The break-even level or break-even point represents the sales amount—in either unit or revenue
terms—that is required to cover total costs. Total profit at the break-even point is zero.
Break-even is only possible if a firm’s prices are higher than its variable costs
per unit. If so, then each unit of the product sold will generate some “contribution”
toward covering fixed costs. In economics and business, specifically cost
accounting, the break-even point is the point at which total cost and total revenue are
equal: there is no net loss or gain, and one has "broken even." A profit or a loss has
not been made, although opportunity costs have been "paid," and capital has received
the risk-adjusted, expected return. In short, all costs that needs to be paid are paid by
the firm but the profit is equal to 0. For example, if a business sells fewer than
200 tables each month, it will make a loss; if it sells more, it will make a profit. With
this information, the business managers will then need to see if they expect to be able
to make and sell 200 tables per month. If they think they cannot sell that many,
to ensure viability they could: Try to reduce the fixed costs
Try to reduce variable costs Increase the selling price of their tables.
Any of these would reduce the break-even point. In other words, the business would not need
to sell so many tables to make sure it could pay its fixed costs.
Purpose The main purpose of break-even analysis is
to determine the minimum output that must be exceeded in order to make profit. It also
is a rough indicator of the earnings impact of a marketing activity.
The break-even point is one of the simplest yet least used analytical tools in management.
It helps to provide a dynamic view of the relationships between sales, costs, and profits.
For example, expressing break-even sales as a percentage of actual sales can give managers
a chance to understand when to expect to break even.
The break-even point is a special case of Target Income Sales, where Target Income is
0. This is very important for financial analysis. Construction
In the linear Cost-Volume-Profit Analysis model, the break-even point) can be directly
computed in terms of Total Revenue and Total Costs as:
where: TFC is Total Fixed Costs,
P is Unit Sale Price, and V is Unit Variable Cost.
The quantity, , is of interest in its own right, and is called the Unit Contribution
Margin: it is the marginal profit per unit, or alternatively the portion of each sale
that contributes to Fixed Costs. Thus the break-even point can be more simply computed
as the point where Total Contribution = Total Fixed Cost:
To calculate the break-even point in terms of revenue instead of Unit Sales, the above
calculation can be multiplied by Price, or, equivalently, the Contribution Margin Ratio
can be calculated: R=C, Where R is revenue generated, C is cost
incurred i.e. Fixed costs + Variable Costs or Q * P = TFC + Q * VC, Q * P - Q * VC = TFC,
Q * = TFC, or, Break Even Analysis Q = TFCs ratio=Break Even
Margin of safety Margin of safety represents the strength of
the business. It enables a business to know what is the exact amount it has gained or
lost and whether they are over or below the break-even point. In break-even analysis,
margin of safety is the extent by which actual or projected sales exceed the break-even sales.
Margin of safety = Margin of safety% =/current output × 100
When dealing with budgets you would instead replace "Current output" with "Budgeted output."
If P/V ratio is given then profit/PV ratio. Break-even analysis
By inserting different prices into the formula, you will obtain a number of break-even points,
one for each possible price charged. If the firm changes the selling price for its product,
from $2 to $2.30, in the example above, then it would have to sell only 1000/(2.3 - 0.6)=
589 units to break even, rather than 715.
To make the results clearer, they can be graphed. To do this, you draw the total cost curve
which shows the total cost associated with each possible level of output, the fixed cost
curve which shows the costs that do not vary with output level, and finally the various
total revenue lines which show the total amount of revenue received at each output level,
given the price you will be charging. The break-even points are the points of intersection
between the total cost curve and a total revenue curve. The break-even quantity at each selling
price can be read off the horizontal axis and the break-even price at each selling price
can be read off the vertical axis. The total cost, total revenue, and fixed cost curves
can each be constructed with simple formula. For example, the total revenue curve is simply
the product of selling price times quantity for each output quantity. The data used in
these formula come either from accounting records or from various estimation techniques
such as regression analysis. Limitations
Break-even analysis is only a supply-side analysis, as it tells you nothing about what
sales are actually likely to be for the product at these various prices.
It assumes that fixed costs are constant. Although this is true in the short run, an
increase in the scale of production is likely to cause fixed costs to rise.
It assumes average variable costs are constant per unit of output, at least in the range
of likely quantities of sales.. It assumes that the quantity of goods produced
is equal to the quantity of goods sold. In multi-product companies, it assumes that
the relative proportions of each product sold and produced are constant.
Notes There is a myth that Black Friday is the annual
break-even point in American retail sales, but in fact retailers generally break-even,
and indeed profit, nearly every quarter. See also
Cost-plus pricing Pricing
Production, costs, and pricing Contribution margin
References
External links Example of Break Even Point using Microsoft
Excel Videos and Tutorials about Break Even Analysis
Break Even, any profitability ratio search in what-if? model with MS Excel
MASB Official Website Further reading
Dayananda, D.; Irons, R.; Harrison, S.; Herbohn, J.; and P. Rowland, 2002, Capital Budgeting:
Financial Appraisal of Investment Projects. Cambridge University Press. pp. 150.