Definition – Break-even analysis
Break-even analysis is the method used to calculate the break-even point of the business. It is a useful tool to estimate how much sales are needed by the business to avoid a loss. Break-even analysis can be used for a single product or multiple products. However, we will consider the single product break-even analysis in this article.
What is break-even point?
Break-even point is the point where the business experiences no profit and no loss i.e., the business breaks even. At the break-even point, the total revenue of the business covers the total costs. Another way of putting this is that the contribution earned (revenue – variable costs) by the business is just enough to cover the fixed costs.
Key Points
- At the Break-even point, the total revenue of the business covers the total cost or the total contribution = total fixed costs.
- Businesses with low fixed costs tend to have a low break-even point of sales and vice versa.
- Break-even analysis helps in making decisions regarding the production and sales of a product that is needed to break even.
Formula – Break-even in units
Break-even point (Units) = Total fixed costs / Contribution per unit
This formula is derived as follows.
We know that at break-even,
Total contribution = Total fixed costs
Where:
Total contribution = Contribution per unit x number of units sold
Thus:
Contribution per unit x number of units sold = Total fixed costs
Break-even point (Units) = Total fixed costs / Contribution per unit
Explanation – Break-even analysis
To understand the concept of break-even point, let us take the example of Paragon Manufacturing Limited. The management of the company has estimated that the total fixed costs of the business are $100,000. Only one product, GX100, is manufactured by the company that has a selling price of $20. Variable cost per unit is $12.
Now, you can calculate the contribution each unit generates by deducting the variable costs per unit from the selling price per unit. It means each product is contributing $8 to cover fixed costs. Now the main question is, “how many units would be sufficient to cover fixed costs?”. Using the break-even point formula, you can calculate that 12,500 units ($100,000 / $8 per unit) are required to cover the fixed costs of the company resulting in no profit and no loss. It can also be proved as follows:
Formula – Break-even in $
To find the break-even point in terms of sales revenue, there are two methods (whichever is suitable for you):
- Multiply the break-even point (units) by the selling price per unit, OR
- Use contribution to sales ratio to determine the break-even point with the help of following formula:
Break-even point ($) = Total fixed costs / Contribution to sales ratio
Example
Consider the example of Scents n Stories, a perfume manufacturing company. The management of Scents n Stories has estimated that fixed costs for the whole business amount to $150,000. The selling price of each bottle of perfume is $34 and the variable cost is $19. Calculate the breakeven point in terms of units of perfume required as well as in terms of the sales revenue?
Solution
To calculate the break-even point, we need two things:
- Fixed Cost, and
- Contribution per unit.
Fixed cost is given in the question, i.e., $150,000.
Limitations of Break-even analysis
Although break-even analysis gives an estimate of minimum sales needed to avoid a loss, it has some limitations that limit its utility in certain cases. These are:
- This method assumes that 100% of the production is converted into sales and no closing stock is left. In reality, this might not be possible as some of the inventory is unsold at the end of the period and forms a part of closing stock.
- Fixed costs always remain constant in total at all levels of activity (However, there might be step-ups and step-downs in fixed costs at different activity levels)
- Variable cost per unit remains constant over any activity range (Although, there might be discounts available from suppliers on bulk purchases)
- Selling price per unit remains constant at all activity levels. (Again, there might be circumstances leading to an increase or reduction in selling price per unit)
- Volume is the only factor that causes a change in selling price and cost per unit. (Yet, there are other factors such as economic conditions, inflation, supply & demand, etc. which affect the selling price as well as cost per unit of products)
- It is an estimate and estimates can be wrong too. Data input in the analysis derives the results and false data gives incorrect results which lead to inaccurate decisions.