Break-even Analysis

Break-even analysis is a financial assessment tool used to determine the point at which total revenues from sales equal the costs incurred in producing a product or service, resulting in no profit or loss. This critical point, known as the break-even point, helps businesses understand how many units of a product must be sold to cover both fixed and variable costs. Fixed costs remain constant regardless of production levels, while variable costs fluctuate with the quantity produced. By calculating the break-even point, businesses can devise effective pricing and sales strategies to ensure profitability.

The analysis not only aids in understanding profitability but also provides insights into related concepts like contribution margin and margin of safety. The contribution margin reflects the amount of revenue available to cover fixed costs after variable costs have been deducted. Meanwhile, the margin of safety indicates how much sales can decline before a business operates at a loss. Though useful, break-even analysis has limitations, such as assuming constant variable costs and not accounting for market demand fluctuations. Overall, this method serves as a vital tool for businesses looking to make informed financial decisions and optimize their operations.

Published in: 2021

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Subject Terms

Break-even Analysis

Abstract

The break-even point is the point where manufacturing costs and sales of a product or service intersect. This point provides a cutoff where any sales above that point are a profit, while any sales below that point indicates a loss of profit. Once this point is established, the margin of safety can be calculated to determine the distance from the point that a sales performance for a product or service occupies.

Overview

Break-even analysis is an important metric used to determine when the cost of resources used to produce a product and total revenue from selling the product are equal. This means that no profit has been attained, but calculating this value, or the break-even point, provides an important piece of information that can help in the planning of selling strategies that will result in an overall profit. The main purpose of performing a break-even analysis is to guide the least amount of effort to gain a profit for a business; if a business does not surpass this break-even point, it can be onerous to continue operation. The break-even point also serves as a crude indicator of earning impact in a market.

The break-even point is defined as the sales point that must be used to cover both fixed and variable costs. A company cannot break even if it does not surpass the cost of production, which represents the variable costs. Variable costs are associated with the quantity of units for a good produced. For example, the cost of producing one unit of a good is $20. If the company produces five hundred of this good, the total variable costs are calculated as $10,000. Factored into this total are the costs of materials, labor, storage, direct sales, and advertising.

The formula for breakeven analysis is: Break-even point = fixed costs/(average price per unit-average cost per unit). This formula can be used to create a chart demonstrating the dynamic relationship of all variables involved with break-even analysis, called a break-even diagram or chart. The number of units of a product are plotted on the X-axis (horizontal) and total sales/costs are plotted on the Y-axis (vertical). The break-even point is represented on the graph where the two lines intersect. The total cost line is the sum of variable and total costs. This graph can be used to execute what-if analysis, that is, to experiment with different scenarios for each of the variables to produce a theoretical endpoint. Data produced from this calculation can also be analyzed using regression techniques.

To create a break-even analysis, the following four steps should be followed:

Ascertain the variable unit costs. This is the cost of producing one unit of a good or product, including the cost of storing and marketing the product.
Establish fixed costs. Fixed costs include those costs that are required to keep the business in operation. This is usually the budget of running the business for one month. Production costs are excluded from this value.
Determine the unit selling price for the good or product. It is the most variable component of the analysis because it can be changed after determining the break-even point on the graph.
Establish sales volume and the unit price. Experimenting with these values will produce a new break-even point on the graph.

Using this information, managers can assess profitability and make changes to the process accordingly. The greatest advantage of using this method of analysis is the ability to directly control costs of production. Additionally, the analysis can be used to evaluate how sales volume should change to cover other business investments, as well as the impact of producing a product.

Applications

Analysis. An example of using the break-even formula can be found in producing calculators. The variable costs will include the casing, batteries, and electronic components used to make the calculators. This variable cost amounts to $15.25 per calculator. The fixed costs include the cost of operating the factory for a month. These costs include the mortgage/rent, utilities, employee salaries and benefits, and other associated costs. This cost amounts to $20,000 per month. The unit selling price for the calculator is determined to be $50 per calculator. The break-even point for selling one unit is calculated as: Break-even amount=$20,000/($50-$15.25)=576 units.

It is important to correctly interpret the break-even analysis. In the above example, 576 units need to be produced and sold to break even; any fewer sold is a loss, more is a profit. Managers must then decide if it is feasible to sell 576 units within a certain timeframe under current market conditions. All aspects of business circumstances are factored in to the decision to sell at or above the break-even point. If the managers find that it is not possible to sell the calculators at $50, but must lower the price, then the break-even amount must be recalculated.

Break-even analysis can also be used to determine when an investment can be recovered in a business. If the technology company selling calculators invested $100,000 in factory machines at the outset of production, and it is of interest when the investment will be returned (or break-even amount), then the $100,000 investment replaces $20,000 in the formula. The number of selling units to break-even on investment of machines is: Break-even amount= $100,000/($50-$15.25)=2878 units.

Contribution Margin. Three related concepts are often used when analyzing break-even data: contribution margin, margin of safety, and variable cost ratio. First, contribution margin is the portion of revenue generated by sales that is not part of the variable costs involved with producing a good or service. This is the dollar contribution per unit, calculated as selling price/unit-variable costs/unit. This is an alternative means of evaluating profit, more in depth, than just considering profit above the break-even point.

The contribution margin allows a company to see what portion of their sales is free from variable costs. It aids managers in determining whether to add or subtract a product, how to assign price points for the product, and if a product needs to be retired. A negative contribution margin indicates a net loss for the company per unit produced, which means the price must be increased or the product must be retired. If a positive contribution is generated from a product, that revenue helps cover fixed costs. One common pitfall in using the contribution margin is to retire the lowest contribution margin products or services. Fixed cost allocation needs to be considered as well.

Margin of Safety. The second concept, margin of safety, is the amount a company's sales can decrease before a loss of profit occurs. The formula for margin of safety is: (Current sales level - Breakeven Point)/Current sales Level.

This guides management concerning the risk of financial loss. The margin of safety is considered when a product or service is at risk for elimination, or often when a sales contract is nearing completion. A small margin of safety could indicate the need to shift resources to accommodate the revenue loss, whereas a large margin of safety allows a company to consider additional investments.

Alternative calculations for the margin of safety include budget-based and unit-based. The budget-based alternative uses the margin of safety for prediction of future sales, and current sales is replaced by budgeted sales in the above formula. The unit-based approach uses the number of units sold to replace current sales level in the denominator of the above formula. Margin of safety is not effective when analyzing strongly seasonal because of extreme variability. When this is an issue, calculating the yearly performance of a product's sales is more informative and helps to reduce variability. Investors also use margin of safety to determine a company's market value.

Variable Cost Ration. The third concept, variable cost ratio (%), is a measure of a company's variable production costs, calculated as variable costs divided by overall revenues. This value is responsive to changes in production levels and revenues and is the opposite of fixed costs. It reflects a company's decision in determining the minimum profit margin for a product or service.

One way to assess the degree of forecasting risk from fixed and variable costs is a measurement called operating leverage. It is calculated by dividing contribution margin by net operating income. This measurement is useful when comparing profits among similar, competing companies. High operating leverage indicates that higher fixed costs are mixed with lower variable costs, whereas low operating leverage would indicate similar fixed costs but unstable variable costs.

Limitations of the break-even analysis are that it is a supply-side only analysis and does not provide information about actual sales of a product or good at set prices. Fixed costs are a constant in this calculation but increasing production scale can cause fixed costs to increase. Also, it assumes that average variable costs per unit are constant regarding sales, and that number of goods produced is balanced with number of goods sold. Being able to assess different price levels with different levels of demand can aid in establishing how many sales are needed to accommodate fixed costs.

In summary, break-even analysis is a vital performance measure used in business to determine where costs to produce a good or service intersects with revenue (zero profit). This value is used at the outset of a business venture to determine where to set a price point for a good or as an evaluation tool to determine if a product's sales are profitable. To give more depth to product performance analysis is the calculation of contribution margins and margin of safety. Contribution margins remove the effect of variable costs from total revenue for a product to pinpoint actual profit. The margin of safety measures the distance from the break-even point that a product's sales attains in a specific period. When using the break-even point, it is important to evaluate demand of a product by experimenting with different price levels and demand levels to have a range of possibilities. Though there is no perfect measure to help make production and sales decisions easier, the break-even analysis is a robust metric that allows for a variety of straightforward performances measures to be used to determine the fate of a product or service.

Terms & Concepts

Break-even Point: Represents the sales point (revenue or quantity) that must be attained to cover both fixed and variable costs for a given product or line of services.

Contribution Margin: Amount obtained by subtracting variable expenses from revenues. This number represents the amount of revenues that can be applied to fixed costs. It is expressed as either per unit basis/total amount or as a percentage of net sales.

Demand: The desire of consumers for a product or service. Demand, along with the available supply of a product or service, drives the price of a product in a market.

Direct Costs: Costs that are entirely associated with the production of a good or service. In the calculator example, direct costs would be the materials used to make the calculator (i.e., casings, batteries, computer software).

Fixed Costs: Costs that do not vary greatly on a month-to-month basis, for example, rent/mortgage, insurance, and utility bills. Fixed costs remain the same even if no good is produced, as in the case of flooding or crop failure.

Indirect Costs: Costs for a product or service that are not directly related to that product or service. Indirect costs can be fixed or variable. Fixed indirect costs are costs that do not change for a product or good or vary little over time. Variable indirect costs are costs that are subject to change over time, such as pricing on consumables used to make a product or provide a service.

Margin of Safety: Represents the difference between actual or budgeted sales and number of break-even sales. This number indicates the strength of a business. This is the extent by which actual or predicted sales surpass break-even sales.

Operating Leverage: Measurement of the extent a product or service in a business creates fixed and variable costs. If the product has a high margin of safety and less fixed and variable costs, it is said to have high leverage.

Production Costs: Costs amassed by a company to produce a good or service. These costs include labor, overhead, manufacturing supplies, as well as government taxes or royalties paid for natural resources. These costs are further divided into direct and indirect costs.

Revenue: Profit gained from providing goods and services to customers during a defined period. Total revenue is obtained by multiplying number of units sold by price of one unit. This amount is adjusted for discounts and deductions.

Supply: The quantity of a product or service present in a market.

Variable Costs: Periodic costs associated with quantity of units produced. These costs comprise labor, materials, storage, and promotion. These costs increase as production increases. For example, the cost of alcohol needed to make bottle of perfume is $8. If the company produces 1,000 bottles of perfume, the total variable costs equal $8,000, but if no bottles of perfume are produced, total variable costs equal $0.

Bibliography

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Break-even Analysis

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Subject Terms

Break-even Analysis

Abstract

Overview

Applications

Terms & Concepts

Bibliography

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