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By M. Isi Eromosele
Break-even analysis is a useful tool to study the
relationship between fixed costs, variable costs and returns within an
organization.
A break-even point defines when an investment will generate a
positive return and can be determined graphically or with simple mathematics.
Break-even analysis computes the volume of production at a
given price necessary to cover all costs. Break-even price analysis computes
the price necessary at a given level of production to cover all costs. To
explain how break-even analysis works, it is necessary to define the cost items.
Fixed Costs
Fixed costs, incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.
Fixed costs, incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.
Variable Costs
Variable costs change in direct relation to volume of output.
They may include cost of goods sold or production expenses such as labor and
power costs, fuel and other expenses directly related to the production of a
commodity or investment in a capital asset.
Total variable costs (TVC) are the sum of the variable costs
for the specified level of production or output. Average variable costs are the
variable costs per unit of output or of TVC divided by units of output.
Total variable costs increase directly as production
increases.
The total cost line is the sum of the total fixed costs and
total variable costs. The total cost line parallels the total variable cost
line, but it begins at the level of the total fixed
cost line.
The key point (break-even point) is the intersection of the
total cost line and the total income line. A vertical line down from this point shows the
level of production necessary to cover all costs. Production greater than this
level generates positive revenue; losses are incurred at lower levels of production.
The break-even point is found faster and more accurately with
the following formula:
B-E = F / (S - V) where:
- B-E = break-even
point (units of production)
- F = total
fixed costs
- V = variable
costs per unit of production
- S = savings
or additional returns per unit
- of production,
and the mathematical approach is best presented using examples
The main advantage of break-even analysis is that it points
out the relationship between cost, production volume and returns. It can be
extended to show how changes in fixed cost-variable cost relation-hips, in
commodity prices or in revenues will affect profit levels and break-even points.
Limitations of break-even analysis include:
- It is
best suited to the analysis of one product at a time
- It may
be difficult to classify a cost as all variable or all fixed
- There
may be a tendency to continue to use a break-even analysis after the cost and
income functions have changed
Break-even analysis is most useful when used with partial
budgeting or capital budgeting techniques. The major benefit to using break-even
analysis is that it indicates the lowest amount of business activity necessary to prevent
losses.
M. Isi Eromosele is
the President | Chief Executive Officer | Executive Creative Director of Oseme
Group - Oseme Creative | Oseme Consulting | Oseme Finance
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2012 Oseme Group
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