break-even analysis is an essential financial decision-making tool, helping
business owners and future entrepreneurs to predict how quickly, if at all their
potential business venture or product launch will be. This video shows you how
to calculate the break-even point and the key factors businesses should
consider when making those investment decisions.
One way to look at break-even analysis is it being a financial decision-making
tool which businesses use to forecast the potential profitability and risk
associated with a business startup or new product range. Businesses can use a
break-even formula to calculate the amount of units which are required for
their sales revenue to equal their total costs this is known as the break-even
point. The point at which the business is not making a profit, nor is it making a
loss. If the business forecast their sales revenue to be higher than their
total cost, then the business is making a profit. However if the sales revenue
forecast is lower than the total cost, the business is predicting to make a
loss. So we're now going to move on to the concept of contribution which is a
very important financial concept in business and essential to calculate the
break-even point. It essentially looks at the profit made on individual products
and shows a business how much each unit contributes towards cost initially and
profit in the long term. It relies on two essential elements these are the selling
price per unit and the variable cost per unit. Once you have identified these two
figures you can use the contribution per unit formula which is the selling price per
unit less the variable cost per unit to calculate the contribution per unit.
Let's have a go at an example, so here you were given information that the
selling price per unit is ten-pound and the variable cost per unit are just two
pounds, therefore using the contribution per unit formula we will calculate the
selling price of ten pound less the variable costs of two pounds, giving us a
contribution per unit of eight pound. This is a crucial figure for our
break-even calculation and one that we're going to look at completing next. So now
we're going to look at the break-even formula and work through an example. The
break-even formula is on the screen now, to calculate the break-even point you need
two key components, these are the fixed costs and you also need the contribution
per unit, once you have these two factors you simply divide your fixed cost by the
contribution per unit. Let's have a look at how this works in practice.
So there's a scenario on your screen Kenneth and Hilda are planning to start
a t-shirt business and they want to know how many they will have to sell to break
even, the information you are given is they have fixed costs of two hundred
pound their variable costs will be two pound per t-shirt, they're going to produce 80
t-shirts and the selling price will be ten pound. First of all, we need to
calculate the contribution per unit which as we now know is the selling
price per unit less the variable cost per unit, so in this case it will be the ten
pound selling price minus the two pound variable costs given a contribution per
unit of eight pound, which in this case is eight pound per t-shirt as that's the
products that the company is deciding to sell. Now we have this information we can
calculate the break-even point. The fixed cost of two hundred pound are given in
the information and this is divided by the eight pound contribution per unit
which we have just calculated, this gives you an answer of 25. Now it's important
to know what this answer of 25 actually represents, when calculating break-even
using this formula the answer always represents how many units it actually
takes to break-even, if you wanted to know how much sales revenue will be
required to break-even you would simply multiply these units by the selling
price per unit, which in this case is ten pounds.
Therefore, it is 25 units times the 10 pounds selling price per unit which will
provide you with information that the business needs to sell 250 pounds worth
of t-shirts to break-even. Now we have our breakeven point we can now move on
to calculate our margin of safety. If the business is producing and selling
more than the break-even level of output, that a profit is being made and they
have what is known as the margin of safety, this is effectively a safety net.
The margin of safety is the number of units that the business predicts to sell
above their break-even point the formula to calculate this is sales less the
break-even output in units. Now one of the assumptions in break-even analysis
is that whatever the business produces, it also sells unless you are told
otherwise. This is one of the key limitations with break-even analysis
and something you should bear in mind when making investment decisions. So the
calculation for margin of safety in this scenario is the 80 units we're
predicting to sell - the 25 units it takes to break-even, meaning your margin
of safety is 55 units. This gives the business a leeway of 55 units above and
beyond the break-even point. Effectively, they could misjudge their sales
forecast by 55 units and they would still break-even, but any less so if they
sold 56 less than predicted they would actually be making a loss at the end of
their production and sales run. So the higher the margin of safety the safer
the investment is for the business. A common way to see the break-even point
demonstrated is through a chart which shows key financial information such as
the businesses fixed costs, their sales revenue and their potential profit. On
your screen you will see labels a to g. Pause your screen now and have a go at
labelling all seven. Okay, so we're going to talk through what those labels mean now.
So A shows a business's fixed costs,they start at 200 and they do not change
regardless of the business's output. B shows the total cost of the business,
these are made up of the fixed cost of 200 as you can see the starting point is
200 and then they rise in direct proportion with their variable cost per
unit. C identifies the sales revenue, starting at zero when nothing is sold
and then increasing by ten pound consistently. label D is the key reason
for this chart, it's the break-even point which will always be shown as a cross,
the point at which sales and total costs cross paths. E is the area of loss which
is anything under the break-even point. F is the area of profit which is anything
above the break-even point and the final key area labeled G is our margin of
safety, which as we've already calculated is anything above 25 all the way up to 80 units,
hence 55 units and you'll see that is perfectly represented on that
chart we're now going to finish with an
overview of the strengths and limitations of conducting break-even
analysis and the things that a business should consider when making key
financial decisions. One of the key strengths is that the calculations are a
quick and simple aid to financial decision making helping the business to
assess the level of risk in a potential investment or product launch whilst
providing them with the margin of safety and the potential profitability of the
investment. But crucially it allows the business to pinpoint the exact amount of
units or sales revenue it needs to sell to break-even.
However, businesses need to be very careful when using break-even analysis as
it does have its limitations, for example it is only based on forecasts within
which cost can change over time which would actually impact the break-even
point. For example, if costs increase, so
would the break-even point. It also assumes that all products that are made
are also sold which is unrealistic in most circumstances. This is why a margin
of safety is so important and such a key consideration for your investment
decision. A final limitation is for businesses that provide services as the
typical price per service varies drastically and wouldn't provide an
accurate break-even point. Thank you for listening, I hope that helps you to
understand the break-even point and the factors you should consider when making
financial decisions based on break-even analysis. There is a link to a free
worksheet to test your knowledge of break-even analysis in the description
of this video and if you found this video useful remember to hit the like
button and subscribe for lots more business studies videos.