Break Even Analysis Cost Volume-Profit Analysis and Breakeven Owners and managers need to be familiar with tools and techniques that aid them in making short-term and long-term decisions. One good tool that helps in making decisions is known as Cost-Volume-Profit Relationships. Cost-Volume-Profit Analysis deals with how costs and profits change with a change in volume. It analyzes the effects on profits of changes in such factors as variable costs, fixed costs, selling prices, volume, and the mix of products sold. Break-Even Analysis, one of the tools of Cost-Volume-Profit Analysis, determines the break-even sales which is the units and/or sales dollars where total sales equals total costs (expenses). Return To Bookkeeping and Accounting Tutorials Some examples of decisions where Cost-Volume-Profit analysis can provide help are: What price(s) should we charge for our products or services ? How many units of a product should we produce ? Should we spend more on advertising ? Should we add or delete a product line ? Should we accept or decline a special order ? What sales mix (different products) should we strive for ? What is the effect of a change to a different raw material supplier ? Should we increase or decrease our work force ? How should we make our products ? Simple Breakeven Analysis Two important definitions used in break-even analysis are: Variable Costs (Expenses) are costs that change directly in proportion to changes in activity (volume). Fixed Costs (Expenses) are costs that remain constant (fixed) for a given time period despite wide fluctuations in activity (volume). We'll use FleeMarket Bargains as our simple example to illustrate break-even analysis. FleeMarket Bargains information, costs, and prices: Sells cartoon watches that have a cost of $10.00 (variable cost-expense) All unsold watches may be returned to the supplier Booth rental costs $ 100.00 for the day (fixed cost-expense) Selling price of the watches is $20.00 We will use the above information to calculate the number of watches (units) and the sales dollars we need in order for our flea market business to break even for the day. There are three methods that can be used to calculate our break even point: Equation Method Contribution Margin Method Graphic Method Basic Breakeven Equation Method Sales = Variable Expenses + Fixed Expenses + Profit Let's adopt this equation and calculate the number of watches that we must sell in order to breakeven. The basic breakeven equation becomes: Unit Selling Price X Number of Units Sold =(Unit Cost X Number Of Units Sold) + Fixed Costs + Profit Let X = Number of units (watches) that need to be sold to break even $20.00X = $10.00X + $100.00 + 0 $10.00X = $100.00 + 0 X = ($100.00 + 0) / $10.00 X = 10 units (watches) Breakeven Number of Watches is 10 We can easily calulate the dollar sales necessary to break even by multiplying the sales price of the watches by the break even number of watches. Break Even Sales Dollars = 10 (watches) x $20.00/per watch Break Even Sales Dollars = $200.00 Sales of Watches Cost of Watches Booth Rental (Fixed Cost) Profit 10 watches @ $20.00 10 watches @ $10.00     $200.00 100.00 100.00 $0.00 Contribution Margin Method The Unit Contribution Margin is the difference between your product's unit selling price and its unit variable cost. Unit Contribution Margin = Unit Sales Price - Unit Variable Cost Unit Contribution Margin (watches) = $20.00 - !0.00 Unit Contribution Margin = $10.00 Breakeven Point = (Fixed Expenses + Desired Profit) / Unit Contribution Margin Let X = Number of units (watches) that need to be sold to break even X = ($100.00 + 0 ) / $10.00 Look at the highlighted line in the Basic Breakeven Equation. It's the same as the line above. The contribution margin method is merely a shortcut version of the Basic Breakeven Equation Method. X = 10 units (watches) You can use either method to calculate breakeven units and/or sales dollars. The choice is a matter of personal preference. What if you want to see how many units you need to sell to not just breakeven but make a certain amount of profit ? If you want to make a profit of $200.00 from you sale of watches at the flea market all you need to do is include your desired amount of profit in your breakeven calculation. Breakeven Point = (Fixed Expenses + Desired Profit) / Unit Contribution Margin X = ($100.00 + $200.00 ) / $10.00 X = $300 / $10.00 X = 30 units (watches) Let's do one more thing to check our calculation. We'll construct a simple profit and loss statement. Sales of Watches Cost of Watches Booth Rental (Fixed Cost) Profit 30 watches @ $20.00 30 watches @ $10.00     $600.00 300.00 100.00 $200.00 Sure enough, if we sell 30 watches at the flea market we'll make a profit of $200.00. The term contribution margin may be expressed as a total dollar amount, as an amount per unit (as the prior example), or as a percentage. In our last example Unit Contribution Margin is Unit Selling Price less Unit Variable Cost or $20.00 - $10.00 = $10.00 Total Conribution Margin is Units Sold multiplied by the Unit Contribution Margin 30 watches X $10.00 = $300.00 Percentage Contribution Margin is the Unit Contribution Margin / Unit Selling Price or $10.00 / $20.00 = 50% or .50 Using our example where we wanted a profit of $200.00 on our sale of watches, we can calculate the Sales Dollars Needed with another variation of the Breakeven Equation. Sales Dollars Needed = (Fixed Expenses + Desired Profit) / Contribution Margin Ratio Sales Dollars Needed = ($100.00 + $200.00) / .50 Sales Dollars Needed = $600.00 Graphical Approach Since some of the sites I recommend later for further study have a detailed discussion of the graphical approach, I'm only going to provide you with a brief description. The graphical approach has an X-axis (horizontal) that repesents Units (volume) and a Y-axis (vertical) that represents Dollars and contains lines for: Sales Variable Costs (Expenses) Total Costs (Expenses) The point on the graph where the Sales and Total Cost (Expense) Lines intersect is the breakeven point. Another graph that is often used to compare how alternatives on pricing, variable costs, or fixed costs may affect net income (profit) as volume changes is called a P/V Chart or Profit-Volume Graph. Other Comments Our simple Flea Market example assumed we're only selling one product. Most businesses sell many products and use techniques that factor their sales mix into the breakeven analysis. We have just touched on how to use break-even anlysis. It may appear that you have to be good at math and equations, but all you really need is to become familiar with the the tool, learn how to classify cost as fixed and variable, and use a computer program or spreadsheet template that automates the calculations, presents the results, and even provides graphs if desired. If you would like to learn more about Cost-Volume-Profit Relationships and Break-Even Analysis and build on the basics that I have presented I recommend that you visit the following sites: KnowledgeDynamics I luckily ran across this site by accident. This site is just too good to miss if you really want to learn how to use Break-Even Analysis. Their Break-Even Analysis Simulation is a new, revolutionary type of e-Learning course. Unlike other e-learning courses, you will learn-by-doing in a realistic, yet risk-free environment. After completing their Simulation, you will be able to: Derive and explain the Break-Even formula Classify various costs as either fixed or variable Calculate the Break-Even volume and date for a given venture Explain the impact of various manufacturing and marketing decisions BuzGate Good introduction to breakeven anlysis and how this tool can help your business in making decisions. Fixed and Variable Costs CCH Business Toolkit Before you can use cost/volume/profit analysis to help you evaluate your business's operations, you need to get a handle on the fixed costs of your business, as compared to your variable costs. Weatherhead School of Management Excellent review of break-even terminology. Also includes examples and an online break-even calculator and graphics display. Humber College Examples of calculating break even information using break even equations and graphs. Vanderbilt University (Graphical Approach) This material covers the development of the break-even chart, the use of profit graphs (with illustrations of how cost and price changes impact profits), and a discussion of how you can develop a spreadsheet to generate profit graphs and compute break-even points. CPA-Wizard Good discussion and review of breakeven terminolgy and contains an Excel spreadsheet template. SpreadSheetModeling Provides instructions on how to build an Excel Break-Even Analysis worksheet (template). Biznizportal Simple online break even analysis calculator designed to demonstrate how many units of your product must be sold to make a profit. HBS Break Even Analysis Toolkit Link Courtesy of Wachowicz's Web World (John Wachowicz-Professor of Finance University of Tennesee) and Harvard Business School. Downloadable interactive workbook from the HBS Toolkit helps calculate a break-even point or target-profit level based on the fixed costs, variable costs, and unit price of the product or service being analyzed. Estimating Breakeven Sales for Your Small Business PDF Document courtesy of Purdue University Extension Breakeven Analysis CCH Business Owner’s Toolkit A tool for management decision making that has grown out of cost/volume/profit. Improving Decision Maker with Simple Break-Even Analysis Business applications of break-even analysis presented by the Iowa Business Network. Sales Volume Breakeven Analysis CCH Financial Planning Toolkit – Find out how many and at what price you must sell your product in order to make a profit. Break-Even Point Analysis Provided by bizbound.com The Break-Even Calculator Provided by the Weatherhead Connection, the Weatherhead School of Management, and Case Western Reserve University The Break-Even Analysis Module illustrates the fundamentals of break-even analysis, a time-tested technique that is often used by companies and consultants to evaluate alternative business strategies and tactics. It contains a basic break-even calculator and one sample exercise. It is designed to be used with data from any case study or real-world situation for which break-even analysis is appropriate. More sophisticated variations of break-even analysis are used by companies around the world, but the principles remain the same as are illustrated here. I recommend you take the time and visit all the recommended sites in order to gain some knowledge that you can apply to some of your own business decisions. Return To Bookkeeping and Accounting Tutorials