNREALISTIC ASSUMPTIONS OF BREAK-EVEN ANALYSIS (BEA)

i. Break-even analysis is helpful only for single product firms.
ii. It assumes that the total production = total sales. It considers that all
the output produced would be sold.
iii. It considers only total fixed cost and variable cost in the calculation of
total cost. The semi-variable cost stands ignored.
iv. The price of the product is assumed to be constant.
v. It assumes constant technology and no improvement in labor
efficiency.
vi. All the cost functions are linear. Indeed, economies of scale with the
increase in level of output might decrease the costs.
vii. The sales revenue function is also linear. Indeed, in case of bulk
purchases from the customers, discount might be demanded by the
customers leading to lower revenue with increase in sales.

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