Break Even Point Analysis-Definition, Explanation Formula and Calculation:

Learning Objectives:

1. Define and explain break even point.
2. How is it calculated?
3. What are its advantages, assumptions, and limitations?

1. Definition of Break Even Point
2. Calculation by Equation Method
3. Calculation by Contribution Margin Method
4. Advantages / Benefits of Break Even Analysis
5. Assumptions of Break Even Point
6. Limitations of Break Even Analysis
7. Review Problem
8. Break Even Analysis Calculator

Definition of Break Even point:

Break even point is the level of sales at which profit is zero. According to this definition, at break even point sales are equal to fixed cost plus variable cost. This concept is further explained by the the following equation:

[Break even sales = fixed cost + variable cost]

The break even point can be calculated using either the equation method or contribution margin method. These two methods are equivalent.

Equation Method:

The equation method centers on the contribution approach to the income statement. The format of this statement can be expressed in equation form as follows:

[Profit = (Sales − Variable expenses) − Fixed expenses]

Rearranging this equation slightly yields the following equation, which is widely used in cost volume profit (CVP) analysis:

[Sales = Variable expenses + Fixed expenses + Profit]

According to the definition of break even point, break even point is the level of sales where profits are zero. Therefore the break even point can be computed by finding that point where sales just equal the total of the variable expenses plus fixed expenses and profit is zero.

Example:

For example we can use the following data to calculate break even point.

Calculation:

The break even point in sales dollars can be computed by multiplying the break even level of unit sales by the selling price per unit.

350 Units × $250 Per unit = $87,500

Contribution Margin Method:

The contribution margin method is actually just a short cut conversion of the equation method already described. The approach centers on the idea discussed earlier that each unit sold provides a certain amount of contribution margin that goes toward covering fixed cost. To find out how many units must be sold to break even, divide the total fixed cost by the unit contribution margin.

A variation of this method uses the Contribution Margin ratio (CM ratio) instead of the unit contribution margin. The result is the break even in total sales dollars rather than in total units sold.

This approach is particularly suitable in situations where a company has multiple products lines and wishes to compute a single break even point for the company as a whole.

The following formula is also used to calculate break even point

Break Even Sales in Dollars = [Fixed Cost / 1 – (Variable Cost / Sales)]

This formula can produce the same answer:

Benefits / Advantages of Break Even Analysis:

The main advantages of break even point analysis is that it explains the relationship between cost, production, volume and returns. It can be extended to show how changes in fixed cost, variable cost, commodity prices, revenues will effect profit levels and break even points. Break even analysis is most useful when used with partial budgeting, capital budgeting techniques. The major benefits to use break even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.

Assumption of Break Even Point:

The Break-even Analysis depends on three key assumptions:

1. Average per-unit sales price (per-unit revenue):
   This is the price that you receive per unit of sales. Take into account sales discounts and special offers. Get this number from your Sales Forecast. For non-unit based businesses, make the per-unit revenue $1 and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single estimate. The analysis requires a single number, and if you build your Sales Forecast first, then you will have this number. You are not alone in this, the vast majority of businesses sell more than one item, and have to average for their Break-even Analysis.
    

2. Average per-unit cost:
   This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale, this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a Units-Based Sales Forecast table (for manufacturing and mixed business types), you can project unit costs from the Sales Forecast table. If you are using the basic Sales Forecast table for retail, service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50% margin would have a per-unit cost of .5, and a per-unit revenue of 1.
    

3. Monthly fixed costs:
   Technically, a break-even analysis defines fixed costs as costs that would continue even if you went broke. Instead, we recommend that you use your regular running fixed costs, including payroll and normal expenses (total monthly Operating Expenses). This will give you a better insight on financial realities. If averaging and estimating is difficult, use your Profit and Loss table to calculate a working fixed cost estimate—it will be a rough estimate, but it will provide a useful input for a conservative Break-even Analysis.

Limitations of Break Even Analysis:

It is best suited to the analysis of one product at a time. It may be difficult to classify a cost as all variable or all fixed; and there may be a tendency to continue to use a break even analysis after the cost and income functions have changed.

Review Problem:

Voltar Company manufactures and sells a telephone answering machine. The company's contribution format income statement for the most recent year is given below:

Calculate break even point both in units and sales dollars. Use the equation method.

Solution:

Break Even analysis Calculator:

Click here to Launch Break Even Analysis Calculator  [This is external link]

 

In Business | Buying on the Go--A Dot.com Tale Star CD is a company set up by two young engineers, George Searle and Humphrey Chen, to allow customers to order music CDs on their cell phone. Suppose you hear a cut from a CD on your car radio that you would like to own. Pick up your cell phone, punch "*CD." enter the radio stations frequency, and the time you heard the song, and the CD will soon be on its way to you. Star CD charge about $17 for a CD, including shipping. The company pays its suppliers about $13, leaving a contribution margin of $4 per CD. Because the fixed costs of running the service, Searle expects the company to lose $1.5 million on sales of $1.5 million in its first year of operations. That assumes the company sells in excess of 88,000 CDs. What is the company's break even point? Working backward, the contribution margin per CD is $4, the company would have to sell over 460,000 CDs per year just to break even. Source: Peter Kafka, "Pay It Again," Forbes, July 26, 1999, P.94

You may also be interested in other relevant articles:

• Contribution Margin and Basics of CVP Analysis
• Difference Between Gross Margin and Contribution Margin
• Cost volume profit (CVP) relationship in graphic form
• Contribution margin ratio (CM ratio)
• Importance of the contribution margin
• CVP consideration in choosing a cost structure
• Operating leverage--degree of operating leverage
• Assumptions of CVP analysis
• Break even point analysis
• Target profit analysis
• Margin of safety
• Sales mix and break even with multiple products
• Limitations of Cost Volume Profit Analysis

 

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