What is Break-Even Analysis? Types, Significance, Example

Break-even analysis is a tool that helps you to find the point at which your business is making enough money to cover its costs. It can be used to help you decide whether it’s worth continuing with an investment or not. The point at which revenue and costs are equal is known as the break-even point. When this happens, your business will neither make money nor lose any.

What is Break-Even Analysis And Why Is it Significant

What is Break Even Analysis?

Break-even analysis is a type of financial analysis that helps determine the point where revenues equal costs. It is also known as “profit-split” analysis or “pivot point” analysis. When overall revenue and total expense are equal, a sale has reached its break-even point. For example, if a company has $1 million in fixed costs and variable costs of $0.30 per unit sold, then the break-even point would be 30,000 units., where $1 million in total revenue would result in the same amount of total cost.

Types

Cost Break-Even Analysis: It is done when we know all the costs involved in a project or business venture, but we don’t know how much revenue it will generate.

Revenue Break-Even Analysis: It is done when we know all the revenues involved in a project or business venture, but we don’t know how much cost it will generate.

The break-even point is also used to determine the number of units sold to break even or the point at which a business’s profit is zero. For example, if a company has $10 million in fixed costs and variable costs of $3 per unit sold, then it would take 3 million units sold to break even. The break-even analysis is one of the first financial calculations a company will perform. The break-even point can help determine how many units to produce or where to price a product. It is often used in conjunction with the profit equation, which helps determine if a business will make money or not at different levels of sales volume or different prices.

The break-even point is also used to calculate the number of units a business must sell to reach or maintain a certain volume. For example, if a company is considering expanding its product line, and wants to know how many units it would need to sell to maintain its current level of profit, then the break-even point would be calculated. It can also be used when calculating return on investment for different levels of production. It is calculated by taking the total cost of the product and dividing it by the total value of all of its sales. For example, a company might sell $10,000 worth of products and cost $500 in materials to produce. To calculate their break-even point, they would divide 500 by 10. The result is 5 units per sale.

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Definition

A financial tool called break-even analysis aids in pinpointing when a company will begin to turn a profit. It is frequently used to assess the viability of a new product or project and can be used to establish the break-even point for any particular period. It is computed by multiplying the number of units sold by fixed costs, which are divided by the contribution margin per unit.

In break-even analysis, it is determined how much revenue is required for a company to break even and turn a profit. The break-even point is defined as the point at which revenue and cost are equal. A business will turn a profit if its revenue is greater than what it needs to pay its expenses, and the opposite is also true.

The Break-even Point Can Be Determined in One of Two Ways:

  • Only using variable costs
  • Employing both variable and fixed expenses

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It’s Importance

Determines the Size of the Units That Will Be Sold:

The company or the owner learns how many units must be sold to cover the cost with the aid of break-even analysis. To analyze the break-even analysis, the variable cost, the selling price of a certain product, and the overall cost are needed.

Setting Goals and Creating a Budget:

It is simple for the business or owner to select a goal and set a budget for the firm with this knowledge of the point at which a business can break even. This research can also be used to help a business set reasonable goals.

Manage the Margin of Safety:

 A company’s sales are inclined to decline during a financial collapse. The break-even analysis aids the business in determining the fewest number of sales necessary to turn a profit. The management can carry out a significant business decision with the margin of safety reports.

Cost Monitoring and Control:

Both fixed and variable costs have an impact on the profit margins of businesses. Therefore, the management can determine whether any effects are changing the cost using break-even analysis.

Helps Develop Price Strategy:

Any change in a product’s pricing may have an impact on the break-even point. For instance, if the selling price is increased, fewer units of the product must be sold to break even. Similarly, to this, if the selling price is lowered, a business must sell more to break even.

Establishing the baseline of sales revenue and/or volume that must be generated to cover costs, ensuring that they are realistic, and estimating what your monthly cash flow requirements will be, are all important parts of breakeven analysis, especially when you are a startup. This will allow you to meet and even exceed your sales goals. For instance, at a gross margin of $0.40 before fixed expenses, if you only sell 10,000 pickles in the first month, you will have $4,000 to pay for the $10,000 in fixed costs. You are now $6k short, which must be made up by borrowing money from other sources. As they begin to increase sales, it is typical for startups to experience a deficit. To make up for this shortfall, you must predict your cash flow and arrange a bank loan, line of credit, or other sources of funding.

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A Break-Even Analysis is Ultimately Only as Reliable as Its Underlying Assumptions. As a result, It’s Crucial to:

Endeavor, as much as you can, to include ALL expenditures related to your firm; and b) estimate the real costs and sales prices as precisely as you can. Make sure that the estimate takes into account any discounts you might need to offer on your pickles to attract buyers. Additionally, it’s crucial to update the analysis whenever the underlying hypotheses alter. Breakeven analysis is at best an approximation, thus these should be improved and developed over time to achieve maximum accuracy. A review of the profit-loss (income statement) can give you fantastic insights into how your business is doing if you have a competent accounting system that is updated often.

However, it can be a useful and straightforward tool to provide the small business owner with an idea of what their sales need to be to start being profitable as soon as feasible. Like many forecasting indicators, the breakeven point has its limitations.

What Elements Make Up a Break-even Analysis?

A Break-even Analysis consists of two key parts.

First, Fixed Costs

The expenses incurred when a business decides to launch an economic activity are referred to as fixed costs or overhead. They have to do with quality rather than quantity of manufacturing. These expenses include material depreciation, taxes, interest, and other recurring expenses like labor, energy, and others.

Variable Costs

Contrary to fixed costs, variable costs change in response to the production volume. Sales expenses, production costs, labor costs, fuel costs, and other varying costs for items like raw and auxiliary materials are a few examples.

The Following Are Some Other Terms You Should Be Familiar With:

  • The selling price per unit is referred to as the unit selling price.
  • The term “variable cost per unit” describes the different expenses a unit requires to produce.
  • Revenue is the price at which you sell the good, less any variable costs.

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What is the Breakeven Analysis Proposition?

A mathematical method known as a “breakeven analysis formula” can assist you in figuring out when your business will break even and, consequently, when and how to become profitable.

According to Tools Hero, the breakeven analysis (BEA) is a valuable technique to investigate the relationship between fixed expenses, variable costs, and revenue. It is closely related to the breakeven point (BEP), which shows when an investment will start to generate a profit. It can be graphically depicted or calculated using a straightforward mathematical formula. The amount of production at a specific (selling) price required to recover all associated costs is determined by breakeven analysis.”

Break-even analysis “is useful in estimating the quantity of output or a targeted ideal sales mix,” according to Investopedia. ” Since investors, regulators, and other external sources like financial institutions are not compelled to use the metre or calculations, the study is purely for management’s use. Calculating the breakeven point is a prerequisite for this kind of study.”

Having said that, investors can use breakeven analysis to assess the cost at which they’ll break even on a trade or investment. The formula is beneficial for trading in or developing strategies to purchase options or fixed-income securities products.

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The formula for Determining the Break-even Point

You must list all of your expenses—both for running your business and producing your product—to determine your company’s break-even threshold for each product or service. The formula for a break-even analysis, which determines how many things you must sell to break even, is as follows:

The break-even point for units sold equals fixed costs (Price per unit – Variable cost per unit)

What Goes into Break-Even Analysis

Any breakeven analysis must begin by identifying your company’s variable costs, which are essential expenses that are incurred directly with the production of each good. These include the supplies utilised, packaging, labelling, transportation, etc. (see the pickle example below).

The next stage is to identify fixed expenses that your company must pay whether or not any products are being produced. These include the cost of the building’s rent, fixed employee salaries, office and computer expenses, subscriptions, bank fees, professional fees (paid to accountants and lawyers, for example), supplies, telephone and utility costs, as well as any other expenses that are particular to the business and for which a set amount is paid regularly.

It might be challenging to estimate direct expenses like labor and machinery because even while you can calculate the precise number of labor or machinery hours needed to produce a certain quantity of goods, you can still have to pay these prices. Regardless of whether they labor to the fullest extent possible, a full-time employee must be paid. In this scenario, the cost of labor would be fixed. However, since these salaries can be specifically connected to the extra amount of goods produced, overtime pay for employees can be included in variable expenses. Although purchasing machinery is a cash flow outlay, you can tie its approximate utilization throughout its useful life to each product consumed by using the unit of production depreciation approach. Depreciation of machinery may be a variable cost if this method is employed.

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An Example

Consider a rental fee for a child’s lemonade business that is fixed at $10 per month and is paid by the parents. The variable cost per unit for lemonade ingredients is $0.10, while each glass of lemonade is sold for $1.

Break-even Point Determination Unit by Unit

How many glasses of lemonade must be sold each month to turn a profit?

Fix expenses + Break-even point in glasses sales (Sales price per unit – Variable cost per unit)

Break-even point = 10/ (1 – 0.10)

Break-even sales volume is equal to 11.11.

According to the break-even analysis, the lemonade stand will turn a profit when 12 glasses of lemonade are sold and will break even when slightly more than 11 glasses are sold.

Determining the break-even Analysis using sales price per unit

Should the youngster raise the cost per unit? Break-even analysis may also be useful in this situation; however, it will depend on several market factors.

Recall the Following Formulas:

The break-even point is calculated as Fixed Costs/(Sales Price/Unit – Variable Cost/Unit).

Say that instead of 11, we prefer 10 as the number of sales needed to break even.

10 / (0.10 – Sales price per unit) Equals 10.

$1.10 is the unit sales price.

In this instance, the price would need to increase to $1.10 per glass of lemonade if the child wished to reach a break-even point at 10 glasses of lemonade without adjusting any other variables.

Break-even Point Determination Using Fixed Costs

If the lemonade stand is doing well, you might want to recruit a sibling at a fixed wage of $1 per month. Does this have an impact on the break-even point? How many $1 lemonade cups must be sold to break even?

Break-even point = Fixed costs / (Sales price per unit – Variable cost per unit)

Fixed costs have increased to $11 from $10.

Break-even point = 11/ (1 – 0.10)

Sales volume at breakeven is 12.22.

If the selling price stays the same but the child’s fixed costs rise by $1 each month, then slightly over 12 glasses of lemonade must be sold to break even and 13 glasses must be sold to generate a profit.

Calculating Using Unit Variable Costs

Consider a situation where there is a shortage of lemons and the variable cost per unit rises to $0.50. How many glasses of lemonade will the young seller have to sell to break even?

The break-even point is calculated as Fixed Costs/ (Sales Price/Unit – Variable Cost/Unit).

10/ (1 – 0.50) = Breakeven Sales Amount

The Break-even sales amount equals two.

The child will need to sell at least 21 glasses of lemonade to turn a profit and at least 20 to break even if the variable cost per unit rises to $0.50.

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How is Break Even Analysis Calculated?

The Break-even Point Calculation is as follows:

Fixed costs (Price per unit – Variable cost per unit)

Let’s assume the following for a pickle-selling business:

Each (organic, hand-picked, vegan cucumber) pickle costs $1 in sales.

Cucumbers, vinegar, and other components cost $0.50 per pickle.

Each pickle costs $0.05 for packaging, labeling, and shipping.

Using the units of production technique, the cost of the machinery for each pickle is $0.05.

Total fixed costs every month, including rent, insurance, admin salaries, pickle association dues, and utilities, are $10,000.

$10,000/($1-$0.50-0.05-0.05) = 25,000 is the breakeven point.

You would need to sell 25,000 pickles every month based on these (very basic) estimations to essentially cover your costs.

You would get $0.40 in profit for each pickle sold more than 25,000 units ($1, $0.50, 0.05, 0.05). In other words, 30,000 pickles would provide a net profit of $2,000, or (30,000-25,000) X$0.40.

What makes It So Important?

Establishing the baseline of sales revenue and/or volume that must be generated to cover costs, ensuring that they are realistic, and estimating what your monthly cash flow requirements will be will help you meet and even exceed your sales goals.

This is why a break-even analysis is crucial, especially when you are a startup. For instance, if you only sell 10,000 pickles in the first month, you will still have $4,000 to pay for your fixed costs of $10,000 at a gross margin of $0.40 before fixed costs. This leaves you with a $6k deficit that must be made up by additional funds. As they start to ramp up revenues, it is typical for startups to have a deficit. To make up for this shortfall, you must predict your cash flow and arrange a bank loan, line of credit, or other sources of funding.

Frequently Asked Questions

Q1. When should Break Even Analysis be used?

In general, a company should conduct a break-even analysis whenever it considers raising costs. These extra expenses could result from launching a new company, merging with another company, buying another company, adding or removing products from the product mix, or expanding the number of sites or staff.

In other words, if one of the following three circumstances arises, you should apply a break-even analysis to assess the risk and worth of any company investment:

  • Business expansion
  • Price reduction
  • Specifying business situation

Q2. What is Break-Even Analysis Formula?

Quantity needed to break even = Fixed Costs / (Sales price per unit – Variable cost per unit)

Q3. How to Decrease Break Even Point?

Increasing prices and reducing costs are the two main strategies for lowering your break-even point. But neither should be carried out in isolation. Consider your alternatives carefully when it comes to pricing strategies and consumer psychology to avoid increasing product sales at the expense of revenue.

To avoid harm to your brand, take into account all aspects of costs, such as the associated quality and delivery, before reducing them. When demand or volume increases, outsourcing products or services can also help keep prices down.

Conclusion

A breakeven analysis is ultimately only as reliable as its underlying assumptions. As a result, it’s crucial to a) endeavor, as much as you can, to include ALL expenditures related to your firm; and b) estimate the real costs and sales prices as precisely as you can. Make sure that the estimate takes into account any discounts you might need to offer on your pickles to attract buyers.

Additionally, it’s crucial to update the analysis whenever the underlying hypotheses alter. Breakeven analysis is at best an approximation, thus these should be improved and developed over time to achieve maximum accuracy.A review of the profit-loss (income statement) can give you fantastic insights into how your business is doing if you have a competent accounting system that is updated often.

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