Question

By now you all may have read about the meaning of the term "break-even point." It is the level of business activity (volume) where total revenues are just enough to cover total costs, leaving no operating income.
In the Cup Theory of Profitability, the break-even point is reached when Sales Dollars are just enough to fill the blue cup AND the yellow cup, leaving the green cup empty. [You can ignore the rest of the information on that page]

Why do businesses want to know their break-even point? Are they happy just breaking even? And what are some of the assumptions underlying the CVP analysis that we have to make in order to believe in breakeven point?

Answer 1

Business wants to know their break even point due to the following reasons-

• This figure is important because it's the simplest way for a business to determine if what it charges for its products and services will cover what it costs to make the products or provide those services. The higher the fixed costs for the business, the higher the breakeven point will be, meaning the more offerings it needs to sell.
• The process of determining the breakeven point is a good time for businesses to assess their true cost of doing business and their prices. Many start-ups don't understand their direct and indirect costs very well. Working on a breakeven analysis will help business owners and managers learn these figures and gain better insight into the accuracy of their prices and how realistic their sales goals are.
• If the amount of sales a company needs to break even is more than it can realistically achieve in a year, then the business knows its products or services may not be priced well – or it needs to work to reduce costs.
• Additionally, the business owner should know the total contribution each product and service makes to the company's overall profit. This step is important because it can help businesses determine products and services that aren't actually profitable, and the company can decide if it needs to raise the price, reduce the cost of offering it, or possibly discontinue it.
  

no, the firm are not happy just breaking even , as the most important task

1. Making Financial Estimates – When you estimate your income and expenses, your estimates should extend over enough time to catch up with seasonal fluctuations. Depending on your type of business, your revenue and expenses may vary wildly from month to month. For example, if you plan to manufacture custom snowboards, most of your sales will be in late fall and early winter months, while the opposite would be true if you made surfboards. A good way to account for this is to make estimates for each month of the year, then add them up to get a yearly figure. I recommend covering at least a one-year period, which is enough time to account for normal ups-and-downs, but not so long as to maybe overly speculative.

2. Categorizing Your Expenses – Your business expenses need to be divided into two categories: fixed expenses (fixed costs) and variable expenses (variable costs). This division not only is important for your break-even analysis, it’s a standard method of categorizing expenses for accounting and tax reporting. Understanding the difference is your key. Here they are:

• Variable costs – These costs—sometimes also called product costs, costs of goods or costs of sale—are directly related to the products or services you provide and include inventory, packaging, supplies, materials and sometimes labor used in providing your product or service. They’re called “variable” precisely because they go up or down depending on the volume of products or services you produce or sell. (In the case of services, one of the biggest variable expenses is almost always the wages or salary of the service provider.
• Fixed costs – Commonly referred to as “overhead,” these include all regular expenses not directly tied to the product or service you provide. Rent, utility bills, phone bills, payments for outside help like bookkeeping services, postage and most salaries (except in service businesses) are common fixed costs.

assumptions underlying the CVP analysis that we have to make in order to believe in breakeven point -

• Costs are classified into variable or fixed-

  All costs are presumed to be classified as either variable or fixed. In the real business environment however, costs behave differently. Users of CVP analysis need to be able to identify variable costs from fixed costs, and vice versa. Also, different methods are used to segregate mixed costs into purely variable and purely fixed.

• Linear relationship within a relevant range-

  Cost and revenue relationships are linear within a relevant range of activity and over a specified period of time.

• Inventory level does not change from period to period-

  It is assumed that all units produced are sold during the period; hence, there is no change in beginning and ending inventory levels.

• Volume is the only factor affecting variable costs-

  As volume (or level of activity) increases, the total variable cost increases directly with the change in volume. If the variable cost per unit is, say $5 per unit, the total variable costs would be equal to $5 multiplied by the number of units produced. It is important to take note that volume is the only factor affecting total variable costs. The variable cost per unit is assumed to be constant. Productivity and efficiency concerns are likewise ignored (assumed constant).

• Selling price is constant-

The selling price and market conditions are constant. Also, if the business produces and sells multiple products, the sales mix is assumed constant.

the CVP analysis is a useful tool in decision-making when used correctly. CVP analysis provide information to aid managers in determining the break-even point and in setting short-term goals such as sales targets, profit objectives, production budgets, and pricing strategies.

​