In this article we will discuss about:- 1. Introduction to Break-Even Analysis 2. Assumptions of Break-Even Analysis 3. Limitations.
Introduction to Break-Even Analysis:
Break-even analysis is of vital importance in determining the practical application of cost functions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying the dynamic relationship existing between total cost and sale volume of a company.
Hence it is also known as “cost-volume-profit analysis”. It helps to know the operating condition that exists when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred in attaining that level of sales.
Assumptions of Break-Even Analysis:
The break-even analysis is based on the following set of assumptions:
(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.
(ii) The cost and revenue functions remain linear.
(iii) The price of the product is assumed to be constant.
(iv) The volume of sales and volume of production are equal.
(v) The fixed costs remain constant over the volume under consideration.
(vi) It assumes constant rate of increase in variable cost.
(vii) It assumes constant technology and no improvement in labour efficiency.
(viii) The price of the product is assumed to be constant.
(ix) The factor price remains unaltered.
(x) Changes in input prices are ruled out.
(xi) In the case of multi-product firm, the product mix is stable.
Limitations of Break-Even Analysis:
We may now mention some important limitations which ought to be kept in mind while using break-even analysis:
1. In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the cost function is linear. In practice, it will not be so.
2. In the break-even analysis since we keep the function constant, we project the future with the help of past functions. This is not correct.
3. The assumption that the cost-revenue-output relationship is linear is true only over a small range of output. It is not an effective tool for long-range use.
4. Profits are a function of not only output, but also of other factors like technological change, improvement in the art of management, etc., which have been overlooked in this analysis.
5. When break-even analysis is based on accounting data, as it usually happens, it may suffer from various limitations of such data as neglect of imputed costs, arbitrary depreciation estimates and inappropriate allocation of overheads. It can be sound and useful only if the firm in question maintains a good accounting system.
6. Selling costs are specially difficult to handle break-even analysis. This is because changes in selling costs are a cause and not a result of changes in output and sales.
7. The simple form of a break-even chart makes no provisions for taxes, particularly corporate income tax.
8. It usually assumes that the price of the output is given . In other words, it assumes a horizontal demand curve that is realistic under the conditions of perfect competition.
9. Matching cost with output imposes another limitation on break-even analysis. Cost in a particular period need not be the result of the output in that period.
10. Because of so many restrictive assumptions underlying the technique, computation of a breakeven point is considered an approximation rather than a reality.