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IS/PM 535 Handout #2
Handbook of Budgeting, Fourth edition, by Robert Rachlin (ed), John Wiley & Sons, 1999 from 24x7 books free access
Chapter 7: Break-Even And Contribution Analysis As A Tool In Budgeting, by Jay H. Loevy
7.1 Introduction.
The budgeting process is the manager's primary tool for dealing with future uncertainty. In developing a period budget,
managers must make certain assumptions of cause and effect: "Unit sales will increase 10% because of overall demand
for the product, assuming that sales prices can be held to a 5% increase." "Gross profit percentage can be maintained
despite a 6% increase in purchase costs." "Sales demand will hold steady unless there is a war in Abyssinia."
Although they cannot do anything about Abyssinian affairs, managers can, to some degree, influence purchase costs, sales
volume, and selling prices. How well they understand their relationship and the effect on the enterprise will largely
determine the effectiveness of the business plan. This chapter describes the relationship of cost, volume, and price as well
as certain techniques for integrating these considerations into the budgeting process.
7.2 Break-Even Analysis.
Perhaps the best way to understand the cost–volume– profit relationship is to examine the technique commonly referred
to as
break-even analysis.
The name is unfortunate. Except for certain situations, such as the start-up of a new business or
the determination of when to pull the plug on losing operations, managers are not particularly interested in pinpointing
break-even volume. The planning effort is directed toward maximizing profit, and where the break-even point happens to
fall is academic. Nevertheless, the techniques used to determine break-even are useful, because they help us understand
the interplay of cost, price, and volume.
There are two cost elements in break-even analysis: fixed costs and variable costs. These are illustrated in Exhibit 7.1
. In
this example, the fixed cost of $100 remains the same regardless of volume. The minute the doors are opened, $100 is
incurred. Thus, at zero volume the chart indicates $100 of cost. The variable cost is $0.10 per unit. At a volume of 1,000
units, the total cost is $200, calculated as follows:
Exhibit 7.1. Break-even analysis
Doubling the volume to 2,000 units will add only $100 to total cost, since the fixed cost remains at $100.
This calculation, simple though it is, illustrates the basic functioning of costs. It lies at the heart of break-even analysis
and contribution analysis.
Since the treatment of costs as fixed or variable is critical to the analysis, it will be useful to define and illustrate these
terms.