Chapter 5

Break-Even Analysis/ Profit

Contribution Analysis

À B-E studies the relationship between costs,

revenues and profits of an organization.
À Determines the point at which sales must
cover all costs ( fixed + variable).
À At B-E point TR = TC and hence profit = 0.
À The point where losses cease to occur while
profits have not yet begun.
À Indicates the minimum level of production
which an organization has to undertake in
order to be economically viable.

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 Algebraic Analysis
À B-E Quantity is the volume of Q at which TR (PQ)
= TC (F + VQ).
À PQ = F + VQ
À or, (P – V)Q = F
À or, Q = F / P – V
-------------------------------------------------------------
P = Price per unit sold
Q = Quantity produced and sold
F = Total fixed costs
V = Variable cost per unit

À If P = $ 10 and TC = 12 + 7Q, the break-

even Q is: TR = TC or, TR – TC = 0, i.e.,
10Q = 12 + 7Q or, Q = 4.
Class Assignment: 1
The publication of a text book is under
consideration of a firm. By using the
following data, state how the B-E analysis
can be a useful tool in new product
decisions of the firm.
À Fixed Costs: Copy editing- 3000$
Typesetting- 22000$

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À Variable costs per copy:
Printing and binding : 1.60 $
Discounts to book trade : 2.65 $
Author’s Royalties : 1.60 $
General and Admn. Costs : 1.15 $
À Sale Price per copy : 12 $

Y Net Profit
TR

Break-even point
TC
Variable Cost
R&C

ss Fixed Cost
Lo

Fixed Cost

0 X
Output

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À In the linear analysis, the greater the Q, the
larger the profit, and vice-versa.
À Due to FC in SR, profit is negative at zero
and small levels of Q.
À TC curve is above the TR curve for up to
break even output, indicating a loss.
À TR curve is above the TC curve beyond the
break even output, indicating a profit.
À The gap between TR and TVC is known as
total contribution, which is always positive.

TC

C TR

D
R&C

B
0
Q1 Q Q3 Q4 Q5
2
Output

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À In case of non-linear, either the TR
function, TC function or both are non-linear.
À In case of linear analysis, profit maximizing
or sales maximizing output remains
indeterminate.
À Non-linear Analysis helps to find out:
Profit maximizing output (OQ3).
Level of output which maximizes sales
revenue subject to no-profit-no-loss (OQ5).
Equilibrium price-output combination under
the objective of sales revenue maximization
subject to a given amount of profit (OQ4).

Contribution Margin Analysis

À Refers to the difference between revenue
and variable expense.
À The total net profit (Nπ) is the difference
between TR and TC.
À TCM = Nπ + TFC or, TCM = TR – TVC,
hence ACM = P – AVC or, TCM / Q.
À Each unit sold covers variable costs plus an
amount which can then be applied towards
the recovery of fixed expenses.
À P – AVC ($ 5 - $ 3) = $ 2 can be towards
recovery of fixed expenses.

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 Y TR

NP CM
TC

TFC
TVC
R&C

TFC

0 X
Q Output

Assumptions of B-E Analysis

À Costs can be classified into FC and VC.
À Sale price of the product is assumed to be
constant.
À Rate of increase in VC is constant.
À Changes in input prices are ruled out.
À No improvement in technology and labor
efficiency.
À There is no change in inventory.

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 Determination of B-E Point
B-E point can be expressed in three ways:
À As a number of units sold
À As a $ volume of sales
À As a percentage of plant capacity
The B-E point exists where TR = TC or,
P × QB = TFC + QB (AVC)
or, QB (P – AVC) = TFC
or, QB = TFC / P – AVC
À In terms of contribution margin, the
QB = TFC / ACM

À As a number of units that must be sold, B-E

point QB = TFC / P – AVC.
À As sales in $, B-E point would be estimated:
SB = TFC / 1 – (AVC/P) or,
SB = TFC / 1 – (TVC/TR).
À As a percentage of plant capacity, B-E point
% B = {TFC / (P – AVC) Qmax } × 100
or, % B ={ QB / Qmax } × 100

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 Class Assignment: 2
À Mekong Ferry Service has the monthly
seating capacity of 20,000 passengers on
one of its routes at a fare of $ 170. Variable
cost is $ 20 per passenger and fixed cost is
$ 600,000. Compute the following:
Break-even Quantity (QB)
Break-even Sales (SB)
Break-even percentage of capacity (% B).

Applications of B-E Analysis

À Useful in cases where a particular product
may be manufactured under two or more
technologies of production.
Plant I Plant II Plant III
Price 8$ 8$ 8$
TFC 80,000$ 1,80,000$ 2,80,000$
AVC 4$ 2$ 1$
If the estimated minimum sales volume is
25,000 units, find out the most profitable
and suitable plant. (Answer- Plant I).

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À Helps in taking ‘make or buy decisions’.
Suppose it costs $ 12 per unit to out-source
a material from the market to a firm. If
manufactured by the firm, the TFC would be
50,000 $ and the AVC would be 2 $ per
unit.
If the requirement of the firm is 4050 units
of material, what decision the firm will
consider. (Answer- buy it from outside).

À Guides in allocating budget for promotional

activities.
Suppose the FC for producing a product is
10,000 $. The AVC is 1 $, the sale price is 3
$. Whether the firm will decide to incur an
expenditure of 2,000 $ towards promotion if
it expects its sale to increase to 7,500 units.
(Answer- advisable to incur the expenditure
on promotion).

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À Guides in Production planning. It is an
indicator of maximum contribution towards
profit and loss.
Suppose a firm intends to find out the most
profitable item to be produced out of
producing note books or exercise books.
The TFC is 72,000 $ in both cases. The sale
price is 10$ and 12$ and the AVC is 2$ and
3$ for note book and exercise book
respectively.
Which one should be produced by the firm?
(Answer- Exercise book).

À Facilitates in Decision making relating to

price and quantity levels of a proposed
product.
If the expected sales are not likely to reach
the B-E level, the firm can either:
Raise the price of the product,
Reduce its AVC,
Raise the price and reduce its AVC.
The firm must consider each of these B-E
points and take a final decision by
considering the expected minimum sales
volume.

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À Facilitates in determining the sales volume
at which the target profit will be attained.
The target profit amount should be added
to the TFC.
Q = TFC + Tπ / P – AVC
(Q is the target profit quantity).
If TFC = 12$, P = 10$, AVC = 7$ and
Tπ = 15$, find out the BEQ and TπQ.
TπQ > BEQ.

Profit-Volume Ratio
À Shows the relationship of contribution to
total sales.
À It is a ratio between the contribution and
the total sales value.
À PVR = Price – AVC / Price
À Shows the rate of percentage contribution
to total sales.

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 Safety Margin Percentage
À {Actual Sales – QB / Actual sales} × 100
À With a low safety margin the firm is running
the risk of making losses during the phases
of reduced business activity.
À A firm should have a reasonable margin of
safety.
À Class Assignment: 3
FC = 60,000$, VC = 10 $ per unit, Selling
price = 20$, Actual sales = 10,000 units.
Determine QB and margin of safety.

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