Discuss usefulness and assumptions of break even analysis, What are the limitations of Break even analysis

 Usefulness of Break-even Analysis: Break even analysis is a technique of profit planning that has been used for many years by accountants, business executives and some economists. It is essentially a device for integrating costs, revenues and output of the firm in order to illustrate the probable effects of alternative courses of action upon net profits. It is an aid to profit planning. Break even analysis provides useful information to management and lending institutions (banks) in most lucid and precise manner. It is an effective and efficient reporting tool of financial management. The importance of Break even analysis can be enumerated as under.

 1) Fair knowledge about break even analysis can help bankers/banking to examine loan proposal of a firm/enterprise.

 2) Break even analysis helps the bankers in assessing working capital requirement of a unit; it comes in handy to measure the future cost and revenue relationship and also helps to determine the level of production. As and when this level is known, the enterprise can also play its future working capital requirements for the enterprise.

 3) This analysis helps in revealing clear projections of profit planning of an enterprise at different production level vis-a-vis the financial needs. It also helps to find rate of return on investment of capital at varying levels of production.

 4) It helps the banker in studying the projection cost of production and profitability statement of a unit prepared to show net position at a given level of output. Below break even point, the average loss per unit increases as the volume of output declines. When the unit functions above Break even point they can maintain their profitability and be in a position to meet their commitments and debt obligations. In other words, when once a unit Break events from then onwards repayments of debt may begin for the terms loans granted by them. Usually, till a unit reaches the Break even level of production repayment holding is granted by banks.

 5) Break even analysis is a useful diagnostic tool. It indicates the management the causes of increasing Break even point and falling profits. The analysis of these causes will reveal to management what action should be taken. As a practical matter, knowledge of where Break even lies can be quite useful to management in determining the need for action.

 Break even analysis is based on certain assumptions. These are as follows:

 1) Fixed costs will tend to remain constant. In other words, there will not be any change in cost factor, such as, change in property tax rate, insurance rate, salaries of staffs etc. or in management policy;

2) Price of variable cost factors, i.e., wage rates, price of materials, supplies, services etc. will remain unchanged so that variable costs are truly variable;

3) Product specifications and methods of manufacturing and selling will not undergo a change;

4) Operating efficiently will not increase or decrease;

5) There will not be any change in pricing policy due to change in volume, competition etc. In other words, selling price will remain unchanged as the volume expands;

6) The number of units of sales will coincide with the units produced so that there is no closing or opening stock. Alternatively, the changes in opening and closing stocks are insignificant and that they are valued at the same price or at variable cost.

 

Q. What are the limitations of Break even analysis? Ans.:

Limitations of Break even analysis:

Break even analysis is a simple and useful concept. But it is based on certain assumptions but these assumptions may limit the utility and general applicability of Break even analysis. Therefore, the analysis should recognize these limitations and adjust the data wherever possible to get meaningful results. Break even analysis suffers from the following limitations:-

 1) It may be difficult to segregate cost into fixed and variable components;

2) It is not correct to assumption that total fixed cost into fixed and variable components: 3) The assumption of constant unit variable cost is not valid; 4) Selling price may not remain unchanged over a period of time;

5)Break even analysis is a short run concept and has a limited use in long range planning. 6.Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you

nothing about what sales are actually likely to be for the product at these various prices. 7.It assumes that fixed costs (FC) are constant. Although this is true in the short run, an

increase in the scale of production is likely to cause fixed costs to rise;

8.It assumes average variable costs are constant per unit of output, at least in the range of

likely quantities of sales(i.e. linearity);

9.(t assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period);

10. In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant);

 Though Break even analysis suffers from a number of limitations, yet are still remains as an important tool of profit planning.