Determining Profitability with Break Even Analysis

Break Even Analysis

Introduction

Break Even Analysis is that type of analysis where you are required to determine whether the revenue is matching the costs related with obtaining the revenue. This analysis can calculate the margin of safety, where the revenue amount outweighs the breakeven point. The revenue can decrease in this particular point while being above the breakeven point.

Basic Concept

Break even analysis is a particular business tool that is accepted throughout the industries in the world for evaluating the performance of the business with regards to the cost as this is the analysis of the supply side. It is also an important factor in creating a business plan as it helps in determining the cost structures. The analysis can also help in identifying the number of units that are required to be sold for covering the costs for making the profit. The analysis function takes place as an important part of the business plan for determining whether the business idea is practical or not. After the business set up process is over, the break even analysis can be beneficial in the promotion and the pricing process, along with controlling the costs.

Therefore, breakeven point can be identified by calculating the point at which revenue obtained equals with the total costs related with the production of goods and services.

Break Even Point = Fixed Costs / (Unit Selling Price – Variable costs)

How to Use Break Even Analysis in Business?

For applying the break even analysis, you should have some clear concepts about the costs that require operational activities:

Fixed Costs

Irrespective of the number of units the company is manufacturing, these costs remain the same. These costs may include the capital expenses or the start up costs which is not required to be paid periodically. The utility bills, repairs, rent can also be considered as the fixed costs as the variations are very negligible and the amount does not depend on the quantity of the of the items produced. For example, if a pen manufacturer rents a building for $3000 and decides to produce 500 pens per month, the fixed cost will remain same at $3000. It will be same if there is no production of pens at all.

Variable Costs

The costs that remain directly proportional to the production of the manufacturing companies are known as the variable costs. They are recurring in nature and needs to be paid in periodical method. The cost will increase with the increase of the number of manufacturing units. For example, to manufacture a tire you require rubber costing $5. If the company is not producing any tires, the cost will reduce to zero and if 100 tires are produced, the cost will increase to $500. The variable costs generally include the material costs, labor storage, direct sales and promotion etc.

Revenue

The money that is acquired by the business from the customers through the products or the services during a specific period is known as the revenue. After adjusting the discounts and the deductions, the final outcome i.e. the gross income can be obtained. The various costs are deducted from the gross income for measuring the profit and loss. Then the total revenue can be calculated the price of goods with the number of total units sold.

Contribution Margin

The amount that can be obtained by deducting the variable expenses from the revenues is known as the contribution margin. This margin helps in identifying the revenue of the company towards the contribution of the fixed costs. The per unit basis amount can be calculated and can be expressed as the percentage of net sales.

Now, let us discuss about the break even calculations, based on the units and the sales:

Break Even Points Calculated in Units

The breakeven point can be calculated depending on the units, where the number of units can be obtained for the breakeven point. The amount can easily be obtained by dividing the contribution margin with the total fixed costs :

Break Even Point (Units) = Fixed Costs / Contribution Margin per Unit

Break Even Points Calculated in Sales Value

Breakeven point can also be measured with the help of the sales value

Therefore, Contribution Margin = Contribution margin per unit / sales price per unit

Or, Contribution margin = (sales price- variable costs) / sales price per unit

The contribution margin can also be determined with the percentage of sales which is known as the contribution margin ratio.

There are various applications as well as benefits of using this tool in your organization. Let us discuss them now:

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Set Targets and Budgets

The break even analysis helps in setting targets and budgets for your business plans. It helps to determine the number of units to be sold for reaching the breakeven point. Therefore, it helps in setting realistic and achievable targets for the business.

Cost Calculation

For avoiding losses in the business, the breakeven analysis is used for determining the number of breakeven units. This calculation helps in determining the variable costs, fixed costs as well as the selling price. After all the amounts are determined with accuracy, the sale value and the units of the break even become easy to calculate

Tool for Motivation

The tool can add motivation in your company. The employees, specially the sales resources get motivated after this particular analysis. As the charts can clearly show the different profit margins at different points of sales, it can directly create an impact on the minds of the employees.

Pricing Strategy

The break even analysis can act as a good determinant for the selling prices. The break even charts allow access for determining the changes of the selling prices according to the profitability.

Key Points from the Article

From the article we can understand that

  • The meaning and basic concept of breakeven analysis
  • The application and benefits of this tool in the organizations

If the results from the break even can be interpreted correctly, the information can help in better decision making in business.

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