BREAK EVEN ANALYSIS

Like ratio analysis, break even analysis also called cost volume profit analysis, is a tool for financial analysis. It is primarily concerned with the following issues.
1. How profit varies with changes in output?
2. How profit varies with changes in costs prices?

Basic Assumptions

A simple tool for profit planning and analysis,break even analysis is based on several assumptions

Cost classification

The break even model assumes that the costs of the firm can be divided into two components.

A. Fixed costs

B. Variable costs.

Fixed costs remain constant irrespective of the changes in output. They include items such as managerial and supervisory salaries, depreciation charges, property tax, rent, interest on term loans, insurance and so on. Variable costs vary proportionately with output. They include items like material cost, power cost, and selling commission.

Constancy of unit selling price

This implies that the total revenue of the firm is a linear functions of the output. For firms which have a strong market for their products, this Assumptions is quote valid. For other firms, however it may not be so. Price reduction might assumption and not unrealistic enough to impair the validity of the cost volume profit model, particularly in the relevant range of output.

Stability of product mix

In the case of a multi product firm, the cost volume profit model assumes that the product mix of the firm remains stable. Without this premise, it is not possible to define the average variable profit ratio when different products have different variable profit ratios. While it is necessary to make this assumption, it must be borne in mind that the actual mix of products may differ from the planned one. Where this discrepancy is likely to be significant, cost volume profit model has limited applicability.

No change in inventory

A final assumption underlying the conventional cost volume profit model is that the volume of sales is equal ti the volume of production during an accounting period. Put differently inventory changes are assumed to be nil. This is required because in cost volume profit analysis, we match total costs and total revenues for a particular period