Break even analysis
introduction
Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).It is a calculation of the sales volume (in units) required to just cover costs. A lower sales volume would be unprofitable and a higher volume would be profitable. Break-even analysis focuses on the relationship between fixed cost, variable cost (or cost per unit), and selling price (or selling price per unit).
Fixed Costs
Costs that do not change when production or sales levels do change, such as rent, property tax, insurance, or interest expense. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. The fixed costs are summarized for a specific time period (generally one month).
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs
Variable Cost (Per Unit Cost)
Variable costs are costs directly related to production units. Typical variable costs include direct labor and direct materials. The variable cost times the number of units sold will equal the Total Variable Cost. Total Variable costs plus Fixed costs make up the total cost of production. Distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours)
Selling Price (per unit price)
The price that a unit is sold for is the selling price of that product. Sales Tax is not included in selling price and sales taxes paid is not included as a cost. The selling price times the number of units sold equals the Total Sales.
Break Even Point
The sales volume (express as units sold) at which the company breaks even. Profits are 0 at the break even point. The break even point is calculated by the following formula: Break Even Point = Fixed Costs / (selling price-variable costs).
Time Period
- The fixed costs are summarized for a specific time period.
- The per unit variable cost is not dependant on a specific period of time.
- The per unit selling price is not dependant on a specific period of time.
- The Break Even Point is expressed a the number of units, over a specific time period, that must be sold to obtain a Net Profit of 0. The time period the units must be sold is always the same as the time period of the fixed costs.
Typically the time period is monthly, however it could be yearly or even hourly. For example, a farmer seeking the break even on an annual wheat crop would choose a yearly time period. The farmer would add up the fixed costs for the whole year and the break even sales volume would be expressed as a yearly sales volume.
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 infixed 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 budgetingtechniques. The major benefits to use break even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.
Assumptions 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.
CONCLUSION
Break-even analysis is a powerful tool you can use to determine whether your business idea will be profitable or not. Consider your break-even analysis to be only one tool in your arsenal. Even if this analysis shows that you can make a profit given your expected sales and costs, there are other tools you will use in your business plan to give you a fuller picture of your financial forecasts. Among them are:
• A profit and loss statement
• A cash flow projection
• A start-up cost estimate
These tools are covered in the business plan section.
SUBMITTED BY:
AMARJOT SINGH MBA 1(C) (127)
VIPUL VIRAL SACHDEVA MBA 1(B)(206)
PRABHJEET KAUR MBA 1(A)(53)