Limitations of Break Even Analysis

To the management, the utility of break-even analysis lies in the fact that it presents a picture of the profit structure of a business firm. Break-even analysis not only highlights the areas of economic strength and weaknesses in the firm but also sharpens the focus on certain leverages which can be operated upon to enhance its profitability. Through break-even analysis, it is possible for the management to examine the profit structure of a business firm to the possible changes in business conditions.

There are some important limitations of break-even analysis, which are to be kept in mind while using break-even analysis. These limitations are as follows:

  • When break-even analysis is based on accounting data, it may suffer from various limitations, such as negligence towards imputed costs, arbitrary depreciation estimates and inappropriate allocation of overhead costs. Break-even analysis, therefore, can be sound and useful only if the firm in question maintains a good accounting system and uses proper managerial accounting techniques and procedures. The figures must also be adequate and sound. If break-even analysis is based on past data, the same should be adjusted for changes in wages and price of raw materials.
  • Break-even analysis is static in character. It is based on the assumption of given relationship between costs and revenues on one hand and input,on the other hand. Costs and revenues may change over time, making the projection based on past data wrong. Therefore, break-even analysis is more useful only in situations relatively stable while it does not work effectively in volatile, erratic and widely changing ones.
  • Costs in a particular period may not be caused entirely by the output in that period. For example, maintenance expenses may be the result of past output or a preparation for future output. It may therefore, be difficult to relate them to a particular period.
  • Selling costs are especially difficult to handle in break-even analysis. This is because changes in selling costs are a cause and not a result of changes in output and sales.
  • A straight-line total revenue curve presumes that any quantity should be sold at one price only. This implies a horizontal demand curve and is true only under conditions of perfect competition. The situation of perfect competition is rare in real world, which restricts the application of many total revenue curves.
  • A basic assumption in break-even analysis is that the cost-revenue-volume relationship is linear. This is realistic only over narrow ranges of output.
  • Break-even analysis is not an effective tool for long-range use and its use should be restricted to the short run only. The break-even analysis should better be limited to the budget period of the firm, which is usually the calendar year.
  • The area included in the break-even analysis should be limited if too many products, departments and plants are taken together and graphed on a single break-even chart. It will be difficult for the firm to distinguish between the good and bad performances of the business firm.
  • Break-even analysis assumes that profits are a function of output ignoring the fact that they are also caused by other factors such as technological change, improved management, changes in the scale of the fixed factors of production and so on.

To conclude, it can be said that break-even analysis is a device, simple, easy to understand and inexpensive and is there fore, useful to management. Its usefulness varies from a firm to another firm and also among industries. Industries suffering from frequent and unpredictable changes in input prices, rapid technological changes and constant shifts in product mix will not benefit much from break-even analysis. Finally, break-even analysis should be viewed as a guide to decision-making and not as a substitute for judgement and logical thinking.

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