What is Break-Even Point In Accounting?
Break Even Point in Accounting refers to the point or activity level at which volume of sales or revenue exactly equals total expenses. In other words, the breakeven point is that the level of activity at which there is neither a profit nor loss and the total cost and total revenue of business are equal.
It is that level of business activity where the sales are just sufficient enough to meet the total cost, which includes both Fixed and Variable Cost. Also, the Breakeven point acts as an essential level for a business to attain before it can make a profit. The accounting break-even point can be computed in different ways.
Another formula to calculate Break-Even Point in Accounting
Importance of Break-Even Point in Accounting
To understand the importance behind the Break-Even Point in Accounting, it is of paramount importance to understand the classification of CostsClassification Of CostsCost Classification is the process of segregating costs of the company into different categories that gives a fair idea to the decision-maker about the spending pattern. This bifurcation allows teams to efficiently use the data for accounting purposes and for financial modeling which leads the management to decide which cost is important than others.. Cost is classified as either Fixed Cost or Variable Cost.
- Fixed Cost is one which is independent of the level of sales and is of a fixed nature. Some of the popular examples include Rent, Insurance, etc.
- Variable Cost is one that is directly linked to the level of sales. Examples include commissions etc.
Segregation of cost into “Variable Cost” and “Fixed Cost” and their relationship with Sales and Profit is vital in undertaking the Break-even point Analysis. By segregating the cost into fixed and Variable, a business can ascertain 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. in nature (Fixed Cost) and will not be impacted with Sales directly. Secondly, once a business can verify the proportion of Variable Cost to its Sales, it can implement strategies that can result in Cost Efficiency, which again results in better cost managementCost ManagementCost management is an integral part of business management that works on the basis of estimates, where various activities such as data collection, data analysis and mechanisms, process evaluation, and event reporting are carried out so that the decision-maker can plan and control the organization's budget requirements, allowing the decision-maker to make informed decisions. and more profits.
Breakeven Point Analysis helps businesses understand its Cost Structure vis a vis its Sales RevenueRevenueRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions. and how the same gets affected as Revenue changes. It helps them to determine the break-even point for different sales volume and cost structures. With this information, the management can better understand the overall performance and decide what units it should sell to break even or to reach a certain level of profit.
Let’s understand the Break-Even Analysis in Accounting with the help of an example:
Crave Limited has recently entered into the business of making Table fans. The management of the company is interested in knowing the breakeven point at which there will be no profit/loss. Below are the details pertaining to the cost incurred:
|Total Sales Revenue of the Company (@ $300 per table fan)||$300,000|
|Maximum Capacity||$14000 units|
So, first will find out the No. of units sold by Crave limited:
No. of units sold by Crave limited will be:
Now, we need to Calculate Variable Cost per UnitCalculate Variable Cost Per UnitVariable cost per unit refers to the cost of production of each unit produced, which changes when the output volume or the activity level changes. These are not committed costs as they occur only if there is production in the company.
Variable cost per unit will be:
Now we need to find the Contribution per unit i.e., = Selling price per unit-Variable Cost per unit
Contribution MarginContribution MarginThe 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. per unit will be:
Now, at last, will find the Break-Even Point by using its formula = (Fixed Cost/Contribution Margin per unit)
Break-Even Point formula will be:
Thus Crave limited need to sell 1000 units of electric Table fans to break even at the current cost structureCost StructureCost Structure refers to those costs or expenses (fixed as well as variable costs) which businesses will incur or will have to incur to produce the desired objective of the business; such costs include the cost of purchasing the raw material to the cost of packaging the finished products.. At this break-even point of 1000 units, Crave Limited will succeed in meeting both its Fixed and Variable expenses of the business. Below the break-even point of 1000 units, Crave Limited will make losses on a net basis if the same cost structure exists.
Here it is essential to understand that the Fixed Cost (in this case $60000) is constant and doesn’t vary with the level of Sales Revenue generated by Crave Limited. Thus once Crave Limited succeeds in making Break-Even Point, all Sales over and above that level will lead to profits as the excess of sales over Variable Cost will be a positive value since Fixed Cost has already been fully absorbed by Crave Limited on attaining the Breakeven Sales Level.
- One of the most critical and primary benefits of Break-Even Point in accounting is its simplicity of calculation and helping the business determine the number of units to be sold to breakeven, i.e., no profit, no loss.
- It helps in understanding the cost structure, i.e., the proportion of Fixed Cost and Variable Cost. Since Fixed Cost doesn’t change easily, it helps business owners to take measures to control the Variable cost without focusing on the total cost.
- It is vital in forecasting, long-term planning, growth, and stability of the business.
- The biggest shortcoming of Break-Even Point in accounting analysis lies in the nature of assumption, which holds that fixed cost remains constant, and Variable cost varies proportionately with the level of sales, which may not be the case in the real-world scenario.
- It assumes costs are either fixed or variable; however, in reality, some expenses are semi-fixed in nature. Example Telephone expenses comprise a fixed monthly charge and a variable charge based on the number of calls made.
It is difficult for any business to decide with accuracy its expected level of sales volume. Such decisions are usually based on past estimates and market research regarding the demand for products that are offered by the business. On the other side, Business Cost, especially the Fixed Cost of a businessFixed Cost Of A BusinessFixed 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., is fixed in nature, which in any case can’t be recovered by the business and is sunk in nature. BEP FormulaBEP FormulaThe break-even point (BEP) formula denotes the point at which a project becomes profitable. It is determined by dividing the total fixed costs of production by the contribution margin per unit of product manufactured. Break-Even Point in Units = Fixed Costs/Contribution Margin in accounting helps in bridging this gap by enabling business in determining how much quantity they need to sell to break even, i.e., no profit, no loss. It is an important management accounting conceptAccounting ConceptAccounting concepts are the principles, assumptions, and conditions that govern accounting's foundation. They ensure that the accounting is done in a way that the financial statements present a true and fair view. which is continuously used by business in not only determining the Breakeven Sales level but also in optimizing its cost. Once a business is able to know its break-even point, it can make efforts by either reducing the amount of its fixed cost or by increasing its contribution margin, which may be achieved by selling a more significant proportion of high contribution margin products.
This has been a guide to what is Break-Even Point in Accounting. Here we discuss the formula to calculate the break-even point in accounting along with example, advantages, & disadvantages. Here are the other articles in accounting that you may like –