A Break-Even Analysis is an approach used in economics to determine the minimum number of sales/units that a business must sell at a specified price to cover the cost of an ongoing business (fixed and variable costs).
Break-Even Analysis Usage & Importance
The uses of break-even analysis in business are diverse and of great importance in ensuring that a business remains profitable. This article will illustrate when a break-even analysis is used and its importance in business by illustrating the benefits a company is expected to gain from using break-even analysis.
- Price smarter – If effectively carried out, a break-even analysis is an effective tool in determining the appropriate figures to price products and services so that costs are recovered, and the business gets to make a profit.
- Cover fixed costs – The break-even point is calculated from the total fixed costs, meaning the company can strategize on how these fixed costs will be met after the analysis.
- Catching missing expenses – When planning revenue generation, it is easy to leave out some costs. By listing all the costs of production, break-even analysis can help the company identify costs that might have been left out.
- Set sales and revenue targets – The break-even point represents the company’s goals in terms of sales and revenue. The company becomes aware of the number of units they must sell to recover production costs and work towards it. Past the break-even point, the organization can determine the revenue target for a specified period, such as the annual revenue target.
- Financial modeling – When conducting financial modeling to determine the performance of the financial portfolio of a business, break-even analysis is incorporated in sensitivity and scenario analyses which are done under financial modeling.
- Better and smarter decision making – A break-even analysis is a solid and fact-driven base to base decisions on, for example, the viability of a project. Also, a company can determine its profit margin by calculating the value of unutilized capacity (remaining units) in a business once the breakeven point has been reached.
- Limit financial strain – A break-even analysis can be used to limit risks and failures in business by evaluating ideas if they are viable and profitable based on realistic potential numbers.
- Fund the business – When external sources of funds such as investors and financial institutions are approached to acquire funding, the break-even position can be used to pitch the return on investment of a business. The break-even position illustrates profitability which in turn shows the company’s ability to pay off its debts.
When is a break-even analysis used?
Break-even analysis is majorly used when undertaking strategic decisions but can also be used to guide day-to-day business activities. Below are common scenarios when using a break-even analysis that might prove immensely helpful.
- Starting a new business – When starting a business, pricing and profitability are two aspects that entrepreneurs must take into consideration. Carrying out a break-even analysis is an effective way of determining these two aspects. Depending on the results of the analysis, entrepreneurs can determine if the feasibility of the business and set sales goals and plan the minimum number of sales it must sell before starting to generate revenue.
- Creating a new product – It is common for existing business to want to diversify their catalogue. Before commencing production of new products, business can do a break-even analysis to determine if the new product will be profitable and by what margins compared to the additional funding the business will have to inject to produce the new product. It is worth noting that fixed costs like office rent will remain constant in such a situation.
- Changing the business model – Adaptability is crucial in remaining competitive in business. Adaptation might be necessary to accommodate changes in the market, consumption methods, and technology. To adapt, businesses will sometimes have to change their business model to remain competitive. A break-even analysis template is an effective way of checking the impact of changes in the business model on sales and profits, for example, changing from brick-and-mortar stores to online.
Components of Break-Even Analysis Template
To be able to fill out a break-even analysis template, one should have all the elements required to carry out the break-even calculations. A break-even analysis template has three primary components.
- Fixed costs – Fixed costs are costs that remain constant regardless of the number of units produced. They include; rent, insurance, software subscriptions, and labor (salaried staff). A list of all fixed costs is provided; they are normally on a monthly basis. Alternatively, they are referred to as overhead costs.
- Variable costs – Variable costs are costs that fluctuate depending on the number of products produced (production volume) and sold, for example, raw materials, fuel, labor (part-time employees), commissions, packaging, etc. They are directly related to production.
- Average price (sales price per unit) – The average price is the proposed selling price of each unit.
Break-Even Point Monitoring
Monitoring the break-even point ensures the company keeps track of when it is making or losing money which is a key aspect to shareholders. The methods below can be utilized to lower the breakeven point. The breakeven point is defined as the level of production at which the sum of the total costs and variable costs equals the revenue generated from sales.
The breakeven point can be defined in terms of the number of sales (units sold) or the amount of money.
Companies can resort to eliminating or minimizing price reduction offers such as discounts to ensure products or services are sold at the maximum price. This way, fewer units are required to reach the break-even point – the break-even point is lowered.
The use of technology is also a proven method of monitoring the break-even point. Technology that increases the efficiency of operations reduces production costs and variable costs associated with manual operations. As a result, the output is increased relative to the input.
Cost analysis (lower costs)
Cost analysis in break-even analysis is the evaluation of costs and benefits associated with the production and sale of goods and services. Thorough cost analysis helps in identifying and prioritizing cost-saving opportunities through reduction or elimination of costs which lowers the breakeven point while delivering the same quality and quantity of goods and services.
Product margins are also factoring to the break-even point. Marketing products with the highest margin of returns lower the break-even point.
Outsourcing is a method well-known to cut costs of production. If it is cheaper to outsource an activity that is necessary at only one stage of production, then it should be outsourced to lower fixed costs and thus reduce the breakeven point.
The calculations of break-even analysis are essential to investors for their primary concern is to make a profit. The analysis is considered when investors want to determine the price at which they will be break-even on their investment. Therefore, it is an important consideration when investors are evaluating the Return on Investment of different investment options before deciding to invest.
A contribution margin is a difference between the selling price of a product or service and the total variable costs involved in the production of the same. The contribution margin is not inclusive of the fixed costs.
If product A is sold at a wholesale price of $75 with production costs of $25 fixed costs and $30 variable costs. Its contribution margin is the difference between $75 and $30, which is $45.
Calculations for breakeven analysis
Two formulas can be used to carry out a break-even analysis – the basic one being dividing the total fixed production costs by the contribution margin per unit (the average price per unit less the variable costs).
Alternatively, the breakeven point can be determined by dividing the total production costs by the contribution margin ratio (which is the contribution margin divided by the average selling price).
Contribution margin = average selling price – variable costs
Break-even point = fixed costs/ contribution margin or
Break-even point =fixed costs/ (average selling price –variable costs)
For a chair being sold at a retail price of $100 that is produced at variable costs amounting to $50 and $30 fixed costs, with sales amounting to $10, 000. Its breakeven point can be calculated as follows.
Contribution margin = $100 – $50 = $50
Break-even point (BEP) = $10, 000/$50 = 200
Example of Break-Even Analysis
The example below shall be used to illustrate how a break-even analysis is carried out.
Vibrant Co. produces children soldier toys at a fixed cost of £10,000, which covers the property lease, property taxes, and management salaries. The company also incurs a variable cost of £1.6 per ton. The sales manager needs to know how many toys should be solved to cover the cost of production before investors can start making money. Each toy is being sold for £6.
The graphical representation of the costs (fixed and totals costs) and revenue versus the number of toys sold is as follows.
- The number of toys is given in the X-axis (horizontal), while the revenue and costs are given in the Y-axis (vertical).
- The fixed costs shown in both graphs by the purple line are uniform regardless of the units produced because it does not change throughout the period (fixed). Even if the company sold 0 toys, it would still incur a fixed cost of £10 000.
- The difference between the total costs and the fixed costs amounts to the variable costs. It changes and as the number of units sold changes. It is £0 when there are no toys sold.
- The revenue, shown in graph 2 by the blue line, increases uniformly from origin because revenue is directly related to the number of sales made. For example, selling 1500 toys equals £10 000 while selling 3000 toys amount to £20 000.
- To determine the breakeven point, the following calculations should be done.
BEP = £10, 000 (£6 – £1.6) = 2 272 units.
The break-even revenue is 2 272 multiplied by £6, which is equal to £13 632. Variable costs equal to 2, 272 x £1.6 = £3, 635, which is equal to the difference of the total revenue and fixed costs.
Once the sale of toys exceeds 2 272 units, the company is making a profit. On the other hand, sales less than the BEP signify loss as indicated.
Frequently Asked Questions
There are several limitations to break-even analysis. The major ones being, one; it does not predict demand, it assumes demand is stable, which determines how likely the sales projected are likely to be realized. Two, it ignores competition and time – competition will always influence pricing and other aspects, and fluctuations of competition, cost of materials, and such will be time-dependent, especially if the break-even period is significant, like a year. Lastly, it is too simple and thus limiting it to one price-point company. Companies with multiple co-dependent products cannot use a break-even analysis to price their products.
In breakeven analysis, a margin of safety is the difference between the actual sales of a company and the break-even sales. Managers use the margin of safety to determine how much the sales of a company can sustainably decrease before losses are realized. A 10% margin of safety is considered sustainable.