Break even analysis is an estimation that intends to find the particular number of units or the amount of revenues that need to be produced in order to achieve a profit of zero. The break-even point is achieved, therefore, when total revenues are equal to the sum of both variable and fixed costs. The volume of sales required to achieve such level becomes the minimum a firm must produce in order to cover for all its costs.
What is a Break-Even Analysis?
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The Break-Even Point analysis is incredibly useful and widely employed among accountants and financial analysts who intend to provide a clear picture of how much money a company has to bring in to cover for all its costs. These costs are divided into variable costs, those that fluctuate depending on the production volumes or the level of sales, and fixed costs, which are those that remain stable regardless of the production volume or sales level.
Some variables costs include raw materials and direct labor and also sales commissions. On the other hand, some fixed costs include rent, utilities and administrative payroll.
Understanding how much the company must produce in order to cover all its costs is important to set goals, minimum quotas and also to determine before-hand the potential feasibility of a business opportunity. If the Break-Even Analysis indicates an unrealistic amount of sales have to be achieved to cover for variable and fixed costs, the project can be considered unviable even before diving into more complex analytics.
Break-Even Analysis Formula
The Break-Even Analysis can be understood as the point where:
Total Revenues = Variable costs + Fixed Costs
The formula to estimate how much sales or number of units have to be produced to achieve such balance is the following:
BEP: (P * Q) – (VC * Q) – FC = 0; and the way Q can be determined is:
Q = FC / P – VC
Break Even Analysis Equation Components
Q: Number of units produced
FC: Fixed Costs
P: Price per unit
VC: Variable Costs
Also, if the number of units to be produced is known and the price that has to be charged for a particular product in order to achieve the Break-Even point has to be determined, the formula to do so would be this:
P = [(VC * Q) + FC] / Q
Break-Even Analysis Example
Let’s say a business that produces shoe strings wants to know how many of them it has to produce in order to achieve its break-even point. The Finance Department provided the following information to create a Break-Even Analysis:
- Price per Shoe String: $0.45
- Direct Raw Materials per Unit: $0.12
- Direct Labor per Unit: $0.09
- Manufacturing Overhead per Unit: $0.02
- Rent: $65,000
- Utilities: $12,000
- Other Costs: $4,500
Total variable costs would be $0.23 ($0.12 + $0.09 + $0.02)
Also, total fixed costs according to this information would add up to $81,500 ($65,000 + $12,000 + $4,500)
Therefore, the formula to estimate the number of units that have to be produced to achieve the break-even point would be:
Q = $81,500 / $0.45 – $0.23 = 370,455 units.
This means that the company has to produce this number of units per year to cover for both its variable and fixed costs.
Break Even Analysis Explanation
Understanding a company’s break-even point is essential for managers to determine how sustainable a business is at any give point in its life cycle. This means that the result of a break-even analysis can vary from time to time depending on the fluctuation of variable and fixed costs. For example, a business raw materials may increase in price, which means the break-even point will be higher than it was before. Also, fixed costs can also increase, such as an increase in the rent paid for a production facility, which will also boost the break-even point.
A high amount of fixed costs is risky for companies, as the minimum production volume required to cover for its costs may become too high to be sustainable over time. For this reason, companies who want to remain flexible over time, especially those that have seen significant volatility in its sales, avoid incorporating fixed costs to their cost structure, and prefer to add variable costs instead.
Nevertheless, the higher the proportion of variable costs compared to fixed may reduce earnings substantially if the sales volume scales up. This is known as economies of scale. If a company expects its sales or production to be increased in a short period of time, transferring variable costs to fixed ones will benefit the business’ as the cost will remain the same regardless of the increase in the production volume, which will end up turning a larger profit to the business.
Finally, the difference between the price per unit and variable cost per unit is known as the margin of contribution. The larger this margin is, the lower the break-even point will be. Therefore, businesses should aim at widening their margins of contribution in order to reduce the break even point. That way, they will start producing a profit at a lower production volume, with less effort.
Break-Even Analysis Uses, Cautions, Pitfalls
Depending on the type of business, either sales or production volumes can be employed to determine the break-even point. A business that sells services may not have a per unit price. Instead, it will produce a certain amount of sales. The way to estimate the break-even point for these businesses is to estimate how much in variable costs it will produce for different levels of sales. For example, a business may incur in variable costs that add up to 20% of its sales. This means that the business, in order to achieve its break-even point, has to produce a certain number of sales, minus 20% of those sales, minus fixed costs.
In those cases, iterations have to be ran in order to estimate the minimum sales required for profits to be equal to zero. This analysis can be done through certain applications such as MS Excel. In any case, the goal would be the same as in a manufacturing business, which is to estimate the minimum amount of sales that will have to be produced to cover for all costs.