ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Break even analysis: The uses and limitations/weaknesses of break even analysis

  • Break even analysis has it’s strengths and weaknesses

Advantages/Uses/Strengths of Break even analysis

  • Break even analysis is an important investment appraisal option as it allows management to quickly asses the viability of a proposition
  • Margin of safety calculations are a measure of risk that can prove useful in establishing the business’s financial standing
  • Calculations are quick, easy and simple to understand
  • Management can use break even analysis to determine the amount of sales required to reach break even and achieve a set level of profit
  • Are used in make or buy decisions i.e. should we manufacture the product ourselves or buy and resale it
  • Can be used to highlight latent cost increases
  • Primarily break even can be used to determine the business’s cost behavior in relation to changes in output
  • Can also be used in making pricing decisions

Limitations of Break even analysis

  • Break even analysis suffers from certain limitations most of which arise due to the assumptions that are used during the process
  • Fixed costs are likely to be different at certain levels of activity, in realty they are stepped costs as they increase beyond a certain level of activity
  • Variable costs are unlikely to be linear for example when the level of production increases the business will make bulk purchases of raw materials and get discounts reducing the variable cost per unit at this level
  • Similarly sales revenue is unlikely to increase in a linear fashion as the business is likely to reduce the price to encourage more sales
  • Not all produced units are sold and there is likely to be stock at the beginning and in the end
  • Most businesses sale more than one product and a variable product mix consider a supermarket for example
  • The cost of acquiring fixed assets in the even of expansion are ignored on the break even chart

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