Break Even Analysis

Profit analysis

Profit in Business

According to Schumpeter, Profit – reward for innovation

Profit – Reward for undertaking risk Profit motive play a role in the efficient

allocation of resources – In a bid to maximize profit, all firms try to use its resources efficiently when faced with tough competition from the rival firms.

Profit – Some Concepts

Business profits/Accounting profits –

Total Revenue - Explicit Costs Economic Profit = Business Profits – Implicit

Costs Implicit Costs include costs of entrepreneurial

ability and capital goods owned by the company

Imp. Costs measured by opportunity costs

Break-even Analysis

Examines relation between Total Revenue, Total Cost & Profit at different levels of output

Break-even between profit and loss=> No profit no loss situation

Profit is defined as the difference between Total Revenue and Total Cost

Break Even situation => Equality between Total Revenue & Total Cost

Break Even – A division between zone of profit and zone of loss

Break Even output level is referred to that output level where No profit No loss situation exists

Relevance of the study

A firm knowing its break even output can target an output higher than it, to enjoy profit and avoid operating in the loss zone

This helps to set a target of sales To get an idea of the Contribution of the firm

to profit with each level of output, incremental revenue and incremental cost

Fixing a profit margin and then targeting the required sales to achieve the desired profit level

Break-even Chart

Graphically representing the relation between profit, revenue and costs in the form of a break-even chart

Linear Representation of total revenue, total cost, total fixed cost and Total variable costs

Graphical Representation of Break Even

TR,TC,TFC

QQoO

TR

TC

TFC

A

BLoss

Profit

Non-linear Break-even charts

TR, TC curves are non-linear following diminishing marginal returns to a factor and different price-elasticities.

Existence of multiple break-even points

Defined zones of profit unlike linear charts, operating profit zones become closed-bounded areas

Non-linear Graphical representation

TR,TC,TFC

QQoO

TR

TC

TFC

AB

Loss

ProfitB

Qo1

Loss

Break-even output & Contribution of a firm

At, break-even point, TR=TC, therefore, break-even output, QB = TFC/(P-AVC)

P-AVC, is the called the contribution margin per unit, as it represents the portion of the selling price that can be applied to cover the fixed cost of a firm and to provide for profits

TR-TVC, thus signifies the total contribution of the firm to cover its fixed cost and provide for profits

At break-even profits are zero, TFC covered

Profit Planning by a firm

Once the contribution margin is known, it becomes relatively easy for the firm to set an output target, depending on the profit margin they desire.

Let the profit desired by the firm be denoted by π, which has a 10% margin over the Average cost.

Desired output level to achieve this profit π, must have a total contribution of TFC+π

Targeted output, QT=(TFC+π)/(P-AVC)

Changes in price, AVC, TFC

The lower the break-even output, higher is the operating profit zone & lower is the operating loss zone

To achieve a lower break-even output, a firm can operate by

Increasing the prices (TR curve shifts upwards)

Decreasing fixed costs and variable costs (TFC & TVC curves shift downward)

Changes in Break-even Output

TR,TC,TFC

QQoO

TR

TC

TFC

A

B

Profit

TR1

TC1

TFC1

Qo1

Some observations on the linear approach Constant cost & prices – This analysis holds

good under constant cost & prices or constant mix of products assumptions, otherwise break-even analysis difficult

Single product or constant product mix – Over time product mix may change, firms found it difficult to allocate TFC among the products

Cost targets in break-even analysis

American Firms targeting price – A new model introduced is first designed, estimate the cost and setting a desired profit, price is determined

Japanese Cost Management – Instead of designing first, surveys the market first, set a target price (acceptable to the consumers), subtracts the desired profit margin to set the targeted cost & then designs the new product

Example of “NANO” – A Challenge ahead Targeted Cost Approach Biggest challenge – To achieve Break-even which is

already achieved in other models of TATA Motors by cutting costs

Acc. to Ratan Tata, initially a high output target was set to break-even which need a lot of high investment – Impossible target

Instead cost cutting to achieve low-cost, low break-even by technological changes – for e.g. Engine designed to be placed under rear seat

*Source: Website of TATA Motors; interview with Ratan Tata

Reliance Retail almost achieved break-even Almost achieved break-even after first year of

operation Loss less than one crore Expected to achieve break-even after several

years of operations due to high capital expenditure in retail industry

Reliance quite impressive as compared with other established companies, which enjoy very low profit margin of 1% or 2%

* Source: Mint dated 19th May, 2008

CASE STUDY on Lockheed’ Tri Star & Europe’s Airbus Industry 1971- Lockheed’s project L-1011 Tristar –

commercial jet aircraft Sought govt. guarantee for a bank loan to

complete the project Proof of economically sound project framed

on the basis of break-even sales, was forwarded by the company

Break-even 200 aircrafts at a price of $15.5 million

Case Study discussion

103 aircrafts already on demand, and options of another 75 aircrafts shown.

Loan guarantee legislation was passed Inclusion of fixed costs like development

costs of technology & construction facilities actually doubles the break-even output, therefore these were avoided by the firm

Given the market demand and tough competition from McDonell-Douglas and Boeing, a high break-even output difficult to achieve, such costs were thus not included

Outcome – Sales of 250 aircrafts between 1971 & 1984 & phasing out of the plan due to heavy losses

Implication – In aircraft industry, the development cost ( fixed cost) is high, therefore break-even output is high

European Companies took 20 years to reach break-even

*Source: Managerial Economics by Salvatore, 4th ed., Oxford

Preparation of Break –even charts

Choice of Approach: Analytical or Statistical Output Measurement : For multiple, non-

homogeneous products index method or value of sales method

TR curve: two sets of data on revenue & output required

Break-even point-Intersection of TR & TC Margin of Safety – difference between actual

sales or output and break-even sales or output

Example

A coastal ship can carry a maximum of 1,00,000 passengers per month at a fare of Rs. 850. Variable cost per passenger is Rs 100 while the fixed costs are Rs. 75,00,000 per month. Find the Break-even quantity and sales for the ship and break-even percentage capacity.

Suppose the management of shipping company sets a profit target of Rs 75,00,000, what level of output to be produced and at what margin of safety?

Solution 1

1.

2.

3. Average % of seating capacity filled to achieve break-even

000,10

AVCP

TFCQB

000,00,85.)/(1)/(1Rs

TRTVC

TFC

PAVC

TFCSB

%10100000,00,1

000,10100%

max

Q

QBB

Solution 2

1. Output to be targeted

% Capacity to be utilized

000,20

100550

000,00,75000,00,75

AVCP

TFCQD

%20100000,00,1

000,20100%

max

Q

QDD

Margin of Safety

If a firm operates at a higher output level much higher than the break-even output, a firm is said to be operating safely in the profit zone.

Margin of Safety can be expressed as

Solution 2. If targeted output is actually produced & sold in the market, then Margin of Safety = 50%

100

A

BA

Q

QQ

Break-Even Analysis of Hero Honda

Problem – Continuous phenomenal growth & a big jump in Jan, 2004, due to constant innovations. But constant innovations had led to higher costs. The time had arrived to look into the relationship between cost, output and profit more closely, to strengthen the relationship with external stakeholders. It has been the fixed cost that had shown an increase. The problem was to identify the impact of such changes in fixed cost on commodity prices, output & profit.

Steps involved in Calculations of Break-even point Determined the variables like fixed costs,

selling prices and variable costs Contribution Margin can be used in place of

selling price and variable costs where both these variables are tough to separate

Selling Price defined as Total Sales Turnover divided by total sales unit

Fixed and Variable Cost identified from income data

Observations thro’ B.E. Analysis

Both Sales Turnover & Break-even have increased

The gap between actual sales & break-even sales have increased substantially indicating high safety margin

Recommendations

Further cut in cost of production – Adoption of technologies like Chinese companies using plastics, aluminium; employee value addition

Increase value to customer Cutting overhead costs 60% capacity utilization may be increased

further by cutting costs, using resources efficiently and optimally by more value generation.