Question

3. Break Even Analysis is a concept in Marginal Costing, which is a useful tool to study the relation between fixed costs and variable costs and revenue.
Required to:
i. Explain the benefits and limitations of Break Even Analysis. 10 marks
ii. Provide your own numerical data and show the calculations for Break Even point in units and in Omani Rials, explaining how Break Even Analysis helps in decision making. 10 marks
iii. Construct a Break Even Chart showing all its components. 10 marks

additional information.

In Question 3, students need to give an introduction about Break Even analysis (Approximately 400 words) and then answer the question i (Approximately 500 words) ,

ii (numerical part approximately 300 words) and theory part approximately 300 words)

and iii preparation of chart explaining its components( approximately 300 words)

Answer 1

Break Even Analysis is a concept in Marginal Costing, which is a useful tool to study the relation between fixed costs and variable costs and revenue.

Develop the answer by considering the following key points:

i)
- Break-even is a situation where you are neither making money nor losing money, but all your costs have been covered.
- Break-even analysis helps to determine at what stage the company, or a new service or a product, will be profitable.
- It is a financial calculation for determining the number of products or services a company should sell to cover its costs, especially fixed costs.
- It is based on categorising production costs - "variable" and "fixed".
- It is an important aspect of a good business plan - helps to determine the cost structures, and the number of units to be sold to cover the cost or make a profit.
- Break-even analysis is used broadly, from stock and options trading to corporate budgeting for various projects.
- It deals with the contribution margin of a product.
- It is useful in studying the relation between the variable cost, fixed cost and revenue.

Benefits:

- Easy to view and understand even for people with no accounting background.
- Easy Calculation
- Aid to the decision making process
- Helpful to set targets for achieving profit.
- Helps to understand the consequences of changes for a particular product.
- Helpul in determining the appropriate price of the products or services.
- Helps to cover up the fixed cost of the project.

Limitations:

- Mere interpretation of future events
- Not considering the other factors like, the management skills, market conditions, technological factors, etc. which affect the business.
- The assumption of constant selling price and linear cost function may be true in reality.
- Analysis make become poor if the company lacks an efficient accounting system.

ii) Break-even point is a point where total costs (expenses) and total sales (revenue) are equal.
To calculate the break-even point in units, the formula is: Break-Even point (units) = Fixed Costs ÷ (Sales price per unit – Variable costs per unit) or in Omani Rials using the formula: Break-Even point (Sales in Omani Rials) = Fixed Costs ÷ Contribution Margin.

Imagine, fixed costs associated with production of a product is OMR 1,000,000. Its variable cost is OMR 2,500 per unit and expected to sell at OMR 4,500 per unit.

Here, break even point in units is calculated as follows,

Fixed Costs ÷ (Sales price per unit – Variable costs per unit)
= 1,000,000 / (4,500 - 2,500)
= 1,000,000 / 2,500
= 500 units.

Hence, break even point in units is 500 units. That means the company need to sell 500 units to reach a stage where there is no profit or gain. It is a stage in which total revenue equals total expenses.

Now let's calculate the break even point in Omani Rials. The formula is,
Fixed Costs ÷ Contribution Margin

Contribution margin = Selling price - Variable Cost per unit / Selling price
= (4,500 - 2,500 / 4,500) = 44.44%

Hence, break even point in Omani Rials is,
OMR 1,000,000 / 44.44% = OMR 2,250,000

Hence, break even point in Omani Rials is OMR 2,250,000. That means the company need to have a sales of OMR 2,250,000 to reach a stage where there is no profit or gain. It is a stage in which total revenue equals total expenses. From that stage the product can start making profit.

iii) Break even point, graphically means the point where the total cost and the total revenue curves meet.
The graphical representation of the above example is given below.

Here, 'x axis' indicates, number of units and 'y axis' indicates Omani Rials. Fixed cost of OMR 1,000,000 is represented by a straight line. Above the fixed cost line from the y axis, there starts the additional to fixed cost which is total cost ( fixed cost + variable cost).
From the point where both axis intersect, the income or sales in omani rials starts. Total cost and total sales intersect at a place, which is known as break even point. In the x axis break even point in number of units 500 is shown and in y axis break even point in Omani Rials is shown. From the point above break even point, the curve shows profit and below the point curve shows loss.