Here it is required that certain items frequently used in this technique be introduced and the calculations of break even point made with the derivation of various formulas.
Break even Point: The break even point is at which the total cost line and the sales line (i.e. total revenue line) intersect one another on the graph. The spread to the right of the point shows the profit potential while to the left represents the loss potential. This is the level of activity where the undertaking neither earns profits nor incurs loss. Since total revenue and total cost are exactly equal, the beak even point is also the no-profit no loss point.
Angle of incidence: This is the angle at which the sales line cuts the total cost line. The larger angle, the higher the rate of profit would be. A narrow angle shows that even though fixed overheads are recovered, the profit accrued shows a low rate of return. This indicates a larger part of variable costs in total cost. In all, the management aims at widening the angle of incidence and improve the rate of the profitability.
Contribution Margin: Contribution margin refers to the difference between the sales and variable overheads. If both the items are on unit basis, it is Unit Contribution Margin, otherwise it is known as Gross Contribution Margin.
The contribution margin is the fund or pool out of which fixed overheads are to be met and if that leaves any sum, it would be the Break even Analysis. So the contribution margin is the excess of the unit sales price over the unit variable overheads that contributes to the recovery of fixed overheads and share of profit.
Then, again profits realized on one individual product cannot be compared with that of other products since apportionment of fixed profit is not possible for each product. A comparison of the relative contribution margin of each product serves the purpose serves the purpose. Higher the contribution margin in percentage, the product would be more profitable. This concept helps determine the profitability of different products or departments in an undertaking and arriving at the best possible sales mix.
Contribution Margin (unit) = Unit sales Price – Unit Variable Costs
Gross Contribution Margin = Total revenue – Total Variable Costs
Margin of safety: This represents the amount by which the volume of sales exceeds one at break even point. The margin of safety in a way connotes the extent to which the undertaking can afford to lose the sales or lower the prices and yet remain in business. So it is very important that a reasonable level of margin of safety should be there, otherwise a reduced level of activity may prove disastrous and even endanger the very existence of business.
A high margin of safety usually connotes a low level of fixed overheads. So firms with such situation are invulnerable in times of reduced level of activities, especially in a recessionary period. On the other and, a low margin of safety is not sufficient to absorb even fixed overheads in most recessions. This puts the firms out of business.
Algebraically, the margin of safety is,
Sales – Sales at BEP / Sales x 100
Operating Profit / Gross Contribution Margin x 100
Operating profit = Total Revenue – Total Cost
= Total Revenue – Variable Cost – Fixed Cost
= Gross Contribution Margin – Fixed Cost
Margin of safety = gross Contribution Margin – PC / Gross Contribution Margin
P / V Ratio: Profit Volume ratio (P/V Ratio) measures the profitability in relation to sales. So it is a measure to compare profitability of different products. Higher the P/V ratio, the high yielding is the product.
P / V ratio = contribution (p.u) / Sales (p.u) x 100