Break Even Analysis is one of the financial tools that help in the calculation of the margin of safety of a new company or new product. In this article, you will learn about Break Even Analysis in detail and will also learn how to use Break Even Analysis to determine the profitability of your company with the help of an example.
A new company blossom every other day. Do you think people who start these companies work on a hunch? Or whether they put their money in these businesses after thorough planning and analysis? How they make sure that their companies remain profitable? These are all the questions that come into the mind of a person who is naïve in the business world. To answer these questions, we study one of the financial tools that helps professionals to make calculated decisions.
Break Even Analysis can be defined as a calculation of point where revenue generation is equal to the cost incurred in the production. Break-even point is a point where a company is neither making profits nor is losing any money.
What is Break Even Analysis?
The term “Break-even” is used to refer to a situation where a company is neither making any profits nor losing any money. That means whatever business they do is enough to cover all types of costs incurred in the business. Companies use Break Even Analysis for the calculation of the exact number of sales that the company is required to make to cover all the costs. In a Break Even Analysis, you study the relationship between the revenue generated, fixed costs, and variable costs and use this information to make important decisions about your company.
The Break Even Analysis tool is used not only for industrial purposes but also used by financial planners, marketers, managers, accountants, and entrepreneurs. Managers can use this tool for setting goals for their subordinates to achieve the required sales goal to generate profit. If a manager knows exactly how many sales they need to make, then he can push his employees to put efforts accordingly.
Break Even Analysis helps you in seeing the full picture of your business. Having clear information allows managers to decide what methods should be adopted to meet the goal. For example: If you are planning for a seasonal sale, you can determine the discount you can offer on your products by still making a profit using the Break Even Analysis.
The value of break-even point is different for different businesses. For example, the break-even point for a company will be high if its initial fixed cost and variable cost are high. On the other hand, if the fixed cost of a company is zero, then it might reach its break-even point just after selling its first unit.
Break Even Analysis Formula
The formula of Break Even Analysis can be calculated by dividing the total fixed cost with a contribution per unit. The contribution per unit can be calculated by subtracting the variable cost per unit from selling price per unit.
The following are the formulas of break-even point and contribution per unit in equation form.
Contribution per unit = Selling Price per Unit – Variable Cost per Unit
And the break-even point can be calculated using the following formula.
Break-even Point = Fixed Cost / Contribution per Unit
Break-even Point = Fixed Cost/ (Selling Price per Unit – Variable Cost per Unit)
Calculate the values such as fixed costs, which can be obtained by adding all the fixed expenses and contribution per unit and put those values in the above formula to get the break-even point for your business.
Components in Break Even Analysis Calculation
1. Fixed Costs
Fixed costs can be defined as the business costs, which are directly related to the business but not directly associated with the level of production. Therefore, whether your production level is zero or at its highest capacity, the fixed costs are going to be there. For example, you are supposed to pay the rent of your factory building, whether there is no production going on for about a month.
Fixed costs can also be referred to as overhead costs. These costs start as soon as you set up your business or production unit. These costs remain the same, whether your business is growing or going backward. However, your long-term fixed costs change when you decide to expand your business. For instance, when you set up a new production unit.
The followings are examples of fixed costs.
- Salaries and wages
- Rent of the building or lease charges
- Energy cost
- Depreciation cost
- Marketing costs
- Research and development expenses
- Administration cost
2. Variable Costs:
Variable costs are the costs that are directly associated with the level of production. That means the variable cost will reduce with the reduction in the production and will become zero when you cease the production process. For example, the cost of raw material required for the production of goods is directly related to the number of units produced in the production process.
The variable cost can be divided into two types, such as direct variable cost and indirect variable cost.
Direct variable cost: Direct variable costs are those costs that are directly related to the production of a particular product or a specific production center.
The followings are examples of direct variable costs.
- Cost of raw material
- Cost of wages of workers hired, especially for production work.
- Fuel consumed
- packaging cost
2. Indirect variable cost
Direct variable costs are the costs that are directly associated with the production of goods but does not get affected by the level of production. For example, depreciation cost, machine maintenance cost, and labor cost.
That means you are required to pay same day wages to labors whether you are producing 200 units a day or 500 units a day. The same is true in the case of the maintenance cost of machines and production units.
3. Semi variable cost
Semi variable costs are the costs that have characteristics of both variables as well as fixed costs.
Initially, these costs are fixed, but later these costs vary with the expansion of business or with the complex nature of the business.
When to use Break Even Analysis?
Break Even Analysis can be used by managers and accountants at any time to get an idea of total sales required to make to generate profit. However, it is crucial to use Break Even Analysis before you do any of the following.
1. Setting up a new business
Break Even Analysis is essential to be performed before investing money in new business. Using Break Even Analysis, you can decide whether your business is realistic or not. You will get a realistic idea of investing in the business.
2. When you decide to change your business model
Changing the business model of your business is quite similar to getting into a new business. You might have a few resources from the previous business, but you are required to consider other factors that might increase your expenses.
For example, if you are planning to switch from a wholesales business to a retail business then a Break Even Analysis will be helpful for you. Because using that information, you can plan a new price strategy to stay in profit.
3. While launching a new product
A Break Even Analysis will be helpful when you choose to start a new product even when you are running a successful business. A Break Even Analysis will help you in determining whether you should invest in a new product or not especially when the expenditure is too high.
4. Before starting promotional activities:
Many businesses make the use of promotional activities to increase their sales. But if you do not well-plan your promotional activity and well-calculate the expenditure on the activity and calculate expected a return on investment, then you might end up adding an additional financial burden rather than making profits. A Break Even Analysis will provide you with a rough idea of whether your promotional activity will be beneficial for you or not.
For example, if you are planning to start a sale in your store for the festive season, the Break Even Analysis will help to calculate the right discount you can offer and remain in profit.
Example of Break Even Analysis
Let us consider that the fixed cost for producing 20,000 toy cars is $40,000 a year, which is consist of following fixed costs
Business Rent = $20,000
Property Taxes = $5000
Administration cost = $10,000
Equipment cost = $3000
Utility Cost = $2000
The total variable cost for producing 20,000 toys is $10 per unit, which consists of following variable costs.
Raw material = $5
Overhead charges = $3
Labor Cost = $2
Let us consider the selling price of each toy car is $15
Contribution per unit = Selling Price per Unit – Variable cost per unit
Therefore, contribution per unit will be $15 – $10 = $5
Break-even point = Fixed Cost/ contribution per unit = $40,000 / $5 = 8000
8000 units of toy cars are needed to be sold to reach the break-even point, which means the business is required to sell a minimum of 800 units of toy cars to incur neither profit nor loss. After the sale of 8000 units, each unit sold will bring a profit of $5 to the business.
Therefore, to generate a profit of $10,000, the business is required to sell a total of 10,000 units. The first 8000 units to reach the break-even point and the next 2000 units to generate a profit of $10,000.
Benefits of Break Even Analysis
The followings are the benefits of using Break Even Analysis.
- Break Even Analysis helps price your product efficiently. You can use this method to give the best price to your product without increasing the current price abruptly.
- Break Even Analysis helps in covering all the fixed costs. Knowing all fixed costs is vital to calculate the profit generated from the business.
- Using the information obtained from Break Even Analysis, you can make smart and calculated decisions about business investments rather than investing money in a business instinctively.
- Break Even Analysis can help you in setting a revenue target. When you know the number of units you need to sell to generate profit, you can allocate target to your sales team and can motivate them to achieve those targets within the decided time.
- Using Break Even Analysis, you can calculate the funds required to start your business. You can use this information to raise funds from outside. Break Even Analysis is considered one of the most critical tools when someone is trying to raise funds for their business. Investors will ask for this information to know whether their investment in your business will be profitable or not.
- Break Even Analysis requires you to consider all the costs to calculate the right value. In this way, you will not forget about any expenses associated with the business.
Limitations of Break Even Analysis
- The Break Even Analysis doesn’t provide accurate analysis in multi-product companies, as it assumes that the proportion of each product is constant which is not right. Therefore, it does not help companies with the information that which product is more beneficial and profitable for the company.
- It is wrong to assume that variable cost is constant for all the units produced, which is not valid. The variable cost can be different for products produced under different batches. Therefore, the variable cost can never be the same for all units of the product.
- Break Even Analysis assumes that all the units produced will be equal to all the units sold. It does not consider all the units which might break during the delivery or might end up being part of the inventory. Therefore, it does not provide an accurate break-even point.
- The calculation of break-even point depends mainly on fixed costs, and it is assumed that fixed costs are constant. But it is not true because fixed costs change with the change in the scale of the business.
- The last limitation of Break Even Analysis is that it does not consider the sales of products at different prices. It assumes that all produced units will be sold at the same price.