Break Even Analysis
Break-Even Analysis is a financial tool used by businesses to determine the point at which total revenue equals total costs, resulting in neither a profit nor a loss.
It helps businesses understand the minimum level of sales needed to cover all incurred costs.
Questions to ask a business owner or manager is what's your break-even level ? At what level of sales will my company start making a profit ? When can I afford to draw a salary ? One technique for answering these questions is break-even analysis.
What's Involved ?
Basically break-even analysis involves analyzing your products costs and selling prices and applying some simple calculations to arrive at your results. The key to performing a break-even point or break-even analysis is the relationship between expenses and revenues. We need to know how expenses will change as sales increase or decrease. Some expenses will increase as sales increase (variable expenses), whereas some expenses will not change as sales increase or decrease (fixed expenses).
Definitions
Important definitions used in break-even analysis are:
Contribution Margins
The term contribution margin may be expressed as a total dollar amount, as an amount per unit, or as a percentage.
- Unit Contribution Margin is Unit Selling Price less Unit Variable Cost
- Total Contribution Margin is
- Percentage Contribution Margin Ratio is the
Variable Costs (Expenses) are costs that change directly in proportion to changes in activity (volume).
Some Examples Of Variable Cost:
Some Examples Of Variable Cost:
- Direct Raw Materials
- Direct Labor
- Commissions
- Production Supplies
- Packaging
Fixed Costs (Expenses) are costs that remain constant (fixed) for a given time period despite wide fluctuations in activity (volume).
Some Examples Of Fixed Costs:
Some Examples Of Fixed Costs:
- Management Salaries
- Payroll Taxes
- Rent
- Depreciation
- Utilities
- Insurance
- Property Taxes
- Telephone
- Interest
There are three methods that can be used to calculate our break even points:
- Equation Method
- Contribution Margin Method
- Graphic Method
Break-Even Equation Method
Sales = Variable Expenses + Fixed Expenses + Profit
Contribution Margin Methods
Unit Contribution Margin
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 = Unit Sales Price - Unit Variable Cost
Total Contribution Margin
Total Contribution Margin = Total Sales Value - Total Variable Costs
Total Contribution Margin = Total Sales Value - Total Variable Costs
Subtract total variable costs from total sales revenue.
Calculation Including a Profit
What if you want to see how many units you need to sell to not just break-even but make a certain amount of profit ?
Break-Even Point plus Profit = (Fixed Expenses + Desired Profit) / Unit Contribution Margin
Percentage Contribution Ratio.
You can also calculate Break-Even Sales Dollars by using your unit percentage or total contribution ratio.
Unit Percentage Contribution Ratio = (Selling Price - Variable Costs) / Selling Price
Break-Even Sales Dollars = Fixed Costs / Unit Percentage Contribution Ratio
Total Percentage Contribution Ratio = Total Sales - Total Variable Costs / Total Sales
Break-Even Sales Dollars = Fixed Costs / Total Percentage Contribution Ratio
Graphical Approach
For you math guys and gals.
The graphical approach has an X-axis (horizontal) that represents 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 break-even 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.
As you can see there are many methods for calculating your Break-Even Points.
Summary
By conducting a Break-Even analysis, businesses can assess the profitability and feasibility of their products or services. It helps answer questions such as:
- How many units or sales dollars are needed to cover all costs and reach the break-even point?
- What is the impact of changes in variable costs, selling price, or fixed costs on the break-even point?
- How many units or sales dollars need to be sold to achieve a desired level of profit?
Break-Even analysis is a valuable tool for business planning, pricing decisions, and determining the break-even point for new products or services. It helps businesses understand their cost structure, pricing strategy, and sales targets to achieve profitability and make informed business decisions.
Break-Even Analysis Spreadsheet
Break-Even Analysis Video