What is a Break-Even Analysis?
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). 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 Happy Ltd has fixed costs of Rs. 10,000 vs Sad Ltd has fixed costs of Rs. 1,00,000 selling similar products, Happy Ltd will be able to break even with the sale of lesser products as compared to Sad Ltd.
Components of Break Even Analysis
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 rrespective of the production. In case of no production also the costs must be incurred.
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.
Calculation of Break-Even Analysis
The basic formula for break-even analysis is derived by dividing the total fixed costs of production by the contribution per unit (price per unit less the variable costs).
For an example:
Variable costs per unit: Rs. 400
Sale price per unit: Rs. 600
Desired profits: Rs. 4,00,000
Total fixed costs: Rs. 10,00,000
First we need to calculate the break-even point per unit, so we will divide the Rs.10,00,000 of fixed costs by the Rs. 200 which is the contribution per unit (Rs. 600 – Rs. 200).
Break Even Point = Rs. 10,00,000/ Rs. 200 = 5000 units
Next, this number of units can be shown in rupees by multiplying the 5,000 units with the selling price of Rs. 600 per unit.
We get Break Even Sales at 5000 units x Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)
Break-even analysis also deals with the contribution margin of a product. The excess between the selling price and total variable costs is known as contribution margin. For an example, if the price of a product is Rs.100, total variable costs are Rs. 60 per product and fixed cost is Rs. 25 per product, the contribution margin of the product is Rs. 40 (Rs. 100 - Rs. 60). This Rs. 40 represents the revenue collected to cover the fixed costs. In the calculation of the contribution margin, fixed costs are not considered.
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.
Breakeven analysis is useful for the following reasons:
- It helps to determine remaining/unused capacity of the company once the breakeven is reached. This will help to show the maximum profit on a particular product/service that can be generated.
- It helps to determine the impact on profit on changing to automation from manual (a fixed cost replaces a variable cost).
- It helps to determine the change in profits if the price of a product is altered.
- It helps to determine the amount of losses that could be sustained if there is a sales downturn.
Additionally, break-even analysis is very useful for knowing the overall ability of a business to generate a profit. In the case of a company whose breakeven point is near to the maximum sales level, this signifies that it is nearly impractical for the business to earn a profit even under the best of circumstances.
Therefore, it's the management responsibility to monitor the breakeven point constantly. This monitoring certainly reduces the breakeven point whenever possible.
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.
Benefits of Break-even analysis
Catch missing expenses: When you’re thinking about a new business, it's very much possible that you may forget about a few expenses. Therefore, a break-even analysis can help you to review all financial commitments to figure out your break-even point. This analysis certainly restricts the number of surprises down the road or atleast prepares a company for them.
Set revenue targets: Once the break-even analysis is complete, you will get to know how much you need to sell to be profitable. This will help you and your sales team to set more concrete sales goals.
Make smarter decisions: Entrepreneurs often take decisions in relation to their business based on emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be a successful entrepreneur, decisions should be based on facts.
Fund your business: This analysis is a key component in any business plan. It’s generally a requirement if you want outsiders to fund your business. In order to fund your business, you have to prove that your plan is viable. Furthermore, if the analysis looks good, you will be comfortable enough to take the burden of various ways of financing.
Better Pricing: Finding the break-even point will help in pricing the products better. This tool is highly used for providing the best price of a product that can fetch maximum profit without increasing the existing price.
Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.