Make or Buy Decision Approach: Break - Even Analysis
Break-even analysis
Concept
Break – even analysis is also known as
cost volume profit analysis. It is a tool of financial analysis.
Break – even analysis related with
finding the point at which revenues and costs equal exactly. It can be carried
out algebraically or graphically.
Break – even point
Break – even point is a point where the
total sales are equal to total cost.
Break – even chart
To find the cut-off production volume
from where a firm will make profit is the main objective of the break even
analysis.
Let
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
The
total sales revenue (S) of the firm is
S = s x Q
The
total cost (TC) of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
TC = (v x Q) + FC
The
linear plots of the above two equations are shown in Figure.
The intersection point of the total sales
revenue line and the total cost line is called the break-even point.
The corresponding volume of production on
the X-axis is known as the break-even sales quantity. At the intersection
point, the total cost is equal to the total revenue. This point is also called
the no-loss or no-gain situation.
For any production quantity which is less
than the break-even quantity, the total cost is more than the total revenue.
Hence, the firm will be making loss.
For any production quantity which is more
than the break-even quantity, the total revenue will be more than the total
cost. Hence, the firm will be making profit.
Profit =
Sales – (Fixed Cost + Total Variable Costs)
= (s*Q) – (FC + [v*Q])
The
formulae to find the break-even quantity
The
formulae to find the break-even sales
Example problem for break –
even analysis
A
manufacturer of TV buys a TV cabinet at Rs. 500 each. In case the company makes
it within the factory, the fixed and variable costs would be Rs. 4,00,000 and
Rs. 300 per cabinet respectively. Should the manufacturer make or buy the
cabinet if the demand is 1,500 TV cabinets?
Given data
Selling price per unit = Rs. 500
Variable cost per unit = Rs. 300
Fixed cost = Rs. 4,00,000
Formula used
Solution
Break – even quantity = 4,00,000 / (500 – 300)
= 2,000 units
Decision
Here, the demand (1,500
units) is less than the break even quantity (2,000 units). Therefore the
company should buy the cabinets for its TV production.
