There may be change in the level of production due to many reasons, such as competition, introduction of new product, trade depression or boom, increased demand for the product, scarce resources, changes in the selling prices of products, etc.
image source: 234finance.com
In such cases, management must study the effect on profit on account of the changing level of production. The management uses Break Even Analysis as a technique to do such study.
ADVERTISEMENTS:
The term break even analysis is interpreted in the narrower as well as broader sense. Used in narrower sense, it is concerned with finding out the breakeven point i.e., level of activity where the total cost equals total selling price.
Used in the broader sense, it means that the system of analysis which determines the probable profits at any level of production. As the break even analysis establishes the relationship of costs, volume and profits, so this analysis is also known as Cost Volume Profit Analysis.
Limitations of Break Even Analysis (Marginal Costing):
Though very effective planning tool, break even analysis is not free from short comings. The limitations of break even analysis are:
1. It is difficult to separate ‘Fixed’ and ‘Variable’ costs clearly.
ADVERTISEMENTS:
2. There are some semi-variable costs. They are not considered in the analysis.
3. Sales revenue and variable costs do not increase in rigid proportion with the value of production. At higher level of production, they are less proportionate than what they should be. This is due to trade discounts, economies of bulk buying, concessions for higher sale etc.
4. Since variable overheads are appropriated on estimated basis, problem of under or over recovery cannot be eliminated.
5. Price fixation and comparison between two jobs cannot be done without considering fixed costs.
ADVERTISEMENTS:
6. It ignores time element as over a long periods all costs change. Therefore, comparison of performance between two periods on the basis of contribution is not possible.
7. If the amount of fixed costs of two firms differ, the comparison of both the firms on the basis of contribution is likely to mislead.
8. Guided by marginal cost principle, a firm may opt for excessive order at a lower price, ignoring the plant capacity. It may necessitate overtime working, extension of production capacity which in turn may increase cost of production and bring change in fixed costs. Many times, the firm may incur losses.
9. Indiscriminate acceptance of order at lower price may affect local price market.
10. Valuation of closing stock at marginal cost will lead to under-estimating it in the final accounts. Consequently, profits are suppressed and the balance sheet is distorted.
11. In controlling costs, marginal costing is not useful in concerns where fixed costs are huge in relation to variable costs.
12. Since stock is undervalued at marginal costs, in case of loss by fire, full loss cannot be recovered from insurance company.
13. It is found unsuitable in industries like ship building, etc. If fixed expenses are ignored in valuation of work in progress, losses may be incurred every year till the contract is completed. It may create income tax problems.