Limitations of break-even analysis
Break-even analysis looks to be a very valuable and useful aid to decision making. Certainly, break-even charts are relatively easy to construct and provide managers with information on break-even forecasts, margins of safety and profit and loss at different output levels. Manipulation of break-even charts can be used to answer; 'what if?' questions and can be part of a strategic analysis, including the setting of prices and establishing the resource levels required to hit target profits.
However, there are a number of limitations of break-even analysis.
Evaluation of break-even analysis
Examiners like break-even questions as they are relatively easy to set, and require students to show numeracy skills. However, there are many assumptions in the break-even process that may limit its usefulness:
- All output is sold: break-even works on the basis that all output is turned into sales revenue. In reality, firms will have stocks of unsold items at any one time, unless they can work on a purely just-in-time basis.
- One product and price: most businesses sell more their products at different prices in different markets and to different customers. Customers who buy in bulk, for instance will be entitled to a discount. Break-even ignores all economies of scale.
- Straight line costs and revenue curves: if a firm is forced to adopt lower prices at higher output because the market is becoming saturated, then the revenue curve will not be a straight line. Similarly a firm's average variable costs are likely to be lower at higher outputs as it can negotiate a discount from its suppliers. The straight line assumption also means that semi-variable costs are assumed to be directly proportional to output and in essence are just lumped together with other variable costs - in fact the term semi-variable is not used at all.
- A static model where variables change independently of each other: in reality, the business world is dynamic and any increase in output and any change in costs is likely to impact on price levels. Break-even, like a balance sheet is only a snapshot of a situation at a particular point. Increasing shortages of energy, for example, will result in some significant increases in both variable and fixed costs.
- Not all costs can be easiliy classified as fixed or variable.
- The result is no more accurate than the accuracy of the original data it is based on.
- It ignores all factors other than costs and revenues: production is also affected by the availability of finance, people and management influences, competitive action etc. For example, maximising production may place excessive pressure on staff and may require existing employees to work overtime, so changing the cost base.
- Reactions of competitors: break-even analysis ignore the fact that competitors may change their products/and or prices.
These assumptions mean that break-even analysis is only valid over a small range of outputs or sales and with single product firms.
What happens when a firm makes more than one product? Let's look at an example:
Maze Green Yachts Ltd
This firm has been set up to produce a new plastic fun boat. The cost profile is given below.
Fixed costs per month: $100 000
Variable costs per boat: $100
Selling price of boat: $300
Now draw the break-even chart, and then click CHART to see if you have got it correct.
Now the business expands and introduces a new model. The cost profile is now:
Fixed costs per month $150,000
Variable costs Boat A: $120 per boat, Boat B: $160
Price Boat A: $350, Boat B: $460
If you try and draw the charts, you will hit a problem instantly: how to decide on which fixed costs go with which boat. You cannot work this out accurately, so you cannot draw break-even charts. This is a major drawback of break-even charts and analysis, as it really only applies to single product firms.
Some firms may choose to apportion these costs using full-costing or absorption costing and conduct as separate break-even for each boat. The result may be quite inaccurate and is only as good as the method used to apportion the costs.