Break-Even Analysis: Simplified

Break-even analysis is an essential economic tool that helps to determine the point beyond which a company earns a profit. It helps businesses calculate the volume of products that need to be sold so that a company overcomes all the initial cost of investment. Reaching this break-even point means that a company is no more in a state of loss.

What is the Break-even Point? 

In a business context, the break-even point is the threshold at which total expenses equal total revenue. Achieving this point signifies that the business has covered all costs and is no longer operating at a loss. 

Since this calculation reveals such vital information of a business, it is a necessity to learn and calculate break-even points accurately. 

To understand this further, consider this formula. 

Break-even point = Fixed Cost / (Price per cost - Variable cost) = Fixed Cost / Gross Profit Margin

Where, 

Fixed costs refer to expenses incurred by a business unit that do not vary with production volume. For example, rent, loans, insurance premiums, and so on are classified as fixed costs.

Variable cost refers to the expense incurred in producing a single unit of a product. 

Example 

Let's clarify this equation with a break-even analysis example provided below. 

A factory ABC Enterprises produces a particular kind of good wherein the total fixed costs stands at Rs.50,000 and variable cost to produce a good is Rs.30. The company sold these goods with a sale price per unit of Rs.50. 

In this case, 

Break-even point = 50,000/ (50-30) = 2500 units 

So, from the above break-even analysis, it is evident that BEP (break-even point) for ABC enterprises stands at 2500. This means a company will have to sell at least 2500 units of the product to overcome these fixed and variable costs incurred for production. 

This can further help companies in determining the total sales achieved by the company then. They need to multiply the break-even point with the sale price per unit to do so. In this case, the value of total sales made by the company at their break-even point will be equal to (2500*50) Rs.1,25,000. 

Numerical to Solve 

1. A company produces goods at a variable cost of Rs.12 per unit, and the same is sold at Rs.20 per unit. Fixed cost incurred by a company for a period stands at Rs.40,000. Calculate the number of products a company needs to manufacture to attain a profit target of Rs.10,000. 

2. Check the following table to know about cost analysis for 6 months of a business operation. 

1. Calculate the breakeven quantity 

2. Draw break-even chart for the 6 months of business operation 

3. Determine the profit earned by an organization 

3. Fixed costs of an enterprise is Rs.3,00,000, and the variable cost and selling price of the product is Rs.42 per unit and Rs.72 per unit, respectively. The company expects to sell 15,000 units of the product whereas it has a maximum factory capacity of 20,000 units. Draw a break-even chart depicting the break-even point and determine the profit earned at this current situation. 

Students can solve these numerical quickly and accurately after they have a thorough understanding of the concept of break-even analysis. To understand why we need to calculate this, look at its importance in detail.

Significance of Break-even Analysis 

• Determined Volume of Products to be Sold: According to the definition of break-even analysis, its calculation allows companies to identify the minimum number of goods they need to sell to cover total fixed and variable production costs. This means a company can determine the specific number of units required to avoid losses. 

• Deciding Budgets and Targets: Since Break-even analysis gives businesses an idea about the operational scenario, it helps plan the budget for various business operations. Besides, they can set objectives to accelerate the production speed and achieve them positively. 

• Cost Control: Both fixed and variable costs can influence an organization's profit margin. However, conducting a break-even analysis of the business operations allows the organization to assess if any changes are affecting cost value. In these situations, managing costs becomes essential to guarantee profitability from business activities. 

• Designing of Price Strategy: Product pricing significantly affects the calculation of break-even points. For example, when the price of goods rises, their break-even point decreases. If an organization previously needed to sell 50 units to break even, it would now only need to sell 45 units with the increased selling price. 

• Margin of Safety Management: Sales of goods can significantly decline in a situation of financial crisis or breakdown. In such scenarios, managing margin of safety becomes easier with concepts like break even analysis. That’s because the company will have an idea on the minimum number of products they need to sell to ensure their organization doesn’t undergo any loss.

The margin of safety can be calculated by the following formula, 

Margin of safety = (current sales level – Break-even point)/ Current sales level 

Or, Margin of safety = (current sales level – Break-even point)/ Selling price per unit  

These are a few pointers which briefly discuss why it is important to calculate Break-even points and study them in a business environment. 

Components of Break-even Analysis 

The two components that help define break-even analysis are mentioned as follows 

1. Fixed Cost 

Costs incurred in running a business that doesn’t vary with the volume of the production are known as a fixed cost. Also known as an overhead cost, examples of fixed costs are salaries, rent, premiums, loans, bills, etc. 

2. Variable Cost 

This is the cost that varies as the number of manufactured products fluctuates. Cost of fuel, raw material, packaging, etc. comes under this.

Applications of Break-Even Analysis 

• Planning in New Businesses

• Introduction of New Products 

For cases, a company wishes to introduce the production of new products in its business unit; the study of break-evens can emerge very significant. Before they start producing the goods, analyzing break-even will help them understand the cost and pricing strategy. 

• Business Model Modification 

Change in a business model may have an impact on your businesses productivity. The change of model doesn’t necessarily mean it will affect the costs and expenses, but if that’s the case, it will help you change your selling price accordingly. Hence, analyzing Break-even in this scenario is both feasible and important. Further, while discussing, the term marginal costing and break even analysis may appear frequently. Marginal cost is the extra cost incurred in producing one extra unit of a good. This can help determine how variable costs can affect the volume of production in a business unit. Grasping the meaning of break-even analysis will provide students with a deeper understanding of this economic principle. Students seeking thorough study materials can visit Vedantu’s official website for access to study notes. All of our materials are crafted by qualified and experienced educators, ensuring that students can learn the intricacies of the subject effectively. Break-even analysis is an essential economic tool that is used to determine the cost structure of a company or the number of units or services that need to be sold in order to cover the expenditure done by it. Break-even is a condition in which the company makes no profit nor suffers any loss, it just recovers all the money spent on the development of a product. Break-even analysis explores the relationship between fixed costs, variable costs, and a company's revenue. Typically, companies with low fixed costs also have a lower break-even sales point.

Importance of Break-even Analysis

Determines the Size of Units to be Sold: Break-even analysis helps a company in determining the number of units that needs to be sold in order to cover the cost. Variable cost and selling price of an individual product along with the total cost, are required to evaluate the Break-even analysis.

Budgeting and Setting Targets: It allows a company to set a budget and fix a goal and work accordingly since the owner knows at which point their company can break even. It also helps the company in setting an achievable target.

Establishing the Margin of Safety: During financial downturns, when a company's performance is lacking, determining the minimum sales needed for profitability becomes essential. The margin of safety reports provide management with the insights necessary to make informed business decisions.

Monitors and Controls Cost: The fixed and variable cost of a product can affect the profit margins of a company. Therefore, the Break-even analysis can help the management detect if any effects are changing the cost.

Helps to Design Pricing Strategy: If the selling price of a product is increased then the quantity of product to be sold for Break-even will be reduced. And like that, if the selling price is reduced, then a company needs to sell extra to break even. So it also helps in designing the pricing strategy of a product.

Advantages and Disadvantages of Break-even Analysis

Advantages of Break-even Analysis:

• Helps businesses determine the sales needed to cover costs, which is useful for pricing and sales targets.

• Simple and easy to understand, making it a helpful tool for managers and business owners.

• Useful for financial planning by showing when a business will start making a profit.

• Helps assess the risk of launching a new product or service by understanding the required sales volume.

Disadvantages of Break-even Analysis:

• Assumes that costs remain constant, which may not always be the case as costs can change over time.

• Does not consider market changes, competition, or customer preferences.

• Focuses only on costs and sales volume, ignoring the quality of products or customer satisfaction.

• May not be suitable for businesses offering multiple products or those with complex pricing.

• Assumes a simple, direct relationship between costs and sales, which may not reflect reality in all situations.

Components of Break-Even Analysis

• Fixed Costs: These costs are also known as overhead costs. These costs come into existence once the financial activity of a business starts. The fixed costs include taxes, salaries, rents, depreciation cost, labor cost, interests, energy cost, etc.

• Variable Costs: These costs are called variable costs because they decrease or increase according to the volume of the production. Variable costs include packaging cost, cost of raw material, fuel, and other materials related to production.

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Example of Break-Even Analysis

Suppose a company is selling a pen. The company first determines the fixed costs (lease, property tax, and salaries) which sums up to  ₹1,00,000. The variable cost determined by the company for one pen is  ₹2 per unit. And , the pen is sold at a price of ₹10.

Therefore, to determine the break-even point of Company, the pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,00,000/10

= 10,000

Therefore, with the given variable costs, fixed costs, and selling price of the pen, the company  would need to sell 10,000 units of pens to break-even.