Break even analysis
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The break even point for a product is the point where total revenue received equals total costs associated with the sale of the product (TR=TC). A break even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break-Even Analysis can also be used to analyze the potential profitability of an expenditure in a sales-based business.
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In Unit Sales
If the product can be sold in a larger quantity than occurs at the break even point, then the firm will make a profit; below this point, a loss. Break-even quantity is calculated by:
Total fixed costs / (price - average variable costs) .
(Explanation - in the denominator, "price minus average variable
cost" is the variable profit per unit, or contribution margin of
each unit that is sold.)
Firms may still decide not to sell low-profit products, for example those not fitting well into their sales mix. Firms may also sell products that lose money - as a loss leader, to offer a complete line of products, etc. But if a product does not break even, or a potential product looks like it clearly will not sell better than the break even point, then the firm will not sell, or will stop selling, that product.
An example:
- Assume we are selling a product for $2 each.
- Assume that the variable cost associated with producing and selling the product is 60 cents.
- Assume that the fixed cost related to the product (the basic costs that are incurred in operating the business even if no product is produced) is $1000.
- In this example, the firm would have to sell (1000/(2 - 0.6) = 714) 714 units to break even.
In Price Changes
By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm to change the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 714.
To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging.
The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal, axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formuli. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formuli come either from accounting records or from various estimation techniques such as regression analysis.
In Potential Expenditures
Break-Even Analysis can be used in the evaluation of the cost-effectiveness of a new expenditure for a sales-revenue based business. Here, the cost can be evaluated in terms of revenues needed to break even on the investment, or more specifically, to determine how much of an increase in sales revenues would be necessary to break even.
An illustrative example of this is a retail lumberyard who is considering the purchase of a delivery truck. The goal is to evaluate how large an increase in sales revenue is necessary to break even on the investment in a delivery truck. For this example, the company’s front-door margin (that is, sales revenue minus the cost of goods sold and costs of doing business) is 5%, and the cost of the desired delivery truck is $50,000. To calculate the break-even level of an expenditure, the following formula can be used:
Expenditure ($) = (Front-door margin %) X (Revenue Increase needed to break even)
To break even using the above example, $50,000 must equal 5% of the sales INCREASE (“SI”) in order to break even. The variable which must be isolated is the Sales Increase.
$50,000 = 5% of SI
$50,000 = .05 * SI
$50,000/.05 = SI
$1,000,000 = SI
Sales increase of $1,000,000 is needed to break even on the investment on the delivery truck. The business must then decide how it can use the delivery truck to help increase sales by $1,000,000; if it can, then they will break even, and if it can not, then it would be an ill-advised investment. If sales revenues pass the break-even point, 5% of further increase would be bottom line profit.
Of course, in most cases, such an investment will not be paid out in lump sum or in one year, so appropriate adjustments can be made for the payments, and the scenario can be focused on a monthly basis during repayment, or can be extended out through and beyond the repayment period to evaluate a longer term return. Also such calculations can be used with smaller-scale and shorter-term scenarios (such as a temporary employee or a new computer) or on a much larger scale such as a new construction or acquisition.
It is notable that, since most businesses have among their goals to be profitable, desired profits should be added as a cost of doing business.
Limitations
- This is only a supply side (ie.: costs only) analysis.
- It tells you nothing about what sales are actually likely to be for the product at these various prices.
- It assumes that fixed costs (FC) are constant
- It assumes average variable costs are constant per unit of output, at least in the range of sales (both prices and likely quantities) of interest.
See also : cost-plus pricing, pricing, production, costs, and pricing