Break-Even Analysis

What is the Break-Even Analysis?

Break-even analysis refers to the identifying of the point where the revenue of the company starts exceeding its total cost i.e., the point when the project or company under consideration will start generating the profits by the way of studying the relationship between the revenue of the company, its fixed cost, and the variable cost.

It 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 a profit.

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Source: Break-Even Analysis (wallstreetmojo.com)

Break-Even Analysis Formulas

There are two approaches to calculate the break-even pointBreak-even PointBreak-even analysis refers to the identifying of the point where the revenue of the company starts exceeding its total cost i.e., the point when the project or company under consideration will start generating the profits by the way of studying the relationship between the revenue of the company, its fixed cost, and the variable cost.read more. 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 unitContribution Per UnitUnit Contribution Margin is the amount you get after removing the variable costs related to the sale of a unit from its total sales. It measures the contribution of a specific product to the Company’s overall profit. read more 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 RatioContribution Margin RatioThe contribution margin is a metric that shows how much a company's net sales contribute to fixed expenses and net profit after covering the variable expenses. As a result, we deduct the total variable expenses from the net sales when computing the contribution.read more = Contribution per Unit / Selling Price per Unit

Break-Even Analysis Example

Example 1

Suppose XYZ Ltd is expecting to sell 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.

Solution:

Use the following data for the calculation of break-even analysis.

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 a 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 / $10 = 0.5
• Hence Break Even SalesBreak Even SalesBreak-Even Sales are sales where a company's total revenue equals its total expenses, resulting in a zero profit. It is calculated by dividing the company's total fixed expenses by the contribution margin percentage.read more ($) = $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.

Example #2 – Multiproduct Company

Let us take the case of a multiproduct company producing three different kinds of products named A, B, and C and try to find the breakeven number of units. The following table gives a breakdown of the price, variable costs, and the expected number of units to be sold and let us assume the fixed costFixed CostFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity.read more to be $6,600.

In this case, we need to find the weighted average sale price, which is derived as follows,

• Weighted average sale price = {(100*50%)+(50*30%)+(20*20%)}/(100%)
• = $69

Similarly, the weighted average sale price for the variable cost is calculated as follows,

• Weighted average sale price = {(50*50%)+(30*30%)+(10*20%)}/(100%)
• = $36

So Breakeven number of units using the above formula is,

• Breakeven Units = $6,600 / ($69 – $36)
• = 200

Accordingly, the breakeven numbers for Product A are 50% of 200 that is 100 and similarly for Product B, and Product C will be 60 and 40, respectively.

Now let us delve into a real-life example and try to apply this concept.

Example #3 – General Motors

Let us try to find the number of units needed to be sold by General Motors’ automotive division to breakeven.

Source: Company disclosures.MM stands for million.

First, let us give you a brief idea of what these numbers from General Motors’s Annual ReportAnnual ReportAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company's performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more (or 10K) signify. For the number of units, we have taken the worldwide vehicle sales.

For 2018 the number of vehicles sold worldwide is 8,384,000 units.

For the deriving price per unit, the ideal way would have been to calculate a weighted average price of each model of vehicles with different selling price (e.g., Chevy and Le Sabre and many more have different prices). Since that would require extensive analysis, we have just used sales revenueSales RevenueSales revenue refers to the income generated by any business entity by selling its goods or providing its services during the normal course of its operations. It is reported annually, quarterly or monthly as the case may be in the business entity's income statement/profit & loss account.read more as a proxy and divided it by a total number of units to derive the price per unit. The gross salesGross SalesGross Sales, also called Top-Line Sales of a Company, refers to the total sales amount earned over a given period, excluding returns, allowances, rebates, & any other discount. read more for 2018 were $133,045MM, which, when divided by 8,384,000, gives a price per unit of $15,869.

For variable costs per unit, we divided the line item “Automotive and other costs of sales” with the number of units sold. The Automotive and other costs of sales or variable costs for 2018 were $120,656MM, which, when divided by 8,384,000, gives a variable cost per unit of $14,391.

Finally, we took the line item “Automotive and other selling, general and administrative expense” as a proxy for the fixed cost related to the automotive division. For 2018 the Automotive and other selling, general, and administrative expenseAdministrative ExpenseAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts.read more or fixed costs was $9,650MM.

Now it is very easy to calculate the breakeven and to use the formula defined at the beginning,

• Breakeven Units = 9,650*10^6 / (15,869 – 14,391)
• = 6,530,438 units.

An interesting thing to note is that although the number of units the company is currently producing is almost 1.3 times the number of units General Motors is currently selling, there has been a steady decline in the number of units sold worldwide. We can also see the number of units to be sold for General Motors to breakeven has increased in 2018, which may be due to the increase in variable cost per unit.

Advantages

Some of the advantages of break-even analysis are as follow:

• Catches Missing Expenses: One has to figure out all the committed costCommitted CostCommitted Costs are fixed, budgeted, or confirmed payments to be made in the future to vendors for goods or services to be taken, which are necessary for the smooth flow of the business and whose absence may disrupt the main operations of the business, potentially having a significant impact on the company.read more 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 has 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 costSunk CostSunk costs are all costs incurred by the firm in the past with no hope of recovery in the future and are not considered while making any decisions since these costs will not change regardless of the decision's outcome.read more.

Disadvantages

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 levels,s 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 stockClosing StockClosing stock or inventory is the amount that a company still has on its hand at the end of a financial period. It may include products getting processed or are produced but not sold. Raw materials, work in progress, and final goods are all included on a broad level.read more 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.

Important Points

Conclusion

Break-even analysis is very important for any organization so that it can know its overall ability to generate 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.

Recommended Articles

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 the following articles –

• Break-Even Chart
• Accounting Break-Even Point
• Cost-Benefit Principle
• Revenue vs Profit