Module one Break Even Analysis

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point") Break Even Point: When the total costs incurred and the total value of sales made are equal, the organisation attains a stage of no loss and no profit i.e., the sale proceeds are just enough to cover the total costs (both the fixed costs and variable costs). This position is called the break-even point. If sales go up beyond the break-even point, organization makes a profit; if they come down, a loss is incurred. Thus, sales at break-even point is the minimum amount of sales that must be effect in order to avoid any loss. This figure is very useful for accountants in studying the profit factors. In this context acknowledge of the marginal costing method is essential for the study of break even analysis. It may be said that break even analysis is simply an extension of the principles of marginal costing. The Break-Even Chart: In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "breakeven point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made. Fixed Costs Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs: - Rent and rates - Depreciation - Research and development - Marketing costs (non- revenue related) - Administration costs Variable Costs Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between "Direct" variable costs and "Indirect" variable costs. Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples. Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorising business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-

resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed. Significance of, break-even chart: Graphically, break-even point is represented in a break-even chart. A break-even chart or profit graph shows the extent of profit or loss at different levels of sales. It is a graphic analysis of the relationship between costs, volumes of activity and profits. Break- even chart is an excellent tool for management planning and control. It can be used to determine the breakeven volume, optimum level of output, profit for a given level of output and the effect of change in sales on costs and prices. A typical break-even chart prepared on the basis of above of illustration is given below

In this chart quantity of output is shown on the. X-axis. The fixed cost line is horizontal to the X-axis indicating that fixed costs remain unchanged up to 12,000 units of output. The variable cost line is superimposed on the fixed cost line to show total costs. The point at which the total revenue line intersects the total cost line is the break-even point. At the point the quantity produced and sold is 5,000 units or the sales revenue and costs are Rs. 2,00,000. The excess of actual sales volume over the break-even sales value is called the margin of safety. Greater the safety margin higher would be the profits. A firm should have a reasonable margin of safety as resistance power-avoid losses. If the safety margin is low a firm runs the risk of incurring losses during the period of reduced business activity. The margin of safety may be low either because the actual sales are low or the fixed costs are very high.

Break-even analysis is a simple and inexpensive technique, It can be used for several purposes especially in industries which are not subject to frequent changes in technology, product-mix and factor prices. It presents a microscopic picture of the profit structure of a firm. It highlights the areas of economics strengths and weaknesses and reveals the profit vulnerability of the firm to changes in business conditions. However, breakdown analysis is based on several assumptions which are not true in practice. The selling price, rate of increase in variable cost are assumed to be constant. It is assumed that there will be no changes in input prices, product mix, labour efficiency and technology. Production and sales volumes are assumed to be equal, ie., there is no change in inventory level. Selling costs are ignored. Break-even analysis is a static picture as it assumes constant relationship of output to costs and revenue. Break-even analysis is based on accounting data which may suffer from several limitations like neglect of imputed costs, arbitrary depreciation estimates, inappropriate allocation of overheads, etc. Managerial Uses of Break-even Analysis: Despite its limitations, break-even analysis has been found useful in several types of managerial decisions. Some of the important managerial applications of break-even analysis are given below: 1. Capacity Planning. Sometimes, management is faced with the problem of deciding whether to expand plant capacity to meet increased demand for the product. The break- even analysis helps in understanding the impact of increase in output on the firms fixed costs and profits. Example. ABC company is examining a proposal to expand its plant capacity which is expected to increase its annual sales from Rs. 40 lakhs to Rs. 60 lakh. The expansion will involve an increase in fixed cost from Rs. 15 lakhs to Rs. 20 lakhs. The variable cost is likely to remain unchanged at 50% of the sales revenue. Should the company go in for expansion?

As the increase in sales (Rs. 20 lakhs) is greater than the increase in break-even point the company should go in, for expansion. 2. Choice of Technique. Break-even analysis is a useful guide in the selection of most economical production process or equipment. It gives a comparative view of costs of using alternative techniques at different levels of output. Generally, simple and traditional

process/equipments are more economical at low levels of output because they require minimum costs. But at very high levels to output, highly sophisticated and expensive process/equipments might be more profitable. 3. Product-mix Decision. A multi-product firm has to decide the relative proportion of different products in the total output. The objective here is to find out the best combination (mix) of products that can maximize profits. Beak-even analysis is helpful in determining the most profitable product-mix. Example. Shilpa Toys Factory has a capacity to provide 3,999 hours per week. The plant can produce two types of toys x and y. Annual costs are Rs. 12,000. The maximum possible sales are estimated to be 4,000 toys of x types and 3,000 y type. Following additional information is available.

Find out the product-mix that will maximise the net profits of the factory. 4. Plant Shutdown Decision. During recession and such other periods when the demand falls considerably, a firm is faced with the problem of deciding whether to close down the plant temporarily or to continue production and sales at prices that do not .cover total costs. Breakeven analysis facilitates such a decision by differentiating sunk costs from out of pocket costs. Sunk costs are the fixed costs already incurred and which will be there even it the plant is shut down temporarily. Out of pocket costs are the expenses which need not be incurred if the production is stopped. Example. A toys factory is facing recession. Its sunk costs are Rs. 50 lakhs per annum while the out of pocket costs are Rs. 80 per unit. The factory has a capacity to produce 24,000 units per years. Due to recession the maximum expected sales for six months are 6,000 units at a selling price of Rs 100 per unit. The recession is expected to last 6 months. Should the factory be shut down for this period? Solution. If the factory is shut down the total loss will be Rs. 2.5 lakhs (half of annual sunk costs). But if the factory operates :

The factory should not be shut down.

5. Drop or add a product. In the course of product planning the management has to decide whether to add a product to the existing product line. Similarly, management may feel that an existing product has outlived its utility and should be deleted from the product line. Break-even analysis is useful in such decisions as it indicates the impact of such decisions on the costs and revenues of the firm. 6. Make or Buy Decisions. Management of a firm has often to take a decision whether to buy a component or to manufacture it. For example, an automobile manufacturer can make spark plugs or buy them from the market Break-even analysis can enable the manufacturer to take a decision of this type. Example. An automobile manufacturer buys a certain components at Rs. 8 per unit. In case he makes it himself, his fixed and variable Costs would be Rs. 18,000 and Rs. 5 per unit, respectively. Should the manufacturer make or buy the component?

So it would be profitable for the manufacturer to make the component if he needs more than 6,000 units per year. Make or buy decisions, however, should be taken after considering the following points: (a) Is the supply from the market certain and timely? (b) Is the required quality available? (c) Does the supplier try to take any monopoly advantage? In addition to the above uses, break-even analysis can also be used to determine volume required to earn target profits, to find out impact of changes in costs and prices, to determine promotion mix, etc. Margin of safety: Excess of actual sales revenue over the break-even sales revenue, expressed usually as a percentage. The greater this margin, the less sensitive the firm to any abrupt fall in revenue. Formula: (Actual sales revenue-Break-even sales revenue) x 100 Actual sales revenue. Margin of safety is a concept used in may areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons ? Probably not. It would be much more prudent to build to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying is at $7.50 will give you

a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9. Angle of incidence: Angle of incidence indicates the rate at which profit is earned in an organization after crossing the break-even point. In a break even chart, the angle at which the sales line cuts the total cost line is called the angle of incidence. While the point at which the sales and total cost line cut each other is called the break-even point, the angle at which these lines intersect is called the angle of incidence. Sales after breakeven point will bring profit; therefore, this angle indicates the profit earning rate of the business. Hence, it is also called profit angle or profit path1n this sense, the concept of angle of incidence is an important tool for management in times of expansion of the market for the product. Every business concern would like to have as large an angle of incidence as possible because a wide angle represents a higher rate of profit earning and a narrow angle implies relatively a low rate of return. The consideration of the angle of incidence arises only after meeting the entire amount of fixed costs; therefore, the nature of the angle depends upon the incidence of variable costs. In other words, a narrow angle indicates that variable costs form relatively a large part of the cost of the product and vice versa. Profit-volume ratio (P.V.R.)? This indicates the relation between the sales value and its corresponding contribution. This explains the rate at which sales are contributing towards the recovery of fixed costs and profit. A high ratio means that breakeven point is achieved soon after which profit is earned at a higher rate and a low ratio implies the opposite. The following formula calculates this ratio.

From the above discussion, we can understand that the term Profit Volume Ratio is rather misleading, because the term profit where actually means, the contribution of the sales and the term volume actually means sales value and not the sales volume. Therefore, properly speaking it should be called Contribution Sales Ratio (C.S.R.). However, since the term P.V.R. is widely used, we also use the same name in our lessons. Every organization strives to improve their P.V. ratio ether by reducing the variable cost per unit or by increasing the selling price per unit whichever is possible. A high P.V. ratio earns profits at an accelerated rate and vice versa. The P.V. ratio can be depicted graphically.

Construction a profit-volume chart: (1) Use the horizontal axis for the sales value and the vertical axis for the costs and profit. (2) Measure the sales value (in terms of Rupees) on the horizontal axis by drawing Sales line just in the middle of the chart so as to cut the graph into two areas, the area above the line representing the profit area and the area below the line representing the loss area. (3) Measure the fixed costs on the vertical axis below the sales line (in the loss area) measuring from the zero point (see the chart). (4) Measure title profit on the vertical axis above the sales line (in the profit area). (5) Draw a straight line connecting the points of total fixed costs and the profit volume of the maximum sales. Shortcomings of the Break-even Analysis: (1) The Break-even Point (BEP) is based on some assumptions, such as sales-price, costs, production, sales, etc The technique will be only of financial value unless all these assumptions are well calculated. Besides, the technique is a preliminary and supplementary tool in the whole exercise of ratio analysis. (2) The technique is to provide cost-escalation as built-in safeguard against increase in prices. (3) The proper analysis of various costs into fixed costs and variable costs is very important. This is so because; some of the items will neither fall under fixed costs nor under variable costs. Hence, semi-variable costs may cost its effect on the BEP. BEP may not prove useful to rapidly growing enterprises and to enterprises that frequently change their product mix. (4) It has limited utility in case of multi products. (5) It does not due cognizance of factors like uncertainty and risk involved in estimates for costs, volume and profits. (6) It is not a patent tool for long Range Planning.

Formulae:
1. Total cost = Fixed cost + Total variable cost 2. Total revenue = quantity * selling price per unit 3. Total profit = Total revenue Total cost Z= (Q*SP/unit) (FC + Q*VC/unit) 4. Break even volume = FC/(SP/unit VC/unit) = FC/Contribution 5. Contribution per unit = SP/unit VC/unit 6. Break even sales = Break even volume * SP/unit = (FC * SP/unit)/ Contribution (IF unit wise values are provided) Break even sales =Fixed Cost C/S ratio

Module 2 Forecasting
Forecasting is the process of making statements about events whose actual outcomes have not yet been observed. A commonplace example might be estimation of some variable of interest at some specified future date. Prediction is a similar, but more general term. Forecasting is estimating of timing and magnitude of the occurrence of future events.

1. Forecasting is the basis of planning ahead. It involves estimating the future and the expected demand of the companys product. 2. Forecasts of future demand is the companys expectation with the outside environment that permits planning functions to commence activities. 3. While forecasting is not exactly planning it just puts planning action into motion. 4. Forecasts are estimates of the occurrence, timing, or magnitude of future events. 5. They give operations managers a rational basis for planning and scheduling activities, even though actual demand is quite uncertain. Forecasting as a planning tool:
Management in both private and public organizations and in both manufacturing and service organizations typically operate under conditions of uncertainty or risk. Probably the most important function of business is forecasting. A forecast is a starting point for planning. The objective of forecasting is to reduce risk in decision making. In business, forecasts are the basis for capacity planning, production and inventory planning, manpower planning, planning for sales and market share, financial planning and budgeting, planning for research and development and top management's strategic planning. Sales forecasts are especially crucial aspects of many financial management activities, including budgets, profit planning, capital expenditure analysis, and acquisition and merger analysis.

Need for forecasting:

1. New facility planning. It can take as long as five years to design and build a new factory or design and implement a new production process. Such strategic activities in POM require long range forecasts of demand for existing and new products so that operation managers can have the necessary lead time to build factories and install process to produce the products and services when needed.

2. Production Planning. Demand for products and services vary from month to month. Production and services rates must be scaled up or down to meet these demands. It can take several months to change the capacities of production processes. Operation managers need medium-range forecasts so that they can have the lead time necessary to provide the production capacity to produce these variable monthly demands. 3. Workforce scheduling. Demands for products and services vary from week to week. The workforce must be scaled up or down to meet these demands by using reassignment, overtime, layoffs, or hiring. Operations managers need short-range forecasts so that they can have the lead time necessary to provide workforce change to provide the weekly demands.

Types of forecasts :
The types of forecasts used by businesses and other organizations may be classified in several categories, depending on the objective and the situation for which a forecast is to be used. Four types are discussed below.

Sales forecasts As discussed in the previous section, the sales forecast gives the expected level of sales for the company's goods or services throughout some future period and is instrumental in the company's planning and budgeting functions. It is the key to other forecasts and plans. Economic forecasts Economic forecasts, or statements of expected future business conditions, are published by governmental agencies and private economic forecasting firms. Business can use these forecasts and develop its own forecasts about external business outlook that will affect its product demand. Economic forecasts cover a variety of topics including GDP, levels of employment, interest rates, and foreign exchange rates.

Financial forecasts
Although the sales forecast is the primary input to many financial decisions, some financial forecasts need to be made independently of sales forecasts. This includes forecasts of financial variables such as the amount of external financing needed, earnings, and cash flows and prediction of corporate bankruptcy.

Technological forecasts
A technological forecast is an estimate of rates of technological progress. Certainly, software makers are interested in the rates of technological advancement in computer hardware and its peripheral equipment. Technological changes will provide many businesses with new products and materials to

offer for sale, while other companies will encounter competition from other businesses. Technological forecasting is probably best performed by experts in the particular technology.

Forecasting time horizon:

Forecasting Horizon Time Span Example of Things Some typical that must Be forecasted New Products lines Old Products lines Factory Capacities Capital funds Facility needs Product groups Department Capacities Workforce Workers, Purchased materials Inventories Specific products Labor-Skill classes Machine Capacities Units of forecasts

Long range

Years

Dollars, Gallons, Hours, Space, Volume etc.

Medium Range

Months

Hours, Pounds, Gallons, Customers per time period, Workers, Units etc Units, Hours, Pounds, Dollars, Workers, etc

Short range

Weeks

Types of Forecasting:

Qualitative techniques:
The qualitative (or judgmental) approach can be useful in formulating short-term forecasts and also can supplement the projections based on the use of any of the quantitative methods. Four of the better known qualitative forecasting methods are Executive Opinions, the Delphi Method, Sales Force Polling, and Consumer Surveys. Executive opinions The subjective views of executives or experts from sales, production, finance, purchasing and administration are averaged to generate a forecast about future sales. Usually this method is used in conjunction with some quantitative method such as trend extrapolation. The management team modifies the resulting forecast based on their expectations. The advantage of this approach is that the forecasting is done quickly and easily, without need of elaborate statistics. Also, the jury of executive opinions may be the only feasible means of forecasting in the absence of adequate data. The disadvantage, however, is that of "group think." This is a set of problems inherent to those who meet as a group. Foremost among these problems are high cohesiveness, strong leadership, and insulation of the group. With high cohesiveness, the group becomes increasingly conforming through group pressure which helps stifle dissension and critical thought. Strong

leadership fosters group pressure for unanimous opinion. Insulation of the group tends to separate the group from outside opinions, if given. The Delphi method It is a group technique in which a panel of experts is individually questioned about their perceptions of future events. The experts do not meet as a group in order to reduce the possibility that consensus is reached because of dominant personality factors. Instead, the forecasts and accompanying arguments are summarized by an outside party and returned to the experts along with further questions. This continues until a consensus is reached by the group, especially after only a few rounds. This type of method is useful and quite effective for long-range forecasting. The technique is done by "questionnaire" format and thus it eliminates the disadvantages of groupthink. There is no committee or debate. The experts are not influenced by peer pressure to forecast a certain way, as the answer is not intended to be reached by consensus or unanimity. Low reliability is cited as the main disadvantage of the Delphi Method, as well as lack of consensus from the returns. Sales-force polling Some companies use as a forecast source sales people who have continual contacts with customers. They believe that the sales force that is closest to the ultimate customers may have significant insights regarding the state of the future market. Forecasts based on sales-force polling may be averaged to develop a future forecast. Or they may be used to modify other quantitative and/or qualitative forecasts that have been generated internally in the company. The advantages to this way of forecast are that (1) it is simple to use and understand, (2) it uses the specialized knowledge of those closest to the action, (3) it can place responsibility for attaining the forecast in the hands of those who most affect the actual results, and (4) the information can be easily broken down by territory, product, customer or salesperson. The disadvantages include salespeople being overly optimistic or pessimistic regarding their predictions, and inaccuracies due to broader economic events that are largely beyond their control. Consumer surveys / Market research method Some companies conduct their own market surveys regarding specific consumer purchases. Surveys may consist of telephone contacts, personal interviews, or questionnaires as a means of obtaining data. Extensive statistical analysis is usually applied to survey results in order to test hypotheses regarding consumer behavior.

The forecasting process:

Quantitative techniques:
Naive models :
Naive forecasting models are based exclusively on historical observation of sales or other variables such as earnings and cash flows being forecast. They do not attempt to explain the underlying causal relationships which produce the variable being forecast. Naive models may be classified into two groups. One group consists of simple projection models. These models require inputs of data from recent observations, but no statistical analysis is performed. The second group are made up of models, while naive, are complex enough to require a computer. Traditional methods such as classical decomposition, moving average, and exponential smoothing models are some examples. Advantages: It is inexpensive to develop, store data, and operate. Disadvantages: It does not consider any possible causal relationships that underlie the forecasted variable.

Moving Average: A moving average is obtained by summing and averaging the values from a given number of periods repetitively, each time deleting the oldest value and adding a new value. MA = X/ Number of periods Weighted Moving average: (wt) X MAwt = --------- wt Simple linear Regression analysis: X=independent variable values y=dependent variable values n=number of observations Y = a+bX a=vertical axis intercept r = coefficient of correction b=slope of the regression line r 2 = coefficient of determination

x2y- xy a= --------------nx2-(x)2

nxy -xy b= --------------nx2 - (x) 2 nxy - xy r = -------------------------------[nx2-(x) 2][ny2-(y)2]

2

Exponential Smoothing:
Exponential smoothing models are well known and often used in operations management. Exponential smoothing is a type of moving-average forecasting technique which weights past data in an exponential manner so that the most recent data carry more weights in the moving average. Simple exponential smoothing makes no explicit adjustment for trend effect. Whereas adjusted exponential smoothing does take trend effects into account. Simple exponential smoothing: The forecast is made up of the last-period forecast plus a portion of the difference between the last period actual demand and the last-period forecast. Ft = Ft-1 + (At-1 Ft-1) Where Ft =current period forecast Ft-1=last period forecast = smoothing constant At-1 = last period demand If demand was above the last period forecast, the correction will be positive and if demand was below, the correction will be negative. The smoothing constant, actually dictates how much correction will be made. It is number between 0 and 1 used to compute the forecast Ft. The value of is often kept in the range of 0.005 to 0.30 in order to Smooth the forecast. The exact value depends upon the response to demand that is best for the individual firm. Exponential smoothing with trend adjustment: