subject business economics paper no and title 1
TRANSCRIPT
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BUSINESS ECONOMICS
PAPER NO. 1: MICROECONOMICS ANALYSIS
MODULE NO. 15: BREAK-EVEN ANALYSIS
Subject BUSINESS ECONOMICS
Paper No and Title 1: Microeconomics analysis
Module No and Title 15: Break-Even Analysis
Module Tag BSE_P1_M15
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BUSINESS ECONOMICS
PAPER NO. 1: MICROECONOMICS ANALYSIS
MODULE NO. 15: BREAK-EVEN ANALYSIS
TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3.1 Total Revenue (TR)
3.2 Average Revenue (AR)
3.3 Marginal Revenue (MR)
3.4 Profit/Loss
4. Break Even Point
5. Break Even Analysis in different markets
5.1 Perfect Competition
5.1.1 Break-even analysis using TR and TC approach
5.1.2 Break-even analysis using AR and AC approach in short run
5.1.3 Break-even analysis using AR and AC approach in long run
5.2 Monopoly
5.2.1 Break-even analysis using TR and TC approach
5.2.2 Break-even analysis using AR and AC approach in short run
5.3 Monopolistic Competition
5.1.1 Break-even analysis using AR and AC approach
6. Advantage and Disadvantages of break-even point
7. Example
8. Summary
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PAPER NO. 1: MICROECONOMICS ANALYSIS
MODULE NO. 15: BREAK-EVEN ANALYSIS
1. Learning Outcomes
After studying this module, you shall be able to
Know basic concepts of costs, revenue and profit/loss
Learn why it is important to calculate break-even output
Learn what is margin of safety and its importance
Identify the key variables that can affect the break- even point
Know how the break-even point is decided under various market forms
Learn the advantages and disadvantages of break-even analysis
2. Introduction
Break-even point (BEP) is the point where the firm may be said to be in a βneutralβ situation in
terms of profit and loss (i.e., no profit and no loss situation). This kind of situation arises when the
firmβs total revenue is exactly equal to its total costs.
Break-even point is considered as a tool in the hands of a manager who takes a number of decisions
for the progress of its firm. Information based on break-even point is very useful in deciding the
selling price, to make proposals in a bidding process and it is also useful for firms when they apply
for credit in the market. 1
3. Cost, Revenue and Profit/Loss
To understand the concept of break-even point we should first have know about the following
concepts:
3.1 Total Revenue (TR)
Total revenue is defined as the total amount of money which a firm receives after selling its
output in the market.
π»πΉ = π·ππππ πππ ππππ β πΈπππππππ ππππ
The above formula shows total revenue can be calculated by multiplying the price of per unit of
the output to the number of units of the output sold in a particular period.
Example: ABC Ltd. co. makes cell phones. The price of a cell phone is Rs. 4000 and total
number of cell phones sold by him in the year 2014 were 10000.
π»πΉ = ππππ β πππππ = πΉπ. π, ππ, πππππ
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PAPER NO. 1: MICROECONOMICS ANALYSIS
MODULE NO. 15: BREAK-EVEN ANALYSIS
3.2 Average Revenue (AR)
Average revenue is defined as the price per unit of a commodity.
π¨πΉ =π»πΉ
πΈππππππ ππππ = π·ππππ πππ ππππ
Average revenue can be calculated by dividing the total revenue by the total number of quantity
sold in a particular time period.
As average revenue is also called price per unit, the total revenue formula can also be written as:
π»πΉ = π¨πΉ β πΈπππππππ ππππ
Example: ABC Ltd. co. makes cell phones. Its total revenue of the year 2014 was Rs. 40000000
and the number of cell phone it sold were 10000.
π¨πΉ =ππππππππ
πππππ= πΉπ. π, πππ
3.3 Marginal Revenue (MR)
Marginal revenue is known as the change in the total revenue when a firm tries to sell one more
unit of its output in the market.
π΄πΉ =β π»πΉ
β πΈπππππππ ππππ
The above formula suggests that marginal revenue is calculated by dividing the change in total
revenue to the change in the quantity sold by the firm.
Example: ABC Ltd. co. makes cell phones. Its total revenue is Rs. 40000000 when it sells 10000
units and 40005000 when it sells 10001 units. The marginal revenue of firm ABC Ltd. co is
π΄πΉ =ππππππππ β ππππππππ
πππππ β πππππ=
ππππ
π= πΉπ. π, πππ
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PAPER NO. 1: MICROECONOMICS ANALYSIS
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3.4 Profit/Loss
Profit (loss) means the positive (negative) difference between the total revenue and the total cost
of a firm.
π·πππππ/π³πππ = π = π»πΉ β π»πͺ
The firm shows a profit if π»πΉ > π»πͺ, ππππ π > π
The firm incurs a loss if π»πΉ < π»πͺ, ππππ π < π
4. Break Even Point
Break even analysis assumes the following:
1. Total Cost of a firm can be divided into fixed and variable costs.
2. It assumes that the selling price is constant and does not get affected by change in the
number of units of output sold and other factors.
3. Fixed cost is not affected by the change in the sale volume. It is assumed to be constant.
4. Variable cost per unit is assumed to be constant (e.g., the wage rate of the variable factor,
labour is fixed). The total variable cost changes in proportion to the change in quantity
sold.
5. It is assumed that there is no problem of demand, so that total produce is completely sold
out in the market. Therefore total production is equal to total sales.
6. It is assumed that the company is producing only one product; though break even analysis
can be applied to multi product company also.
7. Operating efficiency is assumed to remain unchanged.
Based on the above assumptions, the break-even point of a firm can be defined as a point where
total revenue is equal to the total cost of the firm, so that its profits are zero. To make our analysis
more concrete lets understand break-even point with the help of an example;
Example: Sunil & son Ltd.co. has made 4,000 plastic cups. It has a fixed cost of Rs. 2,000. This
company has also incurred a variable cost of Rs 3 per cup. The selling price of each cup is Rs. 5.
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Table 1
Output FC VC TC TR
Profit/Loss/BEP
0 2000 0 2000 0 -2000
LOSS
200 2000 600 2600 1000 -1600
400 2000 1200 3200 2000 -1200
600 2000 1800 3800 3000 -800
800 2000 2400 4400 4000 -400
1000 2000 3000 5000 5000 0 BEP
1200 2000 3600 5600 6000 400
PROFIT
1400 2000 4200 6200 7000 800
1600 2000 4800 6800 8000 1200
1800 2000 5400 7400 9000 1600
2000 2000 6000 8000 10000 2000
Figure1: Break Even Point
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The above Figure 1 represents three situations, First, if the firm is producing less than 1000 units
it will incur loss because its total cost of production is higher than its total revenue. Second, if the
firm is producing more than 1000 units, then the firm will have profits as its total revenue will
exceed its total cost of production. The third situation is the break even situation at 1000 unit of
output, where total revenue is equal to total cost. When the firm produces exactly 1000 units it
will earn zero profits and no loss. Point A is known as the break-even point of the firm.
There is a concept called margin of safety which is defined as the difference between the actual
sale and break even output.
π΄πππππ ππ ππππππ = π¨πππππ πΊππππ β π©ππππ ππππ πΆπππππ
π΄πππππ ππ ππππππ % =π¨πππππ πΊππππ β π©ππππ ππππ πΆπππππ
π¨πππππ πΊππππ Γ πππ
In some sense, the margin of safety give a kind of warning signal to the manager of a company.
Lower the margin of safety, higher is the risk of loss to a company. Thus the manger should be
more careful in taking decisions regarding revenue and controlling costs when the margin of
safety is low. The manager should try to increase the margin of safety for the better βhealthβ of a
company.
The margin of safety can be improved by the following measures:
By increasing the level of sales
Raising the selling price
Decreasing the fixed and variable cost per unit
Replace unprofitable commodities with relatively more profitable ones
Refer to Figure 1 and suppose the firm produces 1800 units and the break-even output is at 1000
output as per the above figure. Then the margin of safety will be:
π΄πππππ ππ ππππππ = ππππ β ππππ = πππ πππππ
π΄πππππ ππ ππππππ % =ππππ β ππππ
ππππΓ πππ =
πππ
ππππ Γ πππ = ππ. ππ %
Another way to show break-even point is through profit volume graph:
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Figure 2: Profit Volume Curve
We can also define break-even point, as the level of output where the profit of a company is zero.
In Figure 2 above, it has been shown that break- even point is at 1000 units where the profit line
cuts the output line (x-axis) or where the profit is exactly zero. If the company produces less than
1000 units or to the left of the break-even point, then the firm will incur loss. Whereas, if the
company produces more than 1000 units or to the right of the break-even point then the firm will
incur positive profits.
Calculating break-even point by using graphical technique is a cumbersome process. Break-even
point can be calculated by using the following formula:
π©ππππ ππππ πππππ(ππππππ) = πππππ πͺπππ
πΊππππππ π·ππππ β π½πππππππ ππππ πππ πΌπππ
In this formula (πΊππππππ π·ππππ β π½πππππππ ππππ πππ πΌπππ ) is known as the βaverage
contribution marginβ because it shows the part of selling price which is used to pay for the fixed
cost.
The question is, how do we arrive at this formula?
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The answer lies in the definition of Break Even Point and may be explained as follows:
π»πΉ = π»πͺ
πΊππππππ πππππ β πΈπππππππ = π»ππππ πππππ ππππ + π»ππππ ππππππππ ππππ
πΊππππππ πππππ β πΈπππππππ= π»ππππ πππππ ππππ + (π½πππππππ ππππ πππ ππππ β πΈπππππππ)
πΊππππππ πππππ β πΈπππππππ β ( π½πππππππ ππππ πππ ππππ β πΈπππππππ) = π»ππππ πππππ ππππ
πΈπππππππ( πΊππππππ πππππ β π½πππππππ ππππ πππ ππππ) = πππππ πͺπππ
π©ππππ π¬πππ πΈπππππππ = πππππ πͺπππ
πΊππππππ π·ππππ β π½πππππππ ππππ πππ πΌπππ
According to this formula in the above example (Table 1) the BEP is:
π©ππππ ππππ πππππ(ππππππ) = ππππ
π β π=
ππππ
π= ππππ ππππ
From this you can clearly see that the break-even point can change with a change in the value of
fixed cost, variable cost per unit and selling price.
Variables Change Change in Break-even output
Fixed Cost Rise UP
Fall Down
Variable cost per unit Rise UP
Fall Down
Selling price Rise Down
Fall UP
5. Break Even Analysis in Different Markets
In what follows we see how the break-even point for firms is affected with changes in
market structure. We will also cover market structures in greater detail in later modules.
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5.1 Perfect Competition
A perfectly competitive market is a market with large number of buyers and sellers. The product
which is sold out in this market is homogenous and firms in this market are free to enter and exit.
In such markets firms are said to be price-takers as they do not have any control on prices of the
goods they sell, due to the fact there are a large number of firms in the industry. So in perfectly
competitive markets, firmsβ AR is equal to MR.
5.1.1 Break-even analysis using TR (Total Revenue) and TC (Total Cost) approach
Figure 3: BEP in perfect competition
Break-even point is defined as the point where the total revenue is equal to the total cost.
According to Figure 3 above. When the market is perfectly competitive then the BEP can occur at
either one of two points A and B where the total revenue curve cuts the total cost (or in other
words, the total revenue is equal to the total cost). So the two break-even quantities will be Q1
and Q2. Firms will earn a profit if it produces some output that lies between Q1 and Q2;
elsewhere it will incur losses. Profits will be maximum when the firm produces at Q3 level of
quantity where the gap between TR and TC is maximum.
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5.1.2 Break-even analysis using AR and AC approach in short run
Figure 4: BEP in PC with AR and AC approach in Short run
In the case of perfect competitive markets in short run the firm can either earn super normal
profits, or normal profits (i.e., break-even), or incur a loss. Figure 4 above represents the case of
normal profits in short run. In economics normal profits basically means that the firm is earning
zero profit or TR exactly covers the TC of the firm.
Break-even point is where the TR=TC and corresponding to that in the above diagram, AR = AC
as can be shown as follows:
π»πΉ = π·ππππ (π¨πΉ) Γ πΈπππππππ = ππ· Γ ππΈ = ππππ ππ·π¨πΈ
π»πͺ = π¨πͺ Γ πΈπππππππ = ππ· (ππ πΈπ¨) Γ ππΈ = ππππ ππ·π¨πΈ,
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Therefore, at the break-even point, TR=TC or AR = AC, i.e., OP = QA in above diagram
5.1.3 Break-even analysis using AR and AC approach in Long run
Figure 5: BEP in PC with AR and AC approach in Long run
In the case of perfectly competitive markets, in long run, firms will earn only normal profits
(break-even) because in the long run firms have the option to enter and exit the industry. So the
competition among firms will drive down profits to the level of normal profits. This point will
also be analysed in detail in later modules. According to Figure 5 above the break-even point is at
point A where TR=TC:
π»πΉ = π·ππππ (π¨πΉ) Γ πΈπππππππ = ππ· Γ ππΈ = ππππ ππ·π¨πΈ
π»πͺ = π¨πͺ Γ πΈπππππππ = ππ· (ππ πΈπ¨) Γ ππΈ = ππππ ππ·π¨πΈ
Therefore, at the break-even point, TR=TC or AR=AC.
5.2 Monopoly
A monopoly is a market where there is a single seller. Other firms are restricted from entering
into the market in this case.
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5.2.1 Break even analysis using TR and TC approach
Figure 6: BEP in Monopoly
Total revenue and total cost approach can be used to show the break-even points in the case of a
monopoly. If the seller wants to sell more in this case, he has to reduce the price of the good - that
is why the TR in this case is not a straight line, but it is concave in shape. BEP occurs where the
TR curve cuts the TC curve. According to Figure 6 above, the TR curve cuts the TC curve at two
point A and B, so the break-even quantities will be Q1 and Q2. A monopoly firm will earn profits
if it produces a level of output that lies between Q1 and Q2. It will earn maximum profit if it
produces quantity Q3, because the difference between the TR and TC is maximum at this level of
output.
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5.2.2 Break-even analysis using AR and AC approach
Figure 7: BEP in Monopoly with AR and AC approach
In the short run, a monopoly firm can earn super normal profits, normal profits (break-even) or
incur a loss. But in the long run it will not incur loss and it may even earn super normal profits or
at least normal profits. In Figure 7 above, the equilibrium quantity is at Q where the MR=MC (the
equilibrium condition in a monopoly) and according to the AR and AC approach, break-even
point is at A where the TR=TC or AR=AC. At Q:
π»πΉ = π·ππππ (π¨πΉ) Γ πΈπππππππ = ππ· Γ ππΈ = ππππ ππ·π¨πΈ
π»πͺ = π¨πͺ Γ πΈπππππππ = ππ· (ππ πΈπ¨) Γ ππΈ = ππππ ππ·π¨πΈ
Therefore at the break-even point, TR=TC or AR=AC
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5.3 Monopolistic Competition
The main features of a market characterized by monopolistic competitive are that there are many
buyers and sellers, firms are free to enter and exit, but each producer produces a differentiated
product, which gives them some level of monopoly power.
5.3.1 Break-even analysis using AR and AC approach
Figure 8: BEP in Monopolistic competition with AR and AC approach
In the short run, in a market with monopolistic competition, firms can earn super normal profit,
normal profits (break-even) or incur loss in the short run. But in long run, owing to competitive
pressures, they will only earn normal profits, as firms have the option of entry and exit. The only
difference between the Figures for monopoly and monopolistic competition is that AR and MR
curves in monopoly is steeper than in monopolistic competition. The reasons for this will be
discussed in detail in later modules on market structures. In Figure 8 above, the equilibrium
quantity is at Q where MR=MC (the equilibrium condition) and according to the AR and AC
approach break-even point is at A where the TR=TC or AR=AC. At Q
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π»πΉ = π·ππππ (π¨πΉ) Γ πΈπππππππ = ππ· Γ ππΈ = ππππ ππ·π¨πΈ
π»πͺ = π¨πͺ Γ πΈπππππππ = ππ· (ππ πΈπ¨) Γ ππΈ = ππππ ππ·π¨πΈ
Therefore at the break-even point, TR=TC or AR=AC.
6. Advantage and Disadvantages of BEP
6.1 Advantages of break-even point
It is very simple to understand and can be calculated easily
This concept can useful in many real-life situations, e.g., when firms are applying for
a loan
It can be used to assess the impact on profits, when there is a change in the fixed costs
and / or variable costs and / or in the selling price of the product
6.2. Disadvantage of break-even point
The basic assumption of break-even analysis is that there is no problem of demand, so
that total production is always equal to total sales. But this might not be true always.
There may be situations where a part of output remains unsold.
Costs per unit are assumed to be fixed, but in reality they may not be fixed when output
increases.
Selling price is assumed to be constant but in competitive situations this may change.
The value of the break-even output is essentially just a forecast, based on certain
assumptions; the forecast may not be same as the actual situation in certain cases.
Break even analysis does not suit a situation where the company is making more than
one commodity. It is best used to analyse one commodity at a time.
To calculate BEP we need to categorise costs as fixed and variable but in some
situations it is difficult to classify costs as variable or fixed.
Break-even analysis only detects the problem but fails to give any remedial measures
to correct it.
Break-even analysis fails to take into consideration other factors like government
policies, marketing problems, volume of investment etc.
7. Example
Q. (a) A cloth making firm want to replace the old machinery with the new one. The total fixed
cost on desired machine is Rs. 21270 per year and the variable costs are Rs. 8.75 per
hour. This firm can produces 5 meters of cloth in an hour. The firm charges Rs.16
per meter from its customers. How many meters of cloth can be produced to break even?
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Ans. Fixed cost =Rs. 21270.00
Variable Cost = Rs. 8.75/hour
Quantity Produce in an hour=5 meters/hour
Variable cost per unit= 8.75 / 5= Rs. 1.75/meters
Selling Price=Rs.16/meter
π©ππππ π¬πππ πΈπππππππ = = πππππ πͺπππ
πΊππππππ π·ππππ β π½πππππππ ππππ πππ πΌπππ
π©ππππ π¬πππ πΈπππππππ =πππππ
ππ β π. ππ=
πππππ
ππ. ππ= ππππ ππππππ
Q. (b) Now if the firm produced 1500 meters of cloth, what is the effect on the firms profit?
Ans. Total quantity produced = 1500 meters
π»ππππ πππππππ = πΊππππππ πππππ Γ πΈπππππππ = πΉπ. ππ πππ πππππ Γ ππππ πππππ = πΉπ. πππππ π»ππππ πͺπππ = πππππ πͺπππ + π½πππππππ ππππ = πΉπ. πππππ+ (πΉπ. π. ππ Γ ππππ ππππππ) = πΉπ. πππππ + πΉπ. ππππ = πΉπ. πππππ
Profit = Total Revenue - Total Cost
= Rs. 24000-Rs.23875
= Rs. 125
Q. (c) Now if the firm produced 1400 meters of cloth, what is the effect on the firmβs profit?
Ans. Total quantity produced now is 1400 meters
π»ππππ πππππππ = πΊππππππ πππππ Γ πΈπππππππ = πΉπ. ππ πππ πππππ Γ ππππ πππππ = πΉπ. πππππ
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π»ππππ πͺπππ = πππππ πͺπππ + π½πππππππ ππππ = πΉπ. πππππ+ (πΉπ. π. ππ Γ ππππ ππππππ) = πΉπ. πππππ + πΉπ. πππππ = πΉπ. πππππ
Loss = Total Revenue -Total Cost
= Rs. 22400-Rs.23720
= Rs. 1320
This shows that if the firm tries to produce more than its BE quantity then it will earn profit
whereas if it produces less then BE quantity it will incur loss.
Summary
Break-even analysis is useful for the manager of a company for planning its profit.
Through margin of safety, manager can analyse how much he can reduce sales and still
gain some profit out of this.
A firm with higher margin of safety would be strong enough to survive even in a bad
market condition.
While break-even analysis can play an important role in the decisions of a manager it has
certain pros and cons that must be taken into consideration.