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Break-Even Analysis
from QFinance: The Ultimate Resource
WHAT IT MEASURES
Break-even is the point at which a product or service stops costing money to
produce and sell, and starts generating a profit for your business. This means
sales have reached sufficient volume to cover the variable and fixed costs of
producing and distributing your product.
WHY IT IS IMPORTANT
The ultimate goal of any business is to make money, but break-even analysis can
also provide valuable information for profitable businesses in terms of setting
price levels, targeting optimal variable/fixed price combinations and determining
the financial attractiveness of various strategies for a business.
Break-even analysis allows a business to understand what the minimum level of
sales needed is to ensure that it does not make a loss, and how sensitive the
break-even point is to changes in fixed or variable expenses. It can help you to
understand and examine the profit drivers of your business.
HOW IT WORKS IN PRACTICE
Say you are an entrepreneur looking to sell t-shirts across Europe. You will want
to know how many t-shirts you need to sell before your venture generates a
profit. This figure can then be compared to your sales forecasts to judge the likely
success of your venture. There are two ways of calculating break-even points, as
shown below.
The variable cost of producing a single t-shirt is $1. The fixed costs of the
business over a year (those costs that won't vary month to month) include items
such as telecommunications, rent, and insurance, and total $25,000 in year one.
The unit price you are expecting for each t-shirt is $5 and your projected sales in
year one are 50,000 units.
To calculate break-even, either draw a chart showing:
sales revenue at different levels of output;
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fixed costs at different levels of output;
total costs at different levels of output.
The point where total cost equals total sales revenue is the break-even point.
Or use the data available to calculate the contribution of each unit sold or made.
This is the difference between the sales revenue and the variable cost of each
unit. Using the example of the t-shirts, each t-shirt brings in $5 of revenue against
$1 in variable costs. The contribution of each unit is said to be $4, because the
unit makes a $4 contribution towards fixed costs.
The number of units needed to be sold to break even is therefore the total fixed
cost divided by the contribution per unit. The t-shirt venture would need to sell
enough t-shirts to cover fixed costs ($25,000) divided by the unit contribution ($4)
—in other words, 6,250 shirts.
Break-even analysis is particularly useful in comparing alternative scenarios. For
example, you might consider what happens if labor costs rise and the variable
cost of producing a t-shirt doubles to $2. In this scenario, the contribution per
shirt falls to $3 but fixed costs remain $25,000—meaning the business now
needs to sell 25,000 ÷ 3 t-shirts to reach break-even (8,334 shirts).
The simple formula for this method is:
Break-even sales ($) = Fixed costs/Contribution margin/total sales
TRICKS OF THE TRADE
Fundamentally, there are only three ways to reduce break-even: lower
direct costs to increase the gross margin; reduce fixed expenses and lower
necessary total costs; or raise prices to increase revenues.
Categorizing costs as fixed or variable is essential for break-even analysis.
Fixed costs are those not related to the volume of production, often
referred to as “overheads.” These costs will remain static even if you do
not produce any goods, and include items such as staff salaries, insurance,
property taxes, and interest. Variable costs are those related to production
output or sales, and might include raw materials, commission, packaging,
and shipping costs. Without a good understanding of your costs, break-
even analysis will be meaningless.
Remember that the break-even point is not a static figure. You should
compare projections to real-life results every three to six months, and
make adjustments if necessary. In particular, expenses tend to increase
figure that equals total
variable costs divided by
total sales. Labor-
intensive companies have
a higher variable cost
ratio than capital-intensive
o
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over time and you may fall below break-even point because you think it is
lower than it has become.
When conducting break-even analysis, you might want to add in a margin
for profit. For example, you might want to target a specific profit margin
goal and this can be incorporated into break-even analysis as follows:
Break-even ($) = (Fixed costs + Profit goal)/(Contribution margin/Total sales)
Another refinement of the break-even analysis is the “sensitivity analysis.”
This refers to using the break-even point to evaluate different scenarios.
For example, what happens if you increase prices by 25%? What happens
if unit sales fall by 20%? Using a spreadsheet, it is very simple to perform
such calculations quickly, allowing you to look at different situations.
MORE INFO
Articles:
“Fixed, variable costs and break-even.” The Times 100. Online at:
tinyurl.com/6eeuxkj.
“Mind Your Business—Break-even analysis: Debts, revenues and
costs.” Biz/ed (November 18, 2008). Online at:
www.bized.co.uk/current/mind/2008_9/181108.htm.
Copyright © Bloomsbury Information Ltd, 2009, 2011, 2012, 2013, 2014
Chicago Harvard MLA
Break Even analysis. (2014). In Qatar Financial Center, & Qatar Financial Center
(Eds.), QFinance: the ultimate resource (5th ed.). London, UK: A&C Black.
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