A break-even analysis is a financial tool which helps a company to determine the stage at which the company, or a new service or a product, will be profitable. In other words, it is a financial calculation for determining the number of products or services a company should sell or provide to cover its costs (particularly fixed costs).
What is a Break-Even Analysis
Break-even is a situation where an organization is neither making money nor losing money, but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For example, say Happy Ltd has fixed costs of Rs. 10,000 vs Sad Ltd has fixed costs of Rs. 1,00,000 selling similar products, Happy Ltd will be able to break-even with the sale of lesser products as compared to Sad Ltd.
Break-even point formula
To learn how to find break-even point, you must know the break-even point formula. To know how to calculate break-even point, you need the following:
- Fixed costs
- Variable costs
- Selling price of the product
So, what’s the difference between fixed vs. variable costs? Fixed costs are expenses that remain the same, regardless of how many sales you make. These are the expenses you pay to run your business, such as rent and insurance.
On the other hand, variable costs change based on your sales activity. When you sell more items, your variable costs increase. Examples of variable costs include direct materials and direct labor.
Your selling price is how much you charge for the one unit or product.
Without further ado, here’s the break-even formula:
Break-even Point Per Unit = Fixed Costs / (Sales Price Per Unit – Variable Costs Per Unit)
The sales price per unit minus variable cost per unit is also called the contribution margin. Your contribution margin shows you how much take-home profit you make from a sale.
The break-even point is your total fixed costs divided by the difference between the unit price and variable costs per unit. Keep in mind that fixed costs are the overall costs, and the sales price and variable costs are just per unit.
Components of Break-Even Analysis
Fixed costs are also called overhead costs. These overhead costs occur after the decision to start an economic activity is taken and these costs are directly related to the level of production, but not the quantity of production. Fixed costs include (but are not limited to) interest, taxes, salaries, rent, depreciation costs, labour costs, energy costs etc. These costs are fixed irrespective of the production. In case of no production also the costs must be incurred.
Variable costs are costs that will increase or decrease in direct relation to the production volume. These costs include cost of raw material, packaging cost, fuel and other costs that are directly related to the production.
When is Break-even analysis used
- Starting a new business: To start a new business, a break-even analysis is a must. Not only it helps in deciding whether the idea of starting a new business is viable, but it will force the startup to be realistic about the costs, as well as provide a basis for the pricing strategy.
- Creating a new product: In the case of an existing business, the company should still peform a break-even analysis before launching a new product—particularly if such a product is going to add a significant expenditure.
- Changing the business model: If the company is about to the change the business model, like, switching from wholesale business to retail business, then a break-even analysis must be performed. The costs could change considerably and breakeven analysis will help in setting the selling price.
Breakeven analysis is useful for the following reasons:
- It helps to determine remaining/unused capacity of the company once the breakeven is reached. This will help to show the maximum profit on a particular product/service that can be generated.
- It helps to determine the impact on profit on changing to automation from manual (a fixed cost replaces a variable cost).
- It helps to determine the change in profits if the price of a product is altered.
- It helps to determine the amount of losses that could be sustained if there is a sales downturn.
Additionally, break-even analysis is very useful for knowing the overall ability of a business to generate a profit. In the case of a company whose breakeven point is near to the maximum sales level, this signifies that it is nearly impractical for the business to earn a profit even under the best of circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point constantly. This monitoring certainly reduces the breakeven point whenever possible.