Question

What are the pros and cons for each of the following methods for finding breakeven point:

1. Income statement approach.

2. The unit contribution margin.

3. The contribution margin ratio.

Answer 1

ANSWER :-

Break even point :- Breakeven point is the sales level at which operting income is zero,it means

Total sales = Total cost

EXPLANATION :- It means the Point of no profit and no loss.

The pros and cons of the following method for break even pont are as:

I) Income statement approach :- The income statement approach can be used to compute the breakeven point. The income statemet approach consist of :

a) Revenues

b) Variable cost

c) Fixed cost

d) Operting income.

Pros of income statement approach :-

a) It serves as the most useful and important managerial tool to know the cost-output profit relationship at varying level of output.

b) It is useful in reviewing pricing policies.

c) It aids in planning capitalisation of the enterprise.

d) It provides the enterpreneur to decide whether to acquire or not assets involving additioan fixed costs.

Cons of Income statement approach :-

a) The Breakeven point analysis is based on some assumptions,such as sales,price,costs,production,sales ,etc.The technique will be only of financial value unless all these assumptions are well calculated.

b) Income statement approach may not be prove useful to rapidly growing enterprises and to enterprises which frequently change their product mix.

c) In income statement approach the variable cost or expenses are the cost which remain consistent.It includes energy ,wages for labor related to the production ,such cost can be lower or raise with the output level of the business.

2) Unit contibution margin :- It's formula is , Selling price - variable costs.It is the product's price minus all assoiated variable costs,resulting in the incremental profit earned for each unit sold.

PROS OF UNIT CONTRIBUTION MARGIN :-

a) The unit marinal costing technique facilitates not only the recording of costs but their reporting also.The classification of costs into fixed and variable components makes the job of cost ascertainment easier.

b) Unit contribution costs helps into fixed and variable enables management to exercise control over production cost and thereby it hlps the business efficiency.

CONS OF UNIT CONTRIBUTION COSTS:-

a) It is assumed that whatever the level of output the average variable cost remains same.It means that there is no limit to output which the firm can produce which is highly unrealistic.

b) Unit contribution costs approaches can be used for the short term and it is not an effective tool for the long term.

3) The contribution margin ratio :- It is the difference between a company's sales and variable expenses.It's formula is :-

Contribution margin ratio= Contribution margin/sales x100

PROS OF contribution margin ratio :-

a) Marginal costing through contribution assists management in solving problems.Example- Pricing of products,Make or buy decisions,product mix etc.

b) It is a great tool for determining break even point levels and profit targets.It quickly determines the profitability of the various products.

CONS OF CONTRIBUTION MARGIN RATIO:-

a) It ignores the concept of elasticity of demand and the possibility that different prices may lead toto different level of demand.

b) It also ignores the principle of diminishing returns which every firm has to keep in view in contribution of margin ratio.

c) Bt using this type of approach it makes big assumptions that can throw off the validity of the analysis.