To the management, the utility of break even analysis lies in the fact that it presents a microscope view of the profit structure of an undertaking. The break even analysis not only highlights the areas of economic strengths and weakness in business organization but also focuses upon certain averages which can be obtained to enhance profitability. The break even analysis has a dual role to play – one as a tool of financial planning and the second as an instrument of control. In the light of these two facts, the managerial uses can be as follows:
Safety Margin: The break even chart helps the management to know at a glance the profits at different levels of activity. Besides, the management considers the margin of safety associated with it. Here, the safety margin refers to the extent to which an undertaking can afford to lose its sales, before it starts incurring losses, with the help of the formula.
(Safety Margin) = (Sales – sales at BEP) / Sales x 100
In a example, sale is 10,000 units and sale at BEP is 7,000 units.
Safety Margin = (10,000 – 7,000) / 10,000 x 100
= 3,000 x 100 / 10,000 = 30%
But if the next year sales declines to 8,000 units,
Safety Margin = (8,000 – 7,000) / 8,000 x 100
= 1,000 x 100 / 8,000 = 12.5%
This means that the firm’s resistance capacity to avoid losses has become poorer
Volume needed to attain target profit: Sometimes the firm may aim to generate a particular amount of profit in specified period. For this purpose with the help of contribution margin concept under the break even analysis, it is very convenient to calculate the volume of sales necessary to achieve the targeted profit. For instance, a firm furnishes the following information. Let us calculate the target sales for Rs 4,000 profit
Fixed overheads Rs 20,000
Selling overheads Rs 100
Variable overheads Rs 60
Target sales volume = Fixed overhead + Target profits / Contribution margin (p.u)
= 20,000 + 4,000 / 40
= 24,000 / 40 = 600 units.
So the undertaking can plan its effort to ascertain the last sales to accomplish the target profit of Rs 4,000.
Submitting undue Quotations and accepting Special orders–Dumping in Foreign Markets etc: A decision in each of the aforesaid situations depends upon the contribution theory of the analysis. The situation arises only when the firm has sufficient excess capacity i.e. if the decision is taken, the firm need not go in for commissioning any new plant or machinery. So fixed overheads for additional orders undertaken is zero
For instance ABC Ltd., undertakes a special order for 5,000 units at Rs 10 each. The product cost Rs 9.50 to ABC Ltd. So the contribution (Gross) is 5,000 (0.50) = Rs 2,500. So the job is accepted.
Reduction in sales price in competitive and / or Depression or Additional sales volume required to maintain a particular level of profit: In this case, on account of the adverse market situation, it is imperative that prices must be reduced. If the firm wishes to maintain the level of profit as before with the use of formula as,
Expected sales Volume = Fixed Overhead + Target Profit / Contribution (p.u)
Can be derived more easily and likewise the firm can employ its strategies, For instance, ABC Ltd furnishes the following information:
Fixed cost Rs 20,000
Variable cost Rs 6
Selling price Rs 10 units sold 15,000 ,
Selling price (reduced) Rs 8
In this case, originally the firm has a total profit of Rs 40,000 as,
Profit = Gross Margin – Fixed Overhead
= 15,000 (4) – 20,000
= Rs 40,000
Now, with the reduced prices, it is required to attain the sales volume of 30,000 units to attain Rs 40,000 as profits.
Expected volumes of sales = FC + Targeted Profits / Contributions (p.u)
= 20,000 + 40,000 / 8–6
= 60,000 / 2 = 30,000 units
So with the reduced price of Rs 8 the firm must take efforts to sell 15,000 more units.