Break-even analysis used to determine what quantity of a particular good a business needs to produce in order to cover all the costs of production ( to “break-even”).
Frequently Asked Questions About Break-Even Analysis
What is break-even analysis?
Break-even analysis is a financial calculation used to determine the point at which a business's total revenues equal its total costs, resulting in neither profit nor loss. This point is known as the break-even point.
What does a break-even analysis tell a business planner or provide for a firm?
Break-even analysis provides crucial information for business planning and decision-making. It tells a planner:
- The minimum level of sales (in units or revenue) required to cover all costs.
- How changes in costs (fixed or variable) or selling price will affect profitability.
- The potential risk of a new product or business venture.
- A target for sales volume needed to achieve profitability.
How do you calculate break-even analysis?
The break-even point can be calculated in terms of units or sales revenue using these formulas:
- Break-Even Point (Units) = Total Fixed Costs / (Selling Price Per Unit - Variable Cost Per Unit)
- Break-Even Point (Sales Revenue) = Total Fixed Costs / (1 - (Total Variable Costs / Total Sales Revenue)) OR Break-Even Point (Units) * Selling Price Per Unit
The term "(Selling Price Per Unit - Variable Cost Per Unit)" is also known as the Contribution Margin Per Unit.
How to do break-even analysis?
To perform a break-even analysis:
- Identify all Fixed Costs (costs that don't change with production volume, e.g., rent, salaries).
- Identify all Variable Costs (costs that change with production volume, e.g., raw materials, direct labor). Calculate the variable cost per unit.
- Determine the Selling Price Per Unit.
- Use the formulas above to calculate the break-even point in units and/or revenue.
- Analyze the results to understand the required sales volume and the impact of changes in costs or price.
How do managers use break-even analysis?
Managers use break-even analysis for various decisions:
- Pricing Strategy: Evaluating if current prices are sufficient or if changes are needed.
- Cost Control: Understanding how managing fixed and variable costs impacts the break-even point.
- Production Planning: Setting production targets.
- New Product Launches: Assessing the viability and required sales of new offerings.
- Investment Decisions: Evaluating projects based on their potential break-even points.
How to do a break-even analysis in Excel?
In Excel, you can set up columns for Fixed Costs, Variable Cost Per Unit, Selling Price Per Unit, and then use the break-even formulas. You can also create a break-even chart by plotting Total Fixed Costs (a horizontal line), Total Variable Costs, and Total Revenue lines, typically against units produced or sold on the x-axis. The point where the Total Revenue line crosses the Total Cost line (Fixed + Variable) is the break-even point. Excel's "What-If Analysis" tools like Goal Seek can also help find the break-even point quickly.
What are the limitations of break-even analysis?
Break-even analysis has several limitations:
- It assumes costs and revenues are linear (constant per unit), which isn't always true in reality (e.g., volume discounts).
- It assumes all units produced are sold.
- It's harder to apply to multi-product businesses unless a weighted average contribution margin is used.
- It's a static analysis; it doesn't account for changes over time or the impact of external factors.
- Fixed costs are often only fixed within a relevant range of activity.
What two forecasts are used in a break-even analysis?
While implicitly using forecasts for sales volume to see if the break-even point can be reached, the calculation itself fundamentally relies on forecasts or estimates for:
- Costs: Both Fixed Costs and Variable Costs per Unit.
- Revenue: Specifically, the Selling Price Per Unit.
Accurate forecasting of these elements is crucial for the accuracy of the break-even analysis.
