Break - Even Analysis

The break-even point (BEP) is a crucial concept in economics and business that represents the level of
sales or production at which a company's total revenues equal its total costs, resulting in neither profit nor
loss. In other words, it's the point at which a business covers all its expenses, and beyond which it starts
generating a profit.
To calculate the break-even point, you need to consider the following components:
1. Fixed Costs (FC): These are the expenses that do not change with changes in production or sales
volume. Examples include rent, salaries, insurance, and depreciation.
2. Variable Costs per Unit (VC): Variable costs vary in direct proportion to the level of production or
sales. Examples include raw materials, labor, and direct production costs.
3. Selling Price per Unit (SP): This is the price at which you sell each unit of your product or service.
The break-even point can be calculated using the following formula:
Break-Even Point (in units) = Fixed Costs / (Selling Price per Unit - Variable Costs per Unit)
In some cases, you might want to calculate the break-even point in terms of sales revenue instead of units.
You can do this using the following formula:
Break-Even Point (in dollars) = Fixed Costs / (1 - (Variable Costs per Unit / Selling Price per Unit))
Here's a step-by-step explanation of how to use the break-even analysis:
1. Identify Fixed Costs: Determine all the fixed costs associated with your business. This includes
rent, salaries, insurance, and any other expenses that do not change with the level of production or
sales.
2. Determine Variable Costs per Unit: Calculate the variable costs incurred for each unit of your
product or service. This includes raw materials, labor, and any other direct variable costs.
3. Set the Selling Price per Unit: Determine the price at which you plan to sell each unit of your
product or service.
4. Use the Formula: Plug these values into the appropriate formula to calculate the break-even point
in terms of units or sales revenue.
5. Interpret the Result: Once you have calculated the break-even point, you'll know how many units
you need to sell to cover your costs. Beyond this point, any additional sales result in a profit.
Understanding the break-even point is essential for business planning, pricing strategies, and decision-
making. It helps you assess the viability of your business and make informed choices regarding pricing,
production levels, and cost control. Additionally, it can be a valuable tool for financial forecasting and
budgeting.

Average Costing
Average costing is a method used in inventory valuation and cost accounting. It involves calculating the
average cost of all units in a particular inventory. This method is commonly used for items that are
commingled, where it's difficult to distinguish one unit from another. Here are the key aspects of average
costing:
1. Calculation of Average Cost:
 To calculate the average cost, you sum the total cost of the inventory items on hand and then
divide that sum by the total number of units.
 Average Cost = (Total Cost of Inventory on Hand) / (Total Number of Units on Hand)
2. Constant Cost: In the average costing method, the cost per unit remains constant throughout a specific
accounting period (e.g., a month or a year) or until there is a change in the inventory, such as the addition
of new stock with a different cost.
3. Use in Inventory Valuation:
 Average costing is commonly used for inventory valuation purposes. When a business calculates
the cost of goods sold (COGS) under this method, it multiplies the average cost by the number of
units sold during a specific period.
 COGS = (Average Cost) x (Number of Units Sold)
4. Suitable for Homogeneous Goods: It is particularly useful for businesses that deal with homogeneous,
interchangeable goods, where the individual units are essentially identical, and it's challenging to track the
cost of each unit separately. Examples include items like grains, fuel, or standardized parts in
manufacturing.
5. Simplicity: Average costing is relatively simple to implement and manage compared to other costing
methods, such as First-In-First-Out (FIFO) or Last-In-First-Out (LIFO).
6. Smoothing Price Fluctuations: The method can help smooth out the effects of price fluctuations in the
valuation of inventory. This can be advantageous when there are significant price variations over time.
7. Impact on Profit and Taxes: The use of average costing may have an impact on the reported profit of a
business. A business using this method will have COGS figures that are less sensitive to price fluctuations,
which can affect income statements. This, in turn, can influence the taxes a business owes.
8. Compliance and Reporting: Some regulatory bodies and accounting standards may require or
recommend the use of average costing for certain industries or specific types of inventories.
While average costing has its advantages, it may not be the best choice for every situation. For businesses
with complex inventory systems, items with significant cost variations, or strict regulatory requirements,
other costing methods like FIFO or LIFO might be more appropriate. The choice of costing method
depends on the nature of the business and the inventory management needs.

First-in, First-Out (FIFO)

FIFO, which stands for "First-In, First-Out," is a common inventory costing method used in accounting and
inventory management. This method assumes that the first items added to an inventory are the first to be
sold or used. Consequently, the cost of the oldest inventory items is matched with the cost of goods sold
(COGS) first, followed by more recent inventory costs. Here are the key features and principles of the FIFO
method:
1. Sequential Cost Flow: FIFO follows a sequential cost flow, meaning that it assumes items are
used or sold in the order in which they were acquired. This matches the cost of the oldest inventory
with the revenue earned from the earliest sales.
2. Higher Inventory Valuation: In periods of rising prices, FIFO tends to result in a higher valuation
of ending inventory on the balance sheet. This is because the cost of the most recent inventory
purchases (which are often at higher prices) remains in the inventory account.
3. Accurate Matching: FIFO provides a more accurate matching of costs to revenues when
inventory costs are rising. It reflects the economic reality that items in inventory were acquired at
earlier, lower prices.
4. Tax Benefits: FIFO can sometimes provide tax benefits in inflationary environments since it leads
to a lower cost of goods sold (COGS) and higher profits. This, in turn, may result in lower income
taxes.
 5. Complexity in Tracking: In situations where inventory items are not identical, tracking the specific
units that are sold or used can be more complex compared to methods like average costing.
6. Realistic in Some Industries: FIFO is often used in industries where the physical flow of inventory
closely matches the assumption of selling the oldest items first. For example, it is commonly used
in grocery stores, where perishable goods are stocked in a way that naturally follows a first-in, first-
out flow.
7. Compliance and Reporting: Some accounting standards and regulatory bodies may require or
recommend the use of FIFO for certain industries or in specific situations.
It's important to note that the choice of inventory costing method, including FIFO, can significantly impact a
company's financial statements, profitability, and tax obligations. The method used should be applied
consistently and should align with the company's inventory management practices and industry standards.
Businesses should carefully consider the effects of the chosen costing method on financial reporting,
especially in cases where inventory costs fluctuate over time.

Sample Problems:
Problem: FIFO & Average Costing
ABC Electronics is a retail store that sells electronic gadgets. They have the following inventory
transactions for a specific product, Gizmo X, during the month of July:
July 1: Beginning inventory - 50 units at $25 per unit
July 5: Purchase - 30 units at $30 per unit
July 6: Sale - 60 units
July 12: Purchase - 20 units at $28 per unit
July 20: Sale - 40 units
July 28: Purchase - 15 units at $32 per unit
July 29: Purchase - 45 units at $31 per unit
July 31: Sale - 15 units
Using the FIFO inventory costing method, calculate the cost of goods sold (COGS) for the sales that
occurred on July 6, 20 and July 31. Also, determine the value of the ending inventory on July 31.

Solution:
July 6 Sale = COGS = (50 units *25 per unit) + (10 units * 30 per unit) = 1250 + 300 = 1500
July 20 sale = COGS = (20 units * 30 per unit) + (20 units * 28 per unit) = 600 + 560 = 1160
July 31 sale = COGS = (15 units * 32 per unit) = 480
Ending Inventory = 45 * 31 per unit = 1395

If Average Costing
Average Cost = (50 * 25) + (30*30) + (20*28) + (15*32) + (45*31) / 50+30+20+15+45
= 1250 + 900 + 560 + 480 + 1395 / 160 = 4585 / 160 = 28.65625 or 28.65

Solution
July 6 = 60 units * 28.65 per unit = 1719
July 20 = 40 units * 28.65 per unit = 1146
July 31 = 15 units * 28.65 per unit = 429.75
Ending Inventory = 45 * 28.65 per unit = 1289.25
Break Even Point
Company E produces e-bikes. A rental cost of a factory is £8,000 a month and the cost of heat and light
there is £6,000 a month. The selling price per e-bike is £2,000. The cost of materials per e-bike is £400.
How many e-bikes per month does the company have to produce and sell to reach the break-even level of
output?
First, we need to calculate fixed costs.
£8,000 + £6,000 = £14,000
Then, contribution per unit.
£2,000 - £400 = £1,600
Finally, break-even level of output.
£14,000 / £1,600 = 8.75 units