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Managing a business involves numerous challenges to ensure it is successful and profitable. Questions such as how many units should be produced? How many units should be sold? Can the number of units sold monthly or annually enough to cover all the costs? At what price should the product sell? These and many questions must be addressed to save the company from any losses. Break-even point analysis seeks to answer these challenges.
Break-even is the point where the company’s income and expenses are equal, the company is operating at a level where the sales are enough to cover the cost. The company is not losing money and at the same time, it is also not making money. At this point, net income is zero.
Break-even is a concept widely used across all businesses and in different industries regardless of the company size, big and small business recognize this. It can be presented as a number of units, dollar values, and even percentages.
Managers involved in production tend to focus more on the number of units such how many units must be produced to cover the manufacturing costs. On the other hand, C-suite or higher-level management focus on the actual total sales value or percentage required to recover the costs.
Uses of Break-even point analysis:
- Useful in determining a product’s selling price that will result in desired profits.
- Determines the effect of any change in a product’s selling price on company profits.
- Helps in determining sales volume to cover a specified return on capital.
- Helps in forecasting cost and how any changes will affect the company’s profits.
- Helps management in establishing an acceptable level of decline in sales before incurring losses (called safety margin).
- Gives insight on costs and revenue at various levels of production. Management obtains information on the effects of:
- Increase in sales price
- Reduction in cost
- Product substitution of less profitable with more profitable products
- Increase in production levels
- Assists management in decision making such as:
- Introduction of a new product or discontinue a product
- Make or Buy. Make a component or ingredient of a finished product or purchase from outside suppliers.
- Select the most profitable product or sales mix.
- Ascertain the company’s strength by determining its earning capacity.
- And many more…
The formula for break-even point is based on these underlying assumptions:
- Cost Segregation. Total cost is composed of fixed and variable costs.
- Constant Fixed Cost. Fixed costs are constant at all volumes of output.
- Variable cost per unit is constant. Variable cost is in direct proportion to the volume of output. As output increases, variable cost also increase. If output falls, variable cost also decreases.
- Constant Selling Price. Price remains constant regardless of a change in volume of output or other factors such as a discount, promotional offers.
- Production and Sales are in sync. Sales volume and volume of output are equal and inventories are constant at the beginning and end.
- Constant product mix. Only one product is produced and sold. For companies with many products, the product mix is assumed to be stable.
- No change in technology, production methods, and workers efficiency.
- No other factors. Only the volume of output influences cost and revenue. Factors such as trends, competitors are ignored.
Let us discuss in detail the two types of costs mentioned in the assumptions.
- Fixed cost. These are costs that remain unchanged for a period of time regardless of the increase and decrease of products or services manufactured or sold by the company. Fixed costs are expenses that must be paid independent of the volume of production and sales and it is considered time-related; these must be paid either monthly, semi-annually and annually. So if a company manufactures zero goods, it still incurs fixed costs. Examples of fixed costs are:
- Interest expense
- Taxes e.g. property
- Insurance premiums
- Utilities e.g. electricity, water, gas, heating, phone, internet service
- Variable cost. These are costs directly related to the company’s business activity- the manufacture or production of its goods and services. Unlike Fixed Costs that remain unchanged for a period of time, variable costs are dependent on the increase and decrease of goods or services manufactured or produced by the company. Variable costs increase when the volume of units manufactured also increase. On the other hand, it decreases as the volume of units manufactured falls. Simply put, variable costs are volume-related costs. Common examples of variable costs are:
- Raw Materials
- Direct Labor
- Packaging Cost
- Shipping Fees
- Sales Commissions
The formula to calculate for Total Variable Cost:
Three key differences between Fixed Cost and Variable Cost:
To calculate for the Total Cost, simply add Total Fixed Cost and Total Variable Cost.
To calculate for the Total Revenue, simply multiply the total units sold by sales price per unit.
The break-even point analysis shows how fixed costs, the variable cost, total cost, and total revenue are affected by the level or volume of output. Others would argue that Break-even point and cost-volume-profit (CVP) analysis are different but the majority would consider it as one and the same thus they are used interchangeably. Break-even formula is simple and straightforward to calculate, it depends on what kind of information you are trying to get; break-even point in units or in term of sales (dollars).
Break-even point in units identifies the number of units sold (total revenue) to cover the total cost.
It is helpful to note that the denominator in the formula, sales price per unit minus variable cost per unit, is also called the contribution margin per unit. Based on the example, the company sells its pen at $.50 and variable cost to make the shoe is $.35, then the contribution margin is $.15. This amount is used to cover the fixed costs and any excess is attributed to earnings. A low or negative contribution margin indicates the product may not be profitable and is insufficient to cover the fixed costs incurred. The company may have to consider lowering fixed costs or increasing sales.
The contribution margin can also be expressed as a percentage or a ratio. Simply divide the contribution margin by sales price per unit to get the contribution margin ratio. So, $.15 divided by $.50 will result in a contribution margin ratio of 30%. This means that for every dollar increase in sales, there will be a 30% increase in contribution margin to cover fixed costs incurred and anything in excess is the company’s profit.
Utilizing the contribution margin ratio, we can calculate the break-even point in term of sales. To get the break-even point in sales, divide the company’s fixed cost to the contribution margin ratio.
This means the company’s total revenue must be $1,000 to cover its variable cost as well as the fixed cost however profit will be zero.
Aside from calculating the break-even point in units and in terms of sales, it can also be illustrated or plotted in a chart.
The break-even point chart or graph summarizes the relationship between fixed costs, the variable cost, total cost, and total revenue, level of output using visualization. It is basically a line graph with two axes, the X-axis and Y-axis. To create a break-even chart, let us use the same Pen Company example and below details.
- The output (number of units) are presented on the X-axis (horizontal).
- The cost and revenue are presented on the Y-axis (vertical).
- The Fixed Cost line is plotted using a horizontal line to line to reflect how fixed costs do not change and are independent of levels of output.
- Adding the fixed cost and variable cost is the Total Cost which is presented by the upward sloping line. This is to reflect the increasing variable cost with the increase in output.
- The Total Revenue is also presented as an upward sloping line to reflect how every unit sold increases the total revenue.
- The point where Total Revenue and Total Cost crosses is the break-even point.
- Notice that before this point, Total Cost is above the Total Revenue line. This tells the management that the company suffers losses. It is helpful to understand that this area narrows as the output increases, every additional unit produced and sold lessens the loss.
- Notice also that after the break-even point, Total Revenue is above the Total Cost line. This tells the management that the company is profitable. The area widens as the output increases, every additional unit produced and sold increases profits.
- One important information to learn is the relationship between the break-even point and Total revenue. The difference between the break-even point and the Total Revenue is the margin of safety, this indicates how much sales can fall before the company suffers a loss. This is a key indicator of the strength of the company or business. If it is large, the business can successfully withstand a drop in sales and still continue to be profitable. On the other hand, if it is small, any drop in sales can have a significant adverse effect and the business may suffer losses.
To improve a company’s margin of safety, the management can do the following:
- Increase the output of production and sales.
- Increase in Sales Price.
- Lower Fixed Cost.
- Lower Variable Cost.
- Change the product mix. Substitute profitable products with the least profitable or unprofitable products.
Break-even point analysis is an effective tool however it has its shortcomings. The limitations of break-even analysis are the following:
- Unrealistic assumptions such as:
- Assumes sales prices are constant. This is unlikely as companies offer discounts and promotional prices are used.
- Assumes output (production) and sales are equal. In reality, companies do not sell all of its output. There are items that are unsold for a period of time, sales are bound to vary from period to period as demand for the product, consumer preference, etc. changes over time.
- Variable costs do not always increase in proportion to output. In manufacturing, as output increases the business benefits from being able to buy components or ingredients at lower or discounted prices (purchasing power) that will reduce variable cost per unit.
- Not all costs can easily be identified as fixed and variable.
- Mixed Cost. Also known as semi-variable and semi-fixed costs, these are essentially composed of a mix of both fixed and variable components. The fixed portion is incurred independent of the level of output. The variable portion is incurred as a function of the level of output. An example of a mixed cost is payment for a mobile service provider. The telco provides you with a specific service (let’s say a limit on the bandwidth) for a fixed fee (or monthly plan), regardless if you use your mobile you will still have to pay the monthly fee. On the other hand, if you use it frequently and your usage exceeds the limit then you will be charged proportionately to overage.
- Applicable to a single product or single mix of products. Companies sell multiple products at different prices to different customers and markets.
- Applicable in the short-run as its underlying cost assumptions may not hold up in the long run. For example, an increase in the volume of output will likely cause the fixed cost to increase in the long run.
- As the level of production increases, the benefits of economies of scale that affect unit costs are ignored.
- Does not consider other factors that affect cost and revenue such as cost of capital, plant size or capacity, technology (automation) used in production, competitors and market trends.
- Break-even analysis is a static analysis.
Despite these limitations, Break-even analysis is still an important tool in making decisions. It provides management answers to questions such as:
- How much revenue does the company have to achieve to avoid losses?
- What sales level is needed for a targeted profit?
- What are the effects of any changes in the Sales Price, Cost and output on company profits?
- What are the effects of any changes in the Sales Price, Cost and output on the break-even point?
- What is the optimal sales mix? What is the least profitable mix?
- Should the company make or buy ingredients or components key to the finished product?
If you want a closer look, here is a video tutorial discussing break-even analysis in Excel which will also help you in gaining a deeper insight and appreciation.
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