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Wednesday, June 13, 2012

BREAK-EVEN ANALYSIS AND IMPORTANCE OF BREAK EVEN ANALYSIS AND ITS USES

WHAT IS BREAK-EVEN ANALYSIS?

Break-even analysis is a means of determining the point where an IGA's costs exactly equal its sales; that is, the point where the IGA makes neither a profit nor a loss. The break-even point can be expressed as:

    Number of items must have be produced and sold in order to cover costs.

    the total value of sales in Taka that must be achieved in order to cover costs.

IMPORTANCE OF BREAK-EVEN ANALYSIS

Break-even analysis is a very important part of feasibility analysis because it tells the person who is considering starting up an IGA the minimum amount that he needs to produce and sell. If he produces less than this minimum, he will make a loss. If he produces more than this minimum, then he will make a profit.

As most IGAs undertaken by the poor in Bangladesh use unpaid family labor, the break-even point tells how much the business person must produce before he starts to get a return (income) from the family labor. If he can't produce and sell a quantity greater than the break-even quantity, then it is not worth doing the IGA because the family labor will have no financial value.


USES OF BREAK-EVEN ANALYSIS

Knowledge of the break-even point alerts the business person to any need to adjust the costs of the IGA. It may be that fixed costs can be lowered, thus lowering the break-even point and improving profitability. Alternatives are to decrease variable costs per unit or to increase the sales price.


Once the break-even point is known, the margin of safety can also be calculated. This is one way that the analyst can assess the risk of the business. The margin of safety compares actual or expected sales with the break-even sales, and expresses the result as a percentage. In general, the higher the margin of safety, the less the risk that the business will not be able to cover its fixed costs.

For example, if the break-even point of a grocery shop is Tk 200 in sales per day, and the owner expects that he will be able to sell Tk 250 per day, then the break-even point is 80% of expected sales. If, on the other hand, the owner expects sales to be only Tk 220 per day, then the break-even point is 91% of expected sales. In the second situation, the margin of safety that the business person can afford without getting into a loss making position is only 9%, whereas in the first case it is 20%.  Therefore, the second situation is more risky than the first one.


GRAPH OF BREAK-EVEN POINT

•    Variable costs rise as production rises, but fixed costs remain the same. Therefore, the total cost line rises parallel to the variable cost line.

•    Value of sales also rises as production increases.

•    The point at which sales and the total costs is same is the break-even point.