The simplest approach for showing the relationship of revenue to cost is the breakeven chart. Revenue and cost can be studied by directing attention to: (1) total revenue and total cost, (2) average revenue and average cost per unit of output and (3) changes in revenue and cost. Breakeven analysis directs attention to the first of thee. Breakeven analysis implies that at some point in the operations total revenue equals total costs – the breakeven point. This analysis can be handled algebraically or graphically; however, in all cases, the first step is to classify costs into at least two types – fixed and variables.
The mangers has long recognized that, during a given pf time some costs are subject to change as the rate of production changes and other costs will continue unchanged. If the time period is extremely short say one minute all costs will remain unchanged or fixed. If the time period is very long say ten years all costs will be subject to change. Generally, it is useful to use a time period which economists call the short run, in which it is possible to vary the rate of production but which is so short that the capacity or scale of operations cannot be changed be changed. In this period, some costs will be variable as a results of a change in rate of operations (for example, materials and direct labor) but other costs will be fixed( that is, will remain constant regardless of the quantity of output). The manager continually is faced with decisions in which the classification of total costs into variable and fixed costs will help focus attention to the correct costs.
The distinction between total fixed and total variable costs stresses that only variable costs will increase with an increase in the production rate of output. However, it should be clear that when average cost per unit is considered, fixed cost per unit of output will decline as volume increases – the constant fixed costs are spread over more units of output. Variable costs per unit of output may increase proportionally with an increase in output (which will be the assumption in the breakeven charts), or they may decreases per unit of output (for example, if quantity discounts are significant), or they increase per unit of output (if the quantity of materials is very short and thus price increases as output increases as output increases). In most industries, variable costs per unit can reasonably be assumed to be constant and thus total variable costs will appear as a straight line (linear) when plotted against various quantities of output.
The process of classifying costs into fixed and variable costs is a necessary first step in breakeven analysis. At times, this process is complicated by the fact that the types of costs being classified may be partly fixed and partly variable (semi-fixed costs). For example, electrical current may be used partly for lighting the plant (fixed) and also for running machines that may be turned off if output declines (variable). In such cases, additional breakdowns of costs may be necessary in order to segregate fixed from variable. If there is no basis for additional breakdowns, the manager may resort to using judgment (or analysis of past experience) and to considering some fraction of the type of costs as fixed and the other fraction as variable. For example, if it appears that maintenance costs are partly fixed and partly variable the manager may take some percentage of maintenance costs as fixed and some percentage as variable. In any case, a clear, distinction between fixed and variables costs must be made in order to secure the value of breakeven analysis.