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The
break-even pointIn economics & business, specifically cost accounting, the break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even"...
for a
productThe noun product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced. Since 1695, the word has referred to "thing...
is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). A break-even point is typically calculated in order for
businessA business is a legally recognized organization designed to provide goods and/or services to consumers. Businesses are predominant in capitalist economies, most being privately owned and formed to earn profit that will increase the wealth of its owners and grow the business itself...
es to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break even analysis can also be used to analyse the potential profitability of an expenditure in a sales-based business.
break even point (for output) = fixed cost / contribution per unit
contribution (p.u) = selling price (p.u) - variable cost (p.u)
break even point (for sales) = fixed cost / contribution (pu) * sp (pu)
Margin of safety represents the strength of the business.
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The
break-even pointIn economics & business, specifically cost accounting, the break-even point is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even"...
for a
productThe noun product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced. Since 1695, the word has referred to "thing...
is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). A break-even point is typically calculated in order for
businessA business is a legally recognized organization designed to provide goods and/or services to consumers. Businesses are predominant in capitalist economies, most being privately owned and formed to earn profit that will increase the wealth of its owners and grow the business itself...
es to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break even analysis can also be used to analyse the potential profitability of an expenditure in a sales-based business.
break even point (for output) = fixed cost / contribution per unit
contribution (p.u) = selling price (p.u) - variable cost (p.u)
break even point (for sales) = fixed cost / contribution (pu) * sp (pu)
Margin of Safety
Margin of safety represents the strength of the business. It enables a business to know that what is the exact amount he/ she has gained or lost over or below the break even point).
Margin of safety = (( sales - break-even sales) / sales) x 100%
If P/V ratio is given then
sales/pv ratio
In unit sales
If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, the firm will make a loss. Break-even quantity is calculated by:
- Total fixed costs / (selling price - average variable costs).
Explanation - in the denominator, "price minus average variable cost" is the variable profit per unit, or contribution margin of each unit that is sold.
This relationship is derived from the profit equation: Profit = Revenues - Costs where Revenues = (selling price * quantity of product) and Costs = (average variable costs * quantity) + total fixed costs.
Therefore, Profit = (selling price * quantity) - (average variable costs * quantity + total fixed costs).
Solving for Quantity of product at the breakeven point when Profit equals zero, the quantity of product at break even is Total fixed costs / (selling price - average variable costs).
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product.
An example:
- Assume we are selling a product for $2 each.
- Assume that the variable cost associated with producing and selling the product is 60 cents.
- Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000.
- In this example, the firm would have to sell (1000 / (2.00 - 0.60) = 715) 715 units to break even.
Break Even =
where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost
In capital budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time.
The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur.
In using break even analysis, it is important to remember the problem associated with sensitivity analysis as well as some extension specific to the method:
- Variables are often interdependent, which makes examining them each individually unrealistic.
- Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future.
- Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the break even point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid.
- Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis.
Internet research
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 $230, 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 (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be
charging.
The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). 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 formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as
regression analysisIn statistics, regression analysis includes any techniques for modeling and analyzing several variables, when the focus is on the relationship between a dependent variable and one or more independent variables...
.
Limitations
- Break-even analysis is only a supply side (i.e. costs only) 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 (FC) are constant
- It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity)
- It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).
- In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).
External links
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