After reading this article you will learn about Break Even Chart:- 1. Meaning of Break-Even Chart 2. Construction of a Break-Even Chart 3. Method of Preparation 4. Advantages 5. Limitations 6. Multi-Product 7. Types.
Contents:
- Meaning of Break-Even Chart
- Construction of a Break-Even Chart
- Types of Break-Even Chart
- Method of Preparation of Break-Even Chart
- Advantages of Break-Even Chart
- Limitations of Break-Even Chart
- Multi-Product of Break-Even Chart
1. Meaning of Break-Even Chart:
The Break-Even Chart is a graphical representation between cost, volume and profits. No doubt, it is an important tool which helps to make profit planning. It has been defined as, “a chart which shows the profitability or otherwise of an undertaking at various levels of activity and as a result indicates the point at which neither profit nor loss is made.”
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Since it shows the effects of cost and revenue at varying level of sales it has been rightly called Cost-Volume-Profit graph (CVP graph).
BEC depicts the following information:
(a) Cost (i.e. Fixed, Variable and Total);
(b) Sales value and Profit/Loss;
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(c) Break-Even Point;
(d) Margin of Safety.
Certain Assumption about the CVP Graph:
(a) Fixed Cost, will remain constant during the relevant period;
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(b) Semi-Variable Cost can be bifurcated into variable and fixed components.
(c) Variable cost per unit also will not make any change during the relevant period.
(d) Selling price also will not make any change during the relevant period irrespective of the quantity sold.
(e) Operating efficiency also will remain constant.
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(f) Product mix will remain unchangeable.
(g) Volume of production and sales are equal.
2. Construction of a Break-Even Chart:
A Break-Even Chart is constructed on a graph paper Activity or volume of production is plotted on the ‘X’ axis whereas, cost and revenue are plotted on the ‘Y’ axis.
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Again, ‘X’ axis may be represented in the following manner, such as:
(1) Volume in units;
(ii) Sales value;
(iii) Standard Hours; and
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(iv) Percentage level of activity.
The following illustration will help to understand the whole principal:
3. Types of Break-Even Chart:
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The BECs we have discussed so far are the common type. There are certain types of Break-Even Charts which are yet to be discussed and which are used for various purposes.
Some of them are discussed here under:
(a) Detailed Break-Even Chart;
(b) Control Break-Even Chart;
(c) Cash Break-Even Chart; and
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(d) BEC to ascertain the optimum volume.
(a) Detailed Break-Even Chart:
Under this type of BEC, the total variable costs, i.e. direct materials, direct labour, variable overhead are represented in this graph together with the appropriation items, like dividend on equity shares, dividend on preference shares, income-tax and retentions are plotted. In this respect it may be mentioned that if this chart contains only the details of appropriation of profit it may be called profit-appropriations BEC.
The following illustration with help to understand the principle:
Illustration:
From the following particulars, draw up a detailed BEC:
(b) Control Break-Even Chart:
Control Break-Even Chart is prepared in order to make a comparison between budgeted/standard and actual cost, sales and profits, particularly when the Budgetary Control Systems and Marginal Costing system are combined. After analysing the deviations between budgeted/standard and actual figures.
Control Break-Even Chart proves itself a very useful method which directly helps the management in taking decisions. It is to be remembered that the detailed information about deviations between budgeted figures and actual figures is not possible graphically.
(c) Cash Break-Even Chart:
Before preparing a Cash Break-Even Chart we are to divide the amount of fixed cost into two following groups:
Viz:
(i) Fixed Cost which require cost outlay (like, Rent, Salary etc.);
(ii) Fixed Cost which do not require immediate cost (like, deferred expenditure, Depreciation etc.).
In this chart, item
(i) Is treated as base like ordinary BEP whereas item
(ii) Is shown last i.e., after variable cost, so that a comparison can be made easily.
Similarly variable costs which need immediate payment, are plotted as usual. But care should be taken if any credit transaction is included in the variable cost.
If that be so the’ same is to be treated as no. (ii) stated above. This Chart is very useful to those firms which suffer from short-term liquidity and solvency position as well. It is primarily used in cash flow analysis.
Illustration:
From the following information prepare a Cash-Break-Even Chart:
Solution:
(d) BEC to ascertain the Optimum Volume:
This is particularly useful where the demand for a product is elastic. Because in case of perfect competition selling price of a product is to be reduced in order to earn more profit by increasing the volume of sales which ultimately gives a highest contribution. Now, the problem arises before us is that at what stage the amount of profit will be maximised since the volume of sales are fluctuating.
This can be solved with the help of a BEC which is shown below. In this regard, it may be said that if amount of sales and costs at different stages are plotted on a graph paper, it becomes possible for us to know at which point the profit will be maximized. Needless to mention that that point will be the optimum level and that selling price of the products will be the optimum selling price of the products of the firm.
All these information can be had with the help of a BEC which is presented below:
Illustration:
X Ltd. gives you the following particulars for which you are requested to ascertain the volume of sales and selling price at which the company can maximise profits with the help of a graph.
The fixed costs amount to Rs. 24,000 and the same is to increase by Rs. 8,000 if the output exceeds 4,000 units.
Solution:
Before preparing the graph the following table is prepared:
Now taking the above data, we can plot the same on s graph which is depicted as under:
From the above, it becomes clear that at 6,500 units, the profit can be maximised In other words, at this level the sales value/line is higher than the total cost line resulting the highest margin. As such, this will be the optimum level of output at the prevailing selling price which will yield the maximum profit.
4. Method of Preparation of Break-Even Chart:
(a) Draw fixed Cost of Rs 40,000 line parallel to ‘X’ axis. Then plot the variable cost line over fixed cost level at various level of activity and join the variable cost line with fixed cost line at zero level of activity which will indicate total cost line — variable cost being over fixed cost line.
(b) At the same time, ascertain sales value at various activity level and plot them on the graph paper and then to zero which line indicates the volume of sales.
(c) It is interesting to note that where the sales line intersects the total cost line, that is known as Break-Even point. Needless to mention here that BEP will be ascertained by drawing a perpendicular to ‘X’ axis from the point of intersection which measures the horizontal distance from the zero point from where the perpendicular is drawn.
Similarly, in order to find out BES value, another perpendicular to the ‘Y’ axis from the point of intersection is drawn.
Comments:
From the above BEC, it becomes clear that profit/loss at different levels of activity can be understood from this chart. For example, if we find the sales line is above the total cost line, there will be profit and vice-versa. Similarly, if total cost is equal to total sales, there is no profit or no loss i.e., break-even point. In Fig. 4.2 diagram, 50% level of activity brings break-even level.
5. Advantages of Break-Even Chart:
The following advantages may be offered by a BEC:
(i) Easy to Construct and Easy to Understand:
A Break-Even Chart gives us very clear-cut information which helps the management to take correct decisions as it depicts a detailed picture of the entire undertaking.
(ii) Useful Tool to Help Management:
It has already been pointed out that a BEC gives us the relationship between Cost, Volume and Profit. Thus, the same may present the effect of changes in cost and selling price due to the change in variable cost and fixed cost.
(iii) Helps to Select the most Profitable Product Mix:
No doubt a BEC helps us to select the most profitable product mix or sales mix for earning more profits.
(iv) Helps to Ascertain the Strength of the Business:
This chart helps us to determine profit earning capacity after analysing together Angle of incidence and Margin of Safety.
Therefore, the Management obtains some important information relating to:
(i) Increase the selling price,
(ii) To reduce the cost;
(iii) To substitute the less profitable product by more profitable products, and
(iv) To increase the volume of production.
6. Limitations of Break-Even Chart:
The BEC is not free from snags. They are:
(i) Based on Unrealistic Assumptions some of them are:
(a) Selling price remains constant irrespective of the volume of sales;
(b) Production and sales are equal (i.e., without considering value of stock);
(c) Variable cost remains same;
(d) All indirect cost can be segregated into fixed and variable. In actual practice, however, all the above assumptions are not correct
(ii) Ignore the Concept and Effect of Capital Employed:
BEC ignores the basic accounting elements i.e., capital employed which is very significant for calculating the rate of profitability or earnings,
(iii) Construction of Multiple BEC Chart:
If different variety of products are produced, separate BEC should be drawn up which creates a problem of fixed overhead allocation.
7. Multi-Product of Break-Even Chart:
It is quite possible to produce different types of products for a firm and in that case, a Multi-product Break-Even Chart may be constructed for the firm as a whole. Naturally, in that case, BEP will be that point where the Average contribution line will intersect the fixed cost line assuming that there will be no change in sales-mix.
Method of Construction of Multi- Product Break-Even Chart:
(a) Complete P/V ratio and arrange the products in descending order according to P/V ratios.
(b) Y axis represents contribution and fixed cost while X axis represents sales value;
(c) Then plot the total fixed cost line;
(d) And then take the product which has highest P/V ratio, plot its contribution against sales and so on;
(e) Now, get the average contribution line after joining the origin to the end of the last line so plotted.
(f) The BEP will be that point where average contribution will cut fixed cost line of the products.
Illustration:
X Ltd products three types of products, viz. A, B and C.
Construct a BEC in order to determine their BEP from the following particulars:
Solution:
Before constructing the BEC, let us calculate the P/V ratio of each product first. Then according to the importance of P/V ratio,a table showing cumulative sales should also be prepared. At last, complete the graph.
Now we are to prepare the following table:
The same result can also be depicted by the following Multi-Product Break-Even Chart
(BEC) as under:
