No matter how small or big, every business runs on estimations. Calculations are a crucial part of any business, and one needs to consider several things, including analysis, before making important business decisions.
Besides helping in decision making, this analysis also helps find the results in monetary terms. One such necessary calculation for businesses is the Break-Even Analysis, which is done with understanding the company’s break-even point (BEP).
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Meaning of Break-Even Point
In simple terms, the break-even point for a business is a point of ‘no profit, no loss‘. In business terms, the break-even point is when the total revenue of the company and the total cost are equal. It means that the money spent by the business equals the money earned by it. The break-even point is calculated for a specific period. It is an economics concept that often helps decide the number of sales needed to reach profitability.
Importance of Break-Even Analysis in Business
1. Helps in Determining Sales
The break-even point is achieved when the revenue and cost are equal. Since revenue is closely related to sales, it helps determine the number of sales required to earn the profits.
2. Helps in Making Budgeting Decisions
The break-even point is also an essential factor in managing costs. The break-even point considers various aspects of expenses such as fixed cost and variable cost to arrive at a result. Budgeting is an integral part of the cost and relies on the break-even point to determine the future scope of the business’s costs.
3. Helps in Determining the Margin of Safety (MOS)
The margin of safety (MOS) is the gap between the sales at the break-even point and the sales at profit. Therefore, the margin of safety cannot be calculated without the break-even point, and hence break-even point is crucial for many such business calculations.
4. Helps in Costing Analysis
The break-even point is an important term not only in finance but also in cost analysis. Under costing, it has various uses, and many calculations are dependent upon arriving at the break-even point. It helps directly or indirectly for calculative matters related to sales such as raw materials, processing costs, sales and overhead costs etc.
5. Helps in Making Pricing Decisions
As discussed above, sales and the break-even point are related. However, sales are also dependent on various other factors, especially the price of a product. Don’t we all consider the price of a product before buying it? We tend to go with the one that fits our pocket.
If the price of a product is not set correctly, it may often reduce the number of sales. If the sales are reduced, it could also directly affect the break-even point. Sales being directly related to price makes pricing and break-even point inter-related thereby.
Components of Break-Even Analysis
The break-even analysis under different terms is done differently and is done under accounting terms or financial terms. The calculations of break-even analysis under both the terms mentioned above are done using certain factors.
- Factors Under Accounting Terms
1. Fixed Costs
2. Depreciation
3. Contribution Margin (Selling Price per unit – Variable Cost Per Unit)
4. Taxes
5. Profit after Taxes
6. Cash flow from operations
7. Net cash flow
- Factors Under Financial Terms
1. Variable Costs
2. Contribution
3. Fixed Costs
4. Depreciation
5. Profit before taxes
6. Taxes
7. Profit after taxes
8. Cash flow
9. Present value of cash flow
Formula for Break-Even Analysis
The formula for calculating the break-even point or the level of sales at which the break-even point will be achieved is as follows.
Fixed Costs + Depreciation
Contribution Margin Ratio
Note:
1. Contribution Margin (also known as P/V ratio) is calculated as
Contribution
Sales
2. Contribution Margin is calculated as Sales – Variable Costs
Examples of Break-Even Analysis
We will understand how break-even analysis is done by considering the following data.
Let us assume that a product is sold for INR 1,200 per unit. The variable cost per unit is INR 800 per unit, and the fixed costs are INR 80,000 per year.
| Serial No. | Particulars | Amount ( in INR) |
| 1. | Selling price per unit | 1200 |
| 2. | Less: Variable Costs per unit | 800 |
| 3. | Contribution Per Unit | 400 |
Contribution Margin Ratio = Contribution x 100 = 400 x 100 = 33.3333%
Selling price per unit 1200
Now, the break-even point can be calculated as BEP in amount or BEP in units (i.e. number of units sold)
1. Calculation Break-Even Point in Amount (INR)
Contribution Margin Ratio = Contribution x 100 = 400 x 100 = 33.3333%
Selling price per unit 1200
BEP (in INR) = _ Fixed Costs = 80,000 = INR 24,000
Contribution Margin Ratio 33.3333 %
Therefore, BEP = INR 24,000
2. Calculation Break-Even Point in Units
The break-even point for the number of units sold can be calculated as follows.
BEP (in INR) = Fixed Costs_____ = 80000_ = INR 200
Contribution per unit 400
Therefore, BEP = 200 units
When is Break-Even Analysis Used in Business?
- Estimation of Costs
The break-even analysis helps in predicting sales. The sales of an organisation are related to fixed and variable costs, which sum up to form the total cost of the organisation. In the longer run, fixed costs become constant, whereas variable costs are directly proportional to sales. Hence, the estimation of sales through the break-even point can help understand the business’s costs.
- Determination of Profits
The break-even point arrives at that number of sales, where the total costs and the total revenue are the same. When the total revenue exceeds the break-even point, it indicates profits. One can thus determine the profitability of each product through the break-even point.
- Comparative Data Analysis
One can compare the break-even points of similar products, or products of the same category or between more than one business to analyse the data, which can lead to better decision-making. Since the break-even analysis takes into consideration the cost and the volume of sales, a comparison should be made between similar categories of products, and then decisions are taken.
- Launching a New Business or Product
Whenever one plans to start a new business or when an existing company decides to launch a new product, it is advisable to do a break-even analysis before the launch process. Doing so will help you understand the scope of the profits and sales of the business or product to be launched, and they both are coherently a purpose of any business.
Benefits of Break-Even Analysis
1. The information made available by the break-even analysis is apparent and easy to understand, and gives an overall view of the data needed for forecasting.
2. The break-even analysis lays down the emphasis on fixed costs, which are often missed out when considering sales due to its direct relation with variable costs.
3. The break-even analysis is a crucial factor in determining profitability. The phase of profits arrives only after crossing the break-even point, and denotes the minimum volume of sales at which loss can be avoided. It can help decide whether the scope of a product or business is profitable or not and whether one should continue it.
4. The break-even analysis is beneficial to estimate economies of scale, long term business plans, business growth, capacity and utilisation of resources etc.
In a nutshell, the break-even analysis is an important point in the life cycle of a business or a product. Not every business will generate profit from day one, but break-even analysis will help estimate the point from which the sales will start generating. Additionally, it will help in decision making in the further course of business. Calculated or not, every business has its break-even point. But when it is determined, it will bring more essence to the business.
