What is the Break-Even Analysis?
Break-even analysis determines what level of sales is required to cover the total cost of business (Fixed as well as variable cost). It shows us how to calculate the point or juncture when a company would start to make the profit.
Types of Costs in Break-Even Analysis
The following are types of break-even analysis.
- Fixed Cost – It is also known as the overhead cost. The commitment of these costs arise once it is decided to start an economic activity and it is based on the level of production but not at all on the quantity of production. Some common fixed costs are taxes, interests, salaries, depreciation, rent, permanent labor cost, etc. These costs have no linkage with the production or sales quantity.
- Variable Cost – These are the cost that varies directly with the level of production. These are not committed costs and will occur only if the production takes place. Some common variable costs are raw material cost, direct labor or casual labor, fuel, packaging cost, etc.
Break-Even Analysis Formulas
There are two approaches to calculate the break-even point. One can be in quantity termed as break-even quantity and the other is sales which are termed as break-even sales.
In the first approach, we have to divide the fixed cost by contribution per unit i.e.
- Where, Contribution per Unit = Selling Price per Unit – Variable Cost per Unit
In the second approach, we have to divide the fixed cost by contribution to sales ratio or profit-volume ratio i.e.
- Where Contribution Margin Ratio = Contribution per Unit / Selling Price per Unit
Example of Break-Even Analysis
Let us understand the example of Break-Even Analysis.
Suppose XYZ Ltd is expecting of selling 10,000 units at a price of $10 each. The variable cost associated with the product is $5 per unit and the fixed cost is coming $15,000 per year. Do the break-even analysis for the given case.
Use the following data for the calculation of break-even analysis
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The break-even situation for the given case can be calculated in either quantity terms or in dollar terms.
Calculation of Break-Even Point can be done as follows –
To calculate the Break-Even Point (Quantity) for which we have to divide the total fixed cost by the contribution per unit.
- Here, Selling Price per unit = $10
- Variable Cost per unit = $5
- So, Contribution per unit = $10 – $5 = $5
- Hence Break-Even Point (Quantity) = $15000 / $5 units
Break-Even Point (Quantity) = 3000 Units
It means by selling up to 3000 units XYZ Ltd will be in no loss and no profit situation and will overcome its fixed cost only. Selling quantity beyond 3000 will help in earning profit which will be equal to the contribution per unit for every additional unit sold beyond 3000.
Calculation of Break-Even Sales can be done as follows –
To calculate the Break Even Sales ($) for which we will divide the total fixed cost by the contribution margin ratio.
- Here contribution per unit = $5
- Selling price per unit = $10
- So, contribution margin ratio = $5 / $10 = 0.5
- Hence Break Even Sales ($) = $15000 / 0.5
Break Even Sales ($)= $30,000
It means by selling up to sales value of $30,000, XYZ Ltd will be in breakeven point and will overcome its fixed cost only and will earn profit equal to the sales value beyond $30,000 equal to contribution margin * Sales value beyond $30,000.
Advantages of Break-Even Analysis
Some of the advantages of break-even analysis are as follow:
- Catches Missing Expenses: One has to figure out all the committed cost as well as the variable cost while reviewing the financial commitment to figure out the breakeven point and in this way some missing expenses which are caught out.
- Set Targets for Revenue: As and when the break-even analysis is complete, one comes to know their projected sales revenue so as to earn the projected profit and it also helps sales teams to set more concrete goals.
- Powerful Decision Making: As the top management is having more defined data, it will help them in good decision making to expand the business or taking any new contract by offering a good minimum price by considering the sunk cost.
Disadvantages of Break-Even Analysis
Some of the disadvantages of break-even analysis are as follow:
- Unrealistic assumptions as the selling price of a product can’t be the same at different sales level and some fixed costs might vary with the output.
- Sales can’t exactly be the same as to that of production. There can be some closing stock or wastage as well.
- Businesses selling more than one product: It will be tough to analyze break-even as apportioning of fixed cost among two products will be a challenging one.
- Variable product or services cost will not always remain the same. As the level of output will increase one’s bargaining power to procure material or service will also increase.
- It is a planning aid and not a decision-making tool.
- Break-even analysis tells us at what level an investment has to reach so that it can recover its initial outlay.
- It is also considered as a measure for the margin of safety.
- It is used broadly be it the case of stock and options trading or corporate budgeting for various projects.
Break-even analysis is very important for any organization so that it can know its overall ability in generating profit. Suppose for any company if its break level is coming near to the maximum sales level which the company could reach then it is impractical for that company to earn profit even in the all-positive scenario. Therefore, it is the responsibility of the management that it should monitor the organization breakeven point constantly as it helps in cost-saving and resulting in a decrease of the breakeven point.
This has been a guide to Break Even Analysis and its definition. Here we discuss the break-even analysis formula along with calculation example, advantages, and disadvantages. You can learn more about accounting from following articles –