Assumptions and Limitations of Break Even Analysis

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Assumptions:

(1) All costs can be categorized as fixed or variable costs.

(2) Total fixed costs remain unchanged for all output levels.

(3) Total variable costs fluctuate proportionately with output level resulting in no change in per unit variable cost.

(4) Sale price per unit remains the same for each output level.

(5) Costs and revenue behave in a linear fashion within a relevant range.

(6) No factor other than sales volume can affect costs and sales revenue.

(7) The analysis relates to businesses producing one product only or a constant product mix.

(8) The technology, production methods and efficiency remain unchanged.

(9) There are no inventories at start or at end of the accounting period or inventory levels are expected to remain constant.

Limitations:

(1) The existence of semi variable costs is ignored, whereas most of the costs are not either perfectly fixed or perfectly variable.

(2) Fixed costs may change if output increases or decreases substantially.

(3) Possible changes in per unit variable costs due to various reasons like bulk buying discounts, overtime, etc., are ignored.

(4) Sales price may have to be reduced to win the extra sales or may be increased to cover increased costs.

(5) As discussed above selling prices and variable costs per unit vary at different output levels.

(6) Various external factors like inflation rate, economic state may also affect sales volume.

(7) This restricts its usefulness as it is difficult to experience in practice.

(8) The technology, production methods may change in practice.

(9) As a result it ignores the possibility of any increase in inventory levels (when production volume exceeds sales volume) or ‘de-stocking’, (when sales volume exceeds production levels).

Importance/Significance:

Despite of its limitations, break even analysis is a useful technique for managers in the following cases:

(1) To make a feasibility before starting a new business.

(2) To determine the selling price or the desired sales mix for earning target profits.

(3) To measure profits or losses for the businesses for different output levels.

(4) To calculate lowest possible activity level without putting the business in jeopardy.

(5) To evaluate alternatives available and special orders as a part of decision making process.