These days a great deal of importance is attached to cost, volume and profit relationship which, as its name itself implies, is an analysis of three distinct factorsâ€”cost, volume and profit. In a scheme of cost-volume-profit analysis, an attempt is made to study the general effect of the different levels of activity upon total revenue and total cost with the help of revenue-output function and cost-output functions respectively. Ultimately, this technique measures profits corresponding to the different levels of output.
The study of cost-volume profit relationship is frequently referred to as â€œBreak-even Analysisâ€?. In the opinion of some, it is mere misnomer, since the break-even analysis is just incidental to the cost-volume-profit analysis. Contrary to this view, others interpret the term â€œbreakeven analysisâ€? in two senses, narrow and broad. In its narrow sense, it refers to a system of determining that level of operations where total revenue exactly equals total expenses, i.e. the level of operation where the undertaking neither earns a profit nor incurs a loss. Considered in its broad sense, break-even analysis denotes a system of analysis that can be used to determine the probable profits at any level of activity.
As stated above, an understanding of the inter-relationship between these three forces and of the likely effect that any change in sales volume would generate upon the business is extremely helpful to management in a broad variety of problems involving planning and control. Through the knowledge and information obtained from the break even analysis, complicated budgeting and profit-planning issues can be made easy and possible. Thus, the break even analysis is a vital tool of financial planning and control. However, the accuracy of results would largely depend upon the reliability of the data and validity of the assumptions on which the technique functions.
Unless some conditions prevail in the undertaking the break-even analysis cannot be expected to create significant results. Therefore, the break-even analysis to be a vital and meaningful aid in management decision-making requires the following basic assumptions:
1. The total cost can be divided into two watertight componentsâ€”fixed cost and variable cost. That is to say, all costs are either perfectly variable or absolutely fixed over the entire range of volume of production.
2. Fixed cost remains constant for a specified level of activity. Although the total volume of production may vary from zero to the projected full capacity, the fixed cost does not change in amount.
3. The variable cost varies directly and proportionately with the volume of production. Thus, double the level of activity, the variable cost would be twice that before.
4. The selling price does not change with a change in the volume of sales. Since all revenue techniques assume a single price for all the units of production, it is variable with the physical volume of production. The revenue earned from the first unit and that from the last unit is equal. This gives a straight line to the total revenue curve.
5. The firm deals in only one product or in the case of multiple products, all the products have the same contribution margin or the sales mix remains unchanged.
6. There is perfect synchronization between production and sales. This assumes that everything produced is sold and so there is no change in the inventory of finished goods.
Presentation of Break-even analysis:
A break-even analysis is presented graphically, as this method of visual presentation is particularly well-suited to the need of managers to appraise the situation at a cursory glance. The graphical representation of this technique avoids the danger of unnecessary details cropping up in the representation and presents the data and information in the most lucid and simplified manner.
A break-even chart shows the profitability of an undertaking, corresponding to the different levels of activity an as a result, depicts the point at which total revenues meet total costs exactly. This point is known as the break-even point. The break-even point is the level of activity where the undertaking neither earns profits nor incurs losses. Hence, it is also known as â€œNO-PROFIT NO-LOSS POINT.â€?
In a nutshell, break-even analysis is a technique that represents the relationship of costs and revenues to output.