Break-Even Analysis

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 scenario, the break-even point is a perimeter at which the total expenses of the enterprise equals the total revenue generated. Reaching this point indicates that a business has overcome all the expenses and no more in a state of 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 cost refers to the cost incurred in a business unit, which doesn’t depend upon the volume of production. For example, rent, loans, insurance premiums, etc. comes under fixed cost. 

• Variable cost is the cost to produce one unit of product. 

Example 

Let us understand this equation by taking a break even analysis example mentioned as follows. 

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 

As per the break even analysis definition, its calculation can help companies determine the minimum number of goods to be sold so that the total fixed and variable cost of production is met. Therefore, a company already has an exact figure about the number of units to be sold to overcome 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 

Fixed and variable costs may have an impact on an organization's profit margin. But, with break-even analysis of the business operations, they will be able to evaluate if any effects are changing the value of cost. In such scenarios, controlling cost becomes a necessity to ensure they earn profit from business operations. 

• Designing of Price Strategy 

Pricing of products has a huge impact on the calculation of break-even points. For instance, if the price of goods increases, then understandably their break-even point will be reduced. For example, if earlier an organization needed to sell 50 units of this product to reach breakeven, it will be attained at only 45 units if the selling price is increased. 

• 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

New businesses have a lot to plan before they introduce a facility and start manufacturing goods for sale. To ensure the plans regarding cost and pricing of goods are done right, break even analysis is a necessity. One will be able to analyze and state if the new business idea is productive or not. 

• 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. 

Understanding break even analysis meaning will help students get an in-depth idea about this economic concept. Students looking for comprehensive study material can browse to Vedantu’s official website or download the app to access the study notes. All our study materials are prepared by experienced and qualified teachers and are guaranteed to help students learn the nuances of the subject intricately. 

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.

The break-even analysis is used to examine the relation between the fixed cost, variable cost, and revenue generated by a company. Usually, a company with a low fixed cost will have a low break-even point of sale.

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.

• Organizing the Margin of Safety: In times of a financial breakdown, when the company is not performing well, it helps in deciding the minimum number of sales the company requires to make a profit. With the margin of safety reports, the management of the company can take its business decisions accordingly.

• 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.

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.

Applications of Break-Even Analysis

• New Business: This guides the company regarding the productivity of a new business so for a new venture, a break-even analysis is essential. It helps the management in formulating the pricing strategy and is practical about the cost.

• Manufacture New Products: Before launching a new product the company needs to check the break-even analysis before starting its production and see if the product adds necessary expenditure to the company.

• Change in Business Model: The break-even analysis helps a company in determining whether they need to change the selling price of a product if there is any change in any business model like shifting from retail business to wholesale business. 

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.