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Break-Even Point:
Meaning, Assumptions,
Uses and Limitations
Let us make an in-depth study of the meaning, assumptions, uses and limitations of break-even point. Meaning of Break-Even Point: Break-even point represents that volume of production where total costs equal to total sales revenue resulting into a no-profit no-loss situation.
If output of any product falls below that point there is loss; and if output exceeds that point there is profit.
Thus, it is the minimum point of production where total costs are recovered. Therefore, at break-even point.
Sales Revenue – Total Cost
or, Sales – Variable Cost = Contribution = Fixed Cost
It can be concluded that at break-even `point the contribution earned just covers the fixed
cost and, at levels below the point, contribution earned is not sufficient to match the fixed cost and, at levels above the point, contribution earned more than recovers the fixed cost.
P is the break-even point in the break-even chart where OS and CT—being the sales line and total cost line—intersects. Loss results in the left side of P, i.e., before the break-even point is reached, and, beyond P, profit starts to generate. Break-even point has a wide use in the field of marginal costing and helps to decide the product mix, fixation of selling price, steps to be taken in long-term planning etc.
Break-even point can be ascertained by using the following formula:
Assumptions Underlying Break-Even Analysis:
(ii) It helps in the fixation of sales volume to cover a given return on capital employed.
(iii) It helps in forecasting costs and profit as a result of change in volume.
(iv) It gives suggestions for shift in sales mix.
(v) It helps in making inter-firm comparison of profitability.
(vi) It helps in determination of costs and revenue at various levels of output.
(vii) It is an aid in management decision- making (e.g., make or buy, introducing a product etc.), forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without much difficulty and effort.
Limitations of Break-Even Analysis:
- Break-even analysis is based on the assumption that all costs and expenses can be clearly separated into fixed and variable components. In practice, however, it may not be possible to achieve a clear-cut division of costs into fixed and variable types.
- It assumes that fixed costs remain constant at all levels of activity. It should be noted that fixed costs tend to vary beyond a certain level of activity.
- It assumes that variable costs vary proportionately with the volume of output. In practice, they move, no doubt, in sympathy with volume of output, but not necessarily in direct proportions..
- The assumption that selling price remains unchanged gives a straight revenue line which may not be true. Selling price of a product depends upon certain factors like market demand and supply, competition etc., so it, too, hardly remains constant.
- The assumption that only one product is produced or that product mix will remain unchanged is difficult to find in practice.
- Apportionment of fixed cost over a variety of products poses a problem.
- It assumes that the business conditions may not change which is not true.
- It assumes that production and sales quantities are equal and there will be no
