Page 218 - DMGT409Basic Financial Management

Unit 14: Break Even Analysis

6. What are the revenue and cost implications of changing the process of production? Notes

7. Should one make, buy or lease capital equipment?
!
Caution Margin of safety is the difference between the actual sales and sales at break even
point. Sales beyond break even volume bring in profi ts. Such sales represent a margin of
safety.
Margin of safety = Actual sales – Break even Sales

or = Profi t/PV Ratio
Profit × Selling Price per Unit
or
Selling Price per Unit – Variable Cost Per Unit
Margin of safety as % of total sales
= Margin of Safety/Total cost × 100

14.3 Advantages of Break Even Point

A break even point does not help a person to run his business; its usefulness lies in the fact that
it enables him to discern variations a little more clearly.
1. The usefulness of the break even point is evident in budgeting, forecasting and controlling
costs. In itself, a break even point moves only with changing conditions and, in so moving,
it flashes a warning.

2. The cost-volume-profit analysis deals with the net effect of changes in cost, price and
volume in profits. It not only helps a management in profit prediction, but is also very

useful to it in virtually all decision-making areas.
3. It is useful in product decisions, the pricing of products, the selection of channels of
distribution, in making or buying decisions and if changing to the best methods of
production.
4. The price-volume study method has proved to be of the greatest possible assistance to the

management, for it enables to fix prices on a scientifi c basis.
5. A cost-volume-profit analysis is useful when, it determines the sales volume required to

attain a given level of profits, and; it yields the most profitable combination of products to

produce and sell.
14.4 Limitations of Break Even Analysis

Key limitations of break even analysis are:
1. It does not include adjustments for risk and uncertainty.
2. The break even chart shows the short-run relationship of total costs to total revenue. It is a

static picture in which assumption of profit is influenced solely by the level of output.
3. A break even point is virtually useless, if the materials used fluctuate widely in price,

particularly when these materials represent large proportions of the total cost.
4. If the product mix consists of product with varying profi t margins, the picture presented
by a simple break even point may be meaningless.

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