Question

1. ‘A break-even chart must be interpreted in the light of the limitations of its underlying assumptions…’

Required:

1. Discuss the extent to which the above statement is valid, and both describe and briefly appraise the reasons for five of the most important underlying assumptions of break-even analysis.
2. For any three of the underlying assumptions provided in answer to (a) above, give an example of circumstances in which that assumption is violated. Indicate the nature of the violation and the extent to which the break-even chart can be adapted to allow for this violation.

Answer 1

Ans.

a). ‘A break-even chart must be interpreted in the light of the limitations of its underlying assumptions…’

The above statement is true because there are some limitations with the break-even point chart that are required to be considered while making any decision on the basis of break-even chart. Some of the limitations of break-even points are given hereby which are required to be considered:-

(i) The total costs may be classified into fixed and variable costs. It ignores semi-variable cost.

(ii) The cost and revenue functions remain linear.

(iii) The price of the product is assumed to be constant.

(iv) The volume of sales and volume of production are equal.

(v) The fixed costs remain constant over the volume under consideration.

(vi) It assumes constant rate of increase in variable cost.

b).

Examples of circumtances in which the particular assumption is violated are given below:-

1. In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the cost function is linear. In practice, it will not be so.

2. In the break-even analysis since we keep the function constant, we project the future with the help of past functions. This is not correct.

3. The assumption that the cost-revenue-output relationship is linear is true only over a small range of output. It is not an effective tool for long-range use.

4. The fixed costs are assumed to be fixed in the future also. This assumption is not correct as fixed costs may vary in the future. We may some variation in the fixed cost to overcome this limitation.