Breakeven Analysis

Break Even Analysis is a term used in business, cost accounting and economics. It refers to a point where the total cost incurred becomes equal to the total revenue earned. Break Even Analysis determines the number of units to be sold to earn the revenue required to cover the total costs. Total cost is a sum total of fixed and variable costs.

Break Even analysis is a measurement system to calculate the margin of safety. It determines the number of units that must sell to recover the variable and fixed costs incurred to make the sale. It calculates when a business will be profitable by equating the total revenues with the total expenditures.

Revenues earned always do not end up bringing in profits. Sometimes the cost to manufacture a product is greater than the revenues they generate. It is important to understand the difference between revenues generated and profits earned. If the expenditure is more than the revenues earned, the product ends up making a loss. Break Even analysis helps calculate the number of sales required to equate revenues with expenses (fixed and variable costs). Anything above that break-even point is considered as profits.

To calculate Break Even Point, we need to determine –

Fixed Costs: Costs like rent, salaries, machinery etc. These costs do not vary with changing outputs.

Sales price per unit: This is the price at which one unit sells

Variable cost per unit: This is the cost incurred to create a unit. This cost will vary as per the product.

Formula for Break Even Analysis

Break even quantity = Fixed costs / (Sales price per unit – variable cost per unit)

The sales price per unit less the cost price per unit stands for the contribution margin per unit. For example, if a pair of shoes cost $100, and the variable cost to make the shoe is $10, the difference of $90 is the contribution margin per unit. Contribution margin helps to offset the fixed costs.

Therefore,

$\text{Break even quantity = }\frac{\text{Fixed costs}}{\text{Contribution margin per unit}}$

The above figure is a graphical representation to understand the Break Even point. The line OA shows the variation of income at different levels of output or production. OB represents the fixed costs incurred. Higher the output, higher is the variable cost, which in turn increases the total cost inclusive of fixed and variable costs. When the output levels drop, costs become more than the income. In the above diagram ‘P’ is the point of intersection, where costs are the same as the income. This point is called the break-even point, where neither profit nor loss is made.

Example

David is an accountant with Company Hi-fashion, which makes travel bags. He has calculated the fixed costs inclusive of property lease & taxes, executive and labor salaries, and machinery set up to be $100,000. The variable cost of manufacturing one travel bag is $10. The bag sells at a premium cost of $50. The Break Even point of Hi Fashion’s premium travel bag will be calculated as, –

$\text{Break Even Quantity }=\frac{\$100,000}{\left(\$50-\$10\right)}=2,500\text{ units}$

Therefore, considering the fixed costs, variable costs, and the per unit selling price, we can deduce that Company Hi Fashion will have to sell 2,500 units of bag to break even.

$\begin{array}{c}\text{Total sales to Breakeven = 2500 units }\times \$50perunit\\ =\$125,000\end{array}$

Selling 2500 travel bags will help Hi-Fashion break even. At this point no loss will be incurred and no profits will be made by the company. As a next step, David sets $50,000 as the desired profit that the company would like to make. He can use a break-even calculator to determine the number of units that must be produced to earn $50,000 once the break-even point has been achieved. To calculate this –

$\begin{array}{l}\frac{\text{Desired Profit }}{\text{Contribution margin}}\text{ + Total number of units to break-even}\\ \frac{50,000}{40}=1,250\text{ units}\end{array}$

Therefore, 2500 units + 1250 units = 3750 units will have to be sold for Hi-Fashion to achieve the desired profits of $50,000          

Analysis

Any production manager has to be aware of sales at all times to keep a check on how close he/she is to covering the fixed and variable costs. That is the reason a manager will always try and change elements in the break-even point calculation formulas to reduce the number of units required to be produced to increase profitability.

For example, if Hi-fashion Company wants to increase the sales price of the travel bags by $10, there will be a drastic impact on the number of units they need to produce and sell to achieve profitability. The company will also try to lower the variable costs by introducing automation to the entire production process. This will help reduce the variable cost, and hence reduce the number of units to be produced to make profits. Outsourcing can also help redefine the entire cost structure.

Margin of Safety

Margin of safety refers to the difference between the number of units required to cover expenses and the number of units required to meet the desired profits. In the example above, 2500 units are required for the company to break-even, and 3750 units are required to meet the profit goals. This difference of 1250 units is the margin of safety. This amounts to the sales that the company can lose and still cover its expenses.

Break-even analysis is imperative before the start of a new venture, before launching a new product, and before taking the decision to change the business model. It helps to,

• Manage the number of units to be sold
• Figure out budgets and set targets
• Manage the margin of safety
• Monitor and manage costs
• Design the company’s pricing strategy         

Important Formulae

Key descriptions

Fixed Cost – These are also known as overhead costs. These costs are invariable and come into existence at the beginning of financial activity of any business. These costs include the property rent, taxes, salaries, labor cost, depreciation cost, interest, set-up machinery etc.  

Variable Cost – These costs can vary and fluctuate depending on increase or decrease in production volumes. These costs include cost of raw material, packaging cost, fuel, distribution cost etc.

Contribution Margin – This is the selling price per unit minus the variable cost per unit. Once the expenditure made to manufacture a product is covered, the remaining revenue is considered as profit.

Break Even Quantity – It is the number of units a company must sell to cover the cost of their investment, inclusive of fixed and variable costs.

Common Mistake

It is imperative to understand and calculate fixed costs and variable costs correctly to apply the formula and arrive at the break-even point.

Context and Applications

This topic is important for the students pursuing the below-mentioned disciplines.

• Master in Business Administration
• Masters in Commerce
• Bachelor of Economics
• Bachelor of Commerce

Related Concepts

• Professional Accountancy
• Global Economics
• Managerial Economics