Break-Even Analysis: Definition and How to Calculate It
In business and finance, knowing when your business will start to make money is key. This is where break-even analysis comes in. In this post we will explain what break-even analysis is, why it’s important and a step by step guide on how to calculate it. By the end you’ll know how to apply this tool to your own business.
Importance of Break-Even Analysis
- Decision Making: Helps you make big business decisions like launching a new product, entering a new market or increasing production.
- Pricing Strategy: Helps you set the right pricing to cover all costs and achieve desired profit margins.
- Cost Control: Identifies fixed and variable costs and shows you where to cut costs.
- Financial Planning: Required for financial projections and business plans.
The formula for break-even analysis is as follows:
Break-Even Point = Fixed Costs / (Sales Price per Unit – Variable Cost Per Unit)
where:
- Fixed costs are any costs that stay the same like depreciation, rent, insurance, salaries, general office expenses, interest expenses.
- Variable costs are costs that change according to the amount of product that is sold. Examples of variable costs include materials, sales commissions, utilities.
- Sales Price per Unit is the selling price per unit
- Variable Cost per Unit is the variable cost incurred to create a unit.
Break-even analysis deals with the effects on profits of changes in fixed costs, variable costs, sales prices, sales mix, and sales quantities. By calculating the break-even analysis, you can used in:
- New product decisions: to determine how large sales volume on a new product should be to break even on a project.
- Studying the effect of expansion in the level of operations.
- Pricing and cost decisions.
- Estimating the amount of sales needed to obtain a desired level of profit.
Break-Even Benefits
- Risk Assessment: Helps you assess the risk of a business by how much sales volume you need to break even.
- Strategic Planning: Helps you plan for profitability and resource management.
- Investment Decisions: Gives you insights for investment decisions and project viability.
Why is the Contribution Margin Important in Break-Even Analysis?
Contribution margin refers to the contribution of additional sales to the coverage of fixed expenses. The contribution margin is the excess between the selling price of the product and the total variable costs.
The contribution margin shows how much additional revenue is generated by making each additional unit product after the company has reached the breakeven point. This is expressed through the following formula:
Contribution margin = R – V
Where R is the total revenue, and V represents variable costs.
The contribution margin represents the revenue that a company gains by selling each additional unit of a product or good. Additional sales will contribute to covering overhead while the company develops a strategy to increase sales above break-even.
The Limitations of a Break-Even Analysis
Break-even analysis is a useful tool. However, like any tool, there are some limitations. Break-even analysis assumes that prices are constant. Constant price assumption may be valid in perfectly competitive markets where firms can sell more units at a given price without any need for price adjustments. However, some markets may face imperfect competition where prices have to be reduced to be able to sell more.
Another limitation is that it assumes that the fixed and variable costs remain constant over time. However, costs may change due to factors such as inflation, technology, or market conditions. Additionally, many costs are hard to categorize strictly as fixed or variable.
The Bottom Line
Break-even analysis is used by a wide range of entities. If you are an entrepreneur, you need to learn it in order to make smart business decisions. If you’re a financial analyst, you need to use it to measure a company’s risk and profitability. If you’re an investor, you need to use it in order to make smart decisions on your asset selection.
Overall, break-even analysis plays an important role in the financial world. By understanding break-even analysis, you’ll learn what you need to do in order to make smart decisions and manage risks effectively.
More Resources
Thank you for reading our guide to break-even analysis. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:
- Business Risk vs Financial Risk
- What is an Interest Rate?
- What is Financial Planning? An Overview of Financial Planning