Break-even analysis

Break-even analysis

 a commonly used business management tool used by firms deciding on whether to invest in certain projects or products. It is used to determine the level of sales needed in order to cover all the costs associated with the output of a particular good or service.

Purpose (3)

• Determine pricing strategy 

• Prioritize products in portfolio 

• decide whether to make / buy supplies

Break-even

exists when a firm’s sales revenues cover all of its production costs. The break-even quantity (BEQ) is the level of output where a business does not make either a profit or a loss.

Total Contribution

 the sum of money that remains after all fixed and variable costs have been taken away from sales revenue.

Unit contribution

the difference between the selling price and the variable cost for each unit of output.

Unit contribution (equation)

selling price - variable cost per unit

Total contribution

the overall value of contribution from all quantity of output, which contributes to paying total fixed costs

Total contribution (equation) 

unit contribution x quantity sold

Profit (or loss)

total contribution - fixed costs

break-even quantity (eqaition)

total fixed costs / unit contribution

Break-even price (revenue)

break-even quantity x price of product/service

Break-even price (costs)

(break-even quantity x variable costs of product/service) + fixed costs

margin of safety

It represents the difference between actual sales and sales needed to break even. A business that operates with a postiive margin of safety is profitable

Margin of sales (equation)

level of demand - break-even quantity

Just knowing the breakeven point is not sufficient to decide on whether to sell a product Businesses need to know three key pieces of financial information…(3)

• How much profit they might make 

• How many units of output they need to produce 

• How much to charge for the selling price

Target profit quantity (formula)

(fixed cost + target profit) / (price - variable cost)

 BEQ shifting to the left?

Price increases, so the business won’t have to sell as much to reach break-even

Predictions VS Actual (4)

Difference between short and long-term profits due to prices 

• Supply 

• Inflation 

• Exchange rate

• Change in demand / taste

• Changes in demand due to external factors 

• Level of risk → riskier the project, the higher the break-even quantity 

• Innovation and introduction of new technologies

Limitations of break-even (5)

• Assumptions

•  Not useful to a dynamic business environment due to its static nature 

• Garbage in garbage out data entry → if the data you’re using to create the break-even chart is  bad and not reliable, the whole analysis

• Ignores other quantitative and qualitative factors 

• In practical terms, it is only suitable for single-product firms

it is only suitable for single-product firms?

the analysis assumes a single revenue stream, constant variable costs per unit, and a single product-to-market ratio. For multi-product businesses, it becomes difficult to calculate the contribution margin for each product, and combining them into one analysis can lead to an inaccurate "average"

—> Limits the value of the tool

Elements on break-even chart (6)

• break even point

• total revenue

• total costs

• margin of safety

• break even quantity

• fixed. costs

Y-axis on break-even chart

costs, revenuves, profits

break even quantitiy

the level of output that generates nether profit or loss. The BEQ is shown on the x-aix on a break-even chart on the vertical perpendicular where the total cost and revenue lines intersect

low margin of safety means what? 

lower profits, since there is less demand than the amount needed to break-even