Simulated Break- Even Point Analysis
Changing business situations have led to changing decision situations. Break-even analysis being a simple but effective tool has been used un cost analysis of single product, multi products and composite products. Business situations are changing as the environment is dynamic. In organisation where the internal dynamism is less than the environmental dynamism, the organism slowly starts failing. The failing could be in one or more functions – marketing, production, finance, HRD etc. however, all these affect BEP, so if BEP tackled then strategies would be developed and failure of organisation could be tackled. Financially distressed enterprises face one majaor problem i.e., cash crunch. This cash crunch is usually due to the non-achievement of projected capacity utilization, shortfall in sales realization, increased financial charges etc., and resulting working capital erosion. In fact there are only logical reasons for cash crunch-the real reason is however the wrong projections of the organisations make which in turn indicates bas planning. However valid these reasons are, unless drastic changes are made in problem solving approaches, problem will not be solved. The future projections are normally linear and do not take into consideration probable internal and environmental changes. Where uncertainties are very high, more sophisticated methods of projecting the future is warranted which would involve certain qualitative aspects like:
- Clear understanding of the past,
- Actual performance capability of the concern,
- Probable behaviour of the environment in the immediate future,
- Customers reaction/performances,
- Perceptions of manager
Simulated Break-even point analysis (SIMBEP) is a technique that uses simulation in break-even point analysis. This technique incorporates the essence of analytical thinking and creative perceptions. It is a powerful tool for organisations in financial distress. It is easy to use and is not time consuming. It is flexible and throws open a wide variety of alternatives which will enable managers take better decisions. Normally simulation technique is used to solve problems involving uncertainty. In case of financially distressed concerns everything is uncertain. Since the outputs cannot be strictly predicated from the range of inputs, the simulation technique would prove very useful. ‘Monto-carlo’ method of simulation is very popular as it is very simple and easy to use.
In using simulated break-even point analysis technique the following should be borne in mind:
- This technique is more useful only when the managers cannot assess or estimate the variables with reasonable accuracy.
- Where the cost of an adverse event would be prohibitive.
- Where normal analytical solution may not be satisfactory.
Summary
- Break-even analysis refers to ascertainment of level of operations where revenue equal to total costs totals.
- The break-even chart indicates fixed and variable costs, sales revenue so that profit or loss at any given level of production or sales can be ascertained.
- Break-even point helps in assessing the viability of the organisation and to take decisions on profit planning and cost control.
- Break-even point indicates the level of operating capacity and sales to be achieved to recover all costs.
- The firm should always maintain its level of activity above the break-even level to earn profits.
- The break-even analysis requires that all costs should be segregated into fixed and variable components. Variable cost per unit and selling price per unit are assumed to be constant. The total fixed cost component is assumed to be constant.
- P.V. ratio reveals the contribution as a percentage of sales turnovers. It helps in assessing the profitability of business.
- P.V. ratio per unit of sales or per unit of production will indicate the most profitable item only when other conditions are kept constant.
- Margin of safety refers to sales in excess of break-even sales.
- A low margin of safety indicates high fixed costs. The higher the margin of safety is necessary to run the business profitably and to improve the profitability.
- Angle of incidence is an angle formed by the intersection of total cost line and total revenue line in the break-even chart.
- The larger angle of incidence is a sign of profitability and vice verse.
- The selling price and variable cost has direct impact on the P.V. ratio, since P.V. ratio being a function of contribution to sales.
- The CVP analysis studies the interrelationship of different levels of activity and its impact on cost structure and profitability of the firm.
- CVP analysis is an analytical tool in studying the relationship between volume, cost and prices and profits and helps in determining sales volume to achieve a level of profit and to assess the most profitable combination of volume and costs.
- Profit volume chart indicates the impact of cost and revenue on profit at various levels of activity. In PV chart, the point where the profit line intersect the sales line is the break-even point. Sales volume beyond the point of intersection is called ‘margin’ of safety’.
- The break-even and CVP analysis is based on the major assumption that costs can be classified into fixed and variable components. The fixed cost will remain constant irrespective of level of activity, but the variable cost change proportionately to the change in volume or level of activity.
- The break-even charts and profit volume charts will be of immense helps to the finance manager in taking financial decisions.
- In curvilinear break-even analysis, we can observe two break-even points will occur one at lower capacity level and the other at a higher capacity level. While increasing production and sales beyond the first break-even point there will be increase in profit but increase in volume beyond the second break-even point will result in loss.
- In a curvilinear model, the optimum production level is where the total revenue line exceeds the total cost line by the largest amount.
- CVP analysis can be displayed in the form of normal distribution under conditions of uncertainty.
- Linear programming technique can be applied to multi product cost-volume profit analysis. Problems of short-term capacity utilisation where a number of products are involved can be formulated into LP models.
- In a simulated break-even point analysis, the simulation technique is adopted into ascertainment of break-even point. The technique is used to solve the problems of uncertainty.