Module 8

Profits and Break Even Analysis

Contents: Module 8
Profits
Determinants of Short-term & Long-term profits.
Classification
Measurement of Profit.
Break Even Analysis
Meaning,
Assumptions,
determination of BEA,
Limitations
Uses of BEA in Managerial decisions.

8.1 Profit: Concepts

Profit means the excess of revenue over costs.
Revenue (TR) depends on price (P) and quantity of sales (Q).
Cost (C) depends on number of factors employed and average factor
price.
PROFIT= TR-TC

Micro economic concepts of Profits are :

Super Normal profits (TR>TC)
Normal Profits ( TR=TC)

Profit no loss

Subnormal Profits (TR<TC) Loss

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Profits are the reward of risk and uncertainty bearing.

Profit is the reward of risk taken by
insurable and non insurable risks

Entrepreneur. Risk may be

Similarly entrepreneur has to undertake business under uncertain

condition. Uncertainty regarding demand, price and cost

8.2 Determinants profit

Determinants of Short Run Profit
Determinants of long run profit
Short Run Profit
If Average Revenue ( income from selling per unit) is more than Average
Cost (expenses incurred to manufacture single unit) it is said to be profit
situation in the short run.
AR> AC
Determinants of Short Run Profit
Rate of growth of the economy
Market structure
Demand situation
Expenditure on promotional efforts
Fiscal policy of the government

Long Run Profit

A firm is said to be earning profit in the long run, when its Total
Revenue exceeds its Total Cost
TR>TC

Sales receipts must be more than total cost of production for

profitability in the long run
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Determinants of Long Run Profit

Growth of the firm
Availability of internal finance
Innovation ability of the firm
Production technology
Product lines
Efficient management
Qualified personnel
Economies of scale

8.3 Profit: Classification

1) Gross Profit and Net proft
Gross Profit:
Gross profit= Total revenue- Total cost (Including depreciation)
Net Profit:
Net Profit= Gross Profit- Opportunity Cost
2) Accounting profit Vs. Economic profit
Profit can be expressed differently by accountant and economist
Accounting profit Vs. Economic profit
Accounting Profit: For calculating accounting profit only explicit or actual
costs ( Rent, wages etc) are deducted from total revenue.
Economic Profit: Implicit costs are also deducted (Opportunity cost)

3) Normal Profit and Supernormal profits

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Super Normal profits (TR>TC)

Normal Profits ( TR=TC)

Profit no loss

8.4 Profit: Measurement

Profit can be measured by calculating various revenue and deducting it
with various costs.
While measuring we need to consider some of the methods. They are
1) Depreciation
2) Valuation of stock
3) Treatment of differed expenses
4) Capital gains and losses
1) Depreciation:

Straight line Method

Declining balance method

Sum of years digits method

2) Valuation of stock:

FIFO

LIFO

Weighted Average method

3) Treatment of differed expenses

The firm will have intangible assets such as good will, copy right,
trademark etc and the problem is how to write off these?
4) Capital gains and losses
Capital gains and losses are unatnticipated changes in the value
of property relative to other goods
8.5 Break-Even Analysis

 The break-even analysis is the study of revenues and costs of a firm

in relation to its volume of sales and specially the determination of that
volume at which its costs and revenues are equal to each other.
The break-even point (BEP) may be defined as that level of sales of a
firm at which its total revenues are equal to its total costs and hence
its net income is zero.
BEP is also known as no profit and no loss point.

8.6 Determination of BEP

The BEP of a firm can be determined in two ways. They are:

In terms of physical units i.e. volume of output.

In terms of money value i.e. the value of sales.

(1) BEP in terms of Physical Units

This method is convenient for a firm producing a single product.
The BEP is the number of units of the commodity that should be sold to
earn enough revenue just to cover all the expenses of production.
The revenue covers all the cost variable as well as fixed. The firm
does not earn any profit nor does it incur any loss.
Formula=BEP in terms of Physical Units
BEP=

Total Fixed cost

Contribution margin per unit

Contribution Margin Per unit= Selling Price-Average Variable cost

Total Fixed cost.
Selling Price per unit-Variable cost per unit

 The table given above shows that, when the output is zero the TFC is
RS.1000 and this will be the TC.
When the output is 10 units, the TC consisting of TFC is Rs.1000 and
TVC is Rs.1000,is totally Rs.2000. The TR is Rs.1500,since the price is
Rs.150/- unit the firm incurs a loss of Rs.500 at this point.
When the output is 20 units, the TC is Rs.3000 and the TR is also
Rs.3000 and hence TR = TC. At this level the firm is working at a point
where there is no profit and no loss. This is called the BEP.
From this level of output the firm starts earning profit.
BREAK EVEN CHART

 Alternative method to find out BEP in terms of Physical units

There is another method of finding out BEP in terms of physical units of
output. This is by means of formula. We adopt AR and AVC instead of
TR and TC.
The BEP is that level of output at which the price of the product (AR)
covers the AC. The price should be sufficient to cover not only the AVC
but also some portion of AC.
The excess of selling price over AVC goes towards meeting some
portion of the FC. The excess is called contribution margin.
BEP =

TFC.
Contribution margin per unit

Where contribution margin = selling price average variable cost

CM = SP AVC
Therefore ,

BEP =

TFC

Selling Price per unit variable cost per unit

Example:
Suppose the TFC of a firm is Rs.10000 per annum. The variable cost per unit
i.e. AVC is Rs.6 and the selling price is Rs.10 per unit. Find the BEP in terms
of physical units.
BEP = 10000 = 2500
10 6
Thus the company would not make any profit or loss when the
output is 2500 units.
Verification:
Total revenue = 2500 x 10 = Rs.25000
TVC = 2500 x 6 = 15000
TFC =
TC =

+10000
Rs. 25000
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So TC = TR. Hence BEP = 2500 units.

ii) BEP in terms of Money Value Or Sales Value
If a firm is producing many products the BEP has to be approached only
in terms of money value of goods sold or total sales revenue.
Here also total contribution margin (SP-AVC) would be equal to the TFC.
But the contribution margin is expressed as a ratio to sales.
This ratio is also known as profit volume ratio or P/V ratio.
Formula=BEP in terms of Money Value or Sales Value
BEP=

Total Fixed cost

Contribution Ratio

Contribution Ratio

Sales -TVC
Sales

Illustrations
Find out the BEP in terms of sales value on the basis of the
following data
Total sales = Rs. 3000
TVC = Rs. 2000
Fixed cost = Rs.1000
BEP (Sales Value)=

Fixed Cost
Contribution Ratio

Contribution Ratio = Sales- VC=

Sales

1000 =
1/3

3000 = Rs. 3000

1

TR = Rs. 3000
TFC = Rs. 1000

3000 = TR

TVC = RS. 2000

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In this way TR of Rs. 3000 = TC of Rs. 3000. Therefore no profit or no

loss.
KSRTC (Volvo Service) have a capacity to carry a maximum of 10,000
passengers per month from Bangalore to Hyderabad at a fare of Rs.
600. Variable costs are Rs. 100 per passenger and fixed costs are
Rs. 30,000 per month. How many passengers should be carried per
month to break even?
Answer 60 passengers

8.7

Managerial Uses of Break-Even Analysis

Microscopic View

Safety Margin

Profit Target- Calculate output or sales to earn desire profit

To determine the value of sales to maintain the profit level

To expand the production capacity

Profit Projections
Make or Buy decisions

1) Microscopic View

2) Margin of Safety (or) Safety Margin

That amount of sales which is over and above the break-even sales
value is known as margin of safety.

Formula of Safety Margin = Total sales sales at BEP

Margin of safety can also be expressed as % of total sales.

Margin of safety (in %)= Sales- BEP *100

Sales

The margin of safety indicates the extent to which the sales may fall
before the firm suffers loss.
Larger the margin of safety, safer the firm.
Illustrations
If the present sales of a firm are Rs.40 Lakhs and Break even sales
Rs 30 lakhs, find out the percentage of margin of safety?
Safety of Margin = Total sales sales at BEP
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= 40, 00,000- 30,00,0000

= Rs .10, 00,000
Safety of Margin= Sales- BEP
(PERCENTAGE)

x 100

Sales

= 40, 00,000-30,00,000 x 100

40, 00,000
= 25 % safety of margin
If the present sales of a firm are Rs.20,000 and Break even sales Rs
15,000. find out the percentage of margin of safety
Margin of Safety = Total Sales BEP Sales value
= 20,000 15,000 = Rs. 5,000
Margin of safety can also be expressed as % of total sales.
Margin of Safety = Total Sales BEP Sales value x 100
total sales
= 5,000

x 100

20,000
= 25%

To find out MS:

Total sales = 1, 50,000
Variable cost = 75,000
Fixed cost = 50,000
BEP=

FC.
Contribution Ratio

CR = TR TVC = 1,50,000 75,000 = 1

(0.5)
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TR

1,50,000

BES = TFC = 50,000

CR

= 1,00,000

Margin of Safety = TR BES

=1, 50,000 1,00,000
= Rs. 50,000
3) Profit Target- Calculate output or sales to earn desire profit

(BEP)Target Sales Volume= Fixed Cost + Target Profit

Contribution margin per unit
Illustrations
Find out the target sales volume, if the desired profit is Rs.12000
with
the
following
data:
Fixed cost Rs. 20,000, Variable cost per unit Rs.4 per unit and
selling price Rs. 8 per unit
Target Sales Volume = Fixed Cost+ Target Profit
Contribution margin per unit
=20,000+12000
8-4
= 8000 units

4) Changes in price and new sales volume

New Sales =
Volume

Fixed Cost ..

New selling price-Average Variable cost

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Change in price with target profit

New Sales = Fixed Cost + Total Profit
Volume

New selling price-Average Variable cost

Illustrations
A firm sales 4000 units per month at a price of Rs. 40 per unit. Fixed
cost works out to Rs. 10,000 per month and variable cost to Rs. 24
per unit. There is a proposal to reduce the price of the commodity
by 20 %. How many units should the firm sell to maintain the
present level profit?
First Calculate Total Profit:
Profit= TR-TC
= Sales*Selling price- TFC+TVC
=(4000*40)- 10000+(4000*24)
=16, 00,000-1, 06,000
Profit= Rs. 54,000

Proposal to reduce selling price by 20 % so new price is Rs.32. (Old price

Rs.40/- then 20 % reduction becomes Rs.32/-)
New Sales = Fixed Cost + Total Profit
Volume

New selling price-Average Variable cost

= 10,000+54000 = 64000= 8000 units

32-24

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Firm need to increase the sales from 4000 units to 8000 units to
maintain the present profit level

5) BEP helps to take decision to make or buy the components

BEP

Fixed Cost

Purchase price-Variable cost

Illustrations
A manufacture of bicycles buys a certain part at Rs. 40 each. If he
decides to manufacture to himself, his cost would be as follows:
Fixed cost Rs. 48000, Variable cost Rs. 16 per unit. Find out if it is
profitable for him to manufacture the part instead of buying

BEP

Fixed Cost

Purchase price-Variable cost

=

48,000..
40 - 16

= 2000 components

This shows that manufacturer can produce the parts himself profitably, if he
needs more than 2000 components per year. If his requirements is less than
2000, it is better to buy from outside the firm

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6) BreakEven Point as a % of Full Capacity

The term full capacity means maximum possible volume that can be
produced with the firms existing capital equipment and operating
policies and practices. This is also expressed as % of full capacity.
For ex, if the full capacity is 10,000 units and BEP is 4000 units then
the BEP can be expressed as 40% of full capacity.

8.8 Limitations of Break-Even Analysis

Need for system and accounting techniques

Static in nature

Difficult to handle selling costs

Not suitable for long run

Difficult to maintain several price levels

Limited to few products

It is based on some assumptions

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Problem 1
A firm sells its product at Rs 7 per unit. Its variable cost is
Rs. 80,000/-.
Calculate
1) BEP
2) The profit, if the firm sells 40, 000 units?
3) The BEP if the firm spends Rs 4000 on advertisement?
4) The BEP, if selling price is reduced to Rs.5 per unit? How
much the seller should sell to earn of Rs. 40,000/- with a
new price of Rs 5/- per unit?

1) BEP
BEP=

Total Fixed cost

Contribution margin per unit
80,000 ..
7-2
=80000 = 16000 units
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2) The profit, if the firm sells 40, 000 units?

PROFIT= TR

---

TC
16

= Sales *Selling price ---= 40000 *

= 2, 80,000

-----

FC

VC

80000 + (40000*2)

--- -

1, 60,000

PROFIT= 1, 20,000

3) The BEP if the firm spends Rs 4000 on advertisement?

The cost of advertisement to be added to Fixed cost. 80000+4000 = 84000
BEP=

Total Fixed cost

Contribution margin per unit
84,000 ..
7-2
=80000 = 16,800 units
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4) the BEP, if selling price is reduced to Rs.5 per unit? How much the
seller should sell to earn of Rs. 40,000/- with a new price of Rs 5/per unit?
BEP if selling price reduced to Rs 5 per unit
BEP= 80000 = 80000= 26667 units
5-2

The seller should sell to earn of Rs. 40,000/- with a new price of Rs 5/- per
unit
New sales volume= FC+TARGET PROFIT
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SP-VC
= 80000+40000= 120000
5-2

= 40000 UNITS
The seller should sell 40000 units to earn target profit of Rs. 40000 with
new selling price of Rs. 5

Problem 2
A firm sales 2000 units per month at a price of Rs. 20 per unit. Fixed
cost works out to Rs. 5,000 per month and variable cost to Rs. 12
per unit. There is a proposal to reduce the price of the commodity
by 10 %. How many units should the firm sell to maintain the
present level profit?
First Calculate Total Profit:
Profit= TR-TC
= Sales*Selling price- TFC+TVC
=(2000*20)- 5000+(2000*12)
=40,000-29000
Profit= Rs. 11,000

Proposal to reduce selling price by 10 % so new price is Rs.18. (Old price

Rs.20/- then 10 % reduction becomes Rs.2/-)
New Sales = Fixed Cost + Total Profit
Volume

New selling price-Average Variable cost

= 10,000+11000 = 21000= 3500 units

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18-12

Firm need to increase the sales from 2000 units to 3500 units to
maintain the present profit level

Problem 3
Find out the target sales volume, if the desired profit is Rs.24000
with
the
following
data:
Fixed cost Rs. 40,000, Variable cost per unit Rs.8 per unit and
selling price Rs. 16 per unit
Target Sales Volume = Fixed Cost+ Target Profit
Contribution margin per unit
=40,000+24000
16-8
= 8000 units

PROBLEM 4
A manufacture of Steel Cabinets buys the handles for cabinets at
Rs. 20 each. If he decides to manufacture to himself, his cost would
be as follows: Fixed cost Rs. 24, 000, Variable cost Rs. 8 per unit.
Find out if it is profitable for him to manufacture the part instead of
buying

BEP

Fixed Cost

Purchase price-Variable cost

19

24,000..
20 - 8

= 2000 components

This shows that manufacturer can produce the parts himself profitably, if he
needs more than 2000 components per year. If his requirements is less than
2000, it is better to buy from outside the firm

Module 5
PRODUCTION POSSIBILTY CURVE
In economics, Production Possibility Curve a sometimes called a Production
Possibility frontier or Product Transformation curve,
Production Possibility Curve is a graph that shows the different rates of
production of two goods that an economy can produce efficiently during
specified period of time with a limited quantity of factors of production.
This curve shows the maximum amount of one commodity that can be
obtained for any specified production level of the other commodity, given the
societys technology and the amount of factors of production.

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