A break-even analysis is a financial tool which helps a company to determine the stage at which the company, or a new service or a product, will be profitable. In other words, it is a financial calculation for determining the number of products or services a company should sell or provide to cover its costs (particularly fixed costs).
What Is the Breakeven Point (BEP)?
In corporate accounting, the breakeven point (BEP) is the moment a company’s operations stop being unprofitable and starts to earn a profit. The breakeven point is the production level at which total revenues for a product equal total expenses. The breakeven point can also be used in other ways across finance such as in trading.
Understanding Breakeven Points
A breakeven point can be applied to a wide variety of contexts. For instance, the breakeven point in a property would be how much money the homeowner would need to generate from a sale to exactly offset the net purchase price, inclusive of closing costs, taxes, fees, insurance, and interest paid on the mortgage—as well as costs related to maintenance and home improvements. At that breakeven price, the homeowner would exactly break even, neither making nor losing any money.
Traders also apply BEPs to trades, figuring out what price a security must reach to exactly cover all costs associated with a trade, including taxes, commissions, management fees, and so on. A company’s breakeven point is likewise calculated by taking fixed costs and dividing that figure by the gross profit margin percentage.
What is a Break-Even Analysis
Break-even is a situation where an organisation is neither making money nor losing money, but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and revenue. Generally, a company with low fixed costs will have a low break-even point of sale. For example, say cute Ltd has fixed costs of Rs. 10,000 vs rock Ltd has fixed costs of Rs. 1,00,000 selling similar products, cute Ltd will be able to break-even with the sale of lesser products as compared to rock Ltd.
Components of Break-Even Analysis
Fixed costs
Fixed costs are also called overhead costs. These overhead costs occur after the decision to start an economic activity is taken and these costs are directly related to the level of production, but not the quantity of production. Fixed costs include (but are not limited to) interest, taxes, salaries, rent, depreciation costs, labour costs, energy costs etc. These costs are fixed irrespective of the production. In case of no production also the costs must be incurred.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume. These costs include cost of raw material, packaging cost, fuel and other costs that are directly related to the production.
Calculating Contribution Margin and BEPs
Contribution Margin
A product’s contribution margin is the difference between the selling price of the product and its variable costs.1 So, relative to the BEP formula above, you could also say that the BEP = Total Fixed Costs / Contribution Margin.
Contribution Margin = Item Price – Variable Cost Per Unit
Break-Even Point in Units
To find the total units required to break even, divide the total fixed costs by the unit contribution margin.
BEP (Units) = Total Fixed Costs / Contribution Margin
FAQs
When is Break-even analysis used?
- Starting a new business: To start a new business, a break-even analysis is a must. Not only it helps in deciding whether the idea of starting a new business is viable, but it will force the startup to be realistic about the costs, as well as provide a basis for the pricing strategy.
- Creating a new product: In the case of an existing business, the company should still peform a break-even analysis before launching a new product—particularly if such a product is going to add a significant expenditure.
- Changing the business model: If the company is about to the change the business model, like, switching from wholesale business to retail business, then a break-even analysis must be performed. The costs could change considerably and breakeven analysis will help in setting the selling price.
Ways to monitor Break-even point?
- Pricing analysis: Minimize or eliminate the use of coupons or other price reductions offers, since such promotional strategies increase the breakeven point.
- Technology analysis: Implementing any technology that can enhance the business efficiency, thus increasing capacity with no extra cost.
- Cost analysis: Reviewing all fixed costs constantly to verify if any can be eliminated can surely help. Also, review the total variable costs to see if they can be eliminated. This analysis will increase the margin and reduce the breakeven point.
- Margin analysis: Push sales of the highest-margin (high contribution earning) items and pay close attention to product margins, thus reducing the breakeven point.
- Outsourcing: If an activity consists of a fixed cost, try to outsource such activity (whenever possible), which reduces the breakeven point.