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Financial Break-Even Analysis

One of the important parts of financial decision making is profit planning. Profit planning depends on several factors, such as the cost of production, the quantity of a product produced, the cost of marketing, and the revenue generated from product sales. A volume-cost-profit (VCP) analysis helps decision makers understand the financial break-even point (BEP).

The BEP over a set period is the point where a company recovers the costs expended, through its sales. At this point, the total revenue equals the total cost of production. Thus, before the break-even point is reached, a company’s costs exceed its revenues, and there is a net loss. Beyond the break-even point, the company’s revenues exceed costs, and the company makes a profit.

Break-Even Point

Break-even analysis helps us address the following questions (Goyal, 2008) :

· The initial period of establishing a company may not lead to profits since it is used in recovering the expenses incurred to start the company operations. How much production should be there before it results in an operating profit?

· For a new product, how much sales volume would meet the fixed cost of production before it starts making any profit?

· Every production facility has a finite capacity. For a particular production level, how much is the operating profit or loss?

· If the competition forces reduction of prices and consequently the operating profit, how much should the production be increased to maintain the earlier levels of operating profit?

· How is profit affected by an increase in the fixed costs or decrease in the variable costs?

Total costs include fixed costs (FC) and variable costs (VC). Fixed costs do not change with activity volumes, while variable costs are linked to activity volumes. A simple way to determine whether a cost is fixed or variable is to ask if the particular cost would change if the company stopped its production or primary business activities. If the cost continues to be incurred, it is a fixed cost. If the company no longer incurs the cost, it is most likely a variable cost.

Take Note

A variable cost increases proportionately with the volume of the output. Examples of variable costs are direct materials, property tax, insurance, rent, sales commissions.

A fixed cost remains constant regardless of the changes in the volume of the output. Examples of fixed costs are rent, insurance, depreciation, salaries, and utilities.

At the BEP total revenue is equal to the total cost of production (fixed costs and variable costs). At this point, neither a profit is earned nor a loss is incurred. Therefore, if all the costs were variable, the BEP would be at the point where the production level is zero.

A few key terms are helpful in aiding your understanding of financial break-even analysis (Goyal, 2008):

· Operating profit (OP) is the difference between the total revenue generated and the total cost (total variable and total fixed costs) before the payment of income tax.

· Contribution margin (CM) is the difference between the selling price and variable cost of one unit of product. This figure shows the amount that an additional unit of production contributes to the total profit.

· Margin of safety (MS) is the difference between the actual sales revenue and the break- even sales revenue. The larger the MS, the safer the company is from experiencing losses even if there is a temporary decrease in sales.

Accounting Approach (BEP in Units)

From an accounting perspective to analyzing BEP, the fundamental formula to keep in mind is

contribution margin per unit = sales price - variable cost per unit.

The BEP in terms of units (e.g., pairs of shoes) is calculated as

fixed costs / contribution margin per unit.

If the fixed costs are $60,000, then BEP = 150,000 / 80 = 1,875 pairs of shoes. This result shows that the company will break even by producing 1,875 pairs of shoes. At this level of production,

total revenue = (1,875 units x $100 per pair of shoes) = $187,500

total costs = $150,000 fixed costs + $37,500 ($20 x 1,875) = $187,500

This relationship can be shown in a VCP chart, as seen below.

The Break-Even Point

In this case, the units sold are on the x-axis, and the sales revenue generated on the y-axis. Total cost line starts from the point where the fixed cost line meets the Y-axis. The fixed cost line is independent of the volume of production.

The sales line starts from the origin and reaches to the point of maximum production. The BEP lies at the intersection of the total cost line and the total sales line. This is the point at which the production cost becomes equal to the sales revenue.

The area above this point is the profit area, and the area below this point is the loss area.

Finance Approach (BEP in Sales) 

From a finance perspective to analyzing BEP, the basic formula to keep in mind is

contribution margin ratio - contribution margin / sales.

For example, if a pair of shoes sell at $100, and the variable cost is $20 a pair, the contribution is $80 ($100 - $20) a pair. The contribution margin ratio is $80 / $100 = 0.8 = 80 percent. This means that for each dollar in sales, there is $0.80 left over after variable costs to recover fixed costs and generate net income.

A second fundamental formula is

BEP in sales ($) = fixed costs / contribution margin ratio.

In our example, BEP in sales dollars = $150,000 / 0.8 = $187,500.

Assume, now, that this is a new company and has estimated a growth of 10 percent per year in terms of units sold, based on both the growth of the market and the growth of its market share within that market. The table below shows how those estimates influence the break-even point.

Projected Growth
	Year 1	Year 2	Year 3	Year 4	Year 5
Sale price per unit	$100	$100	$100	$100	$100
Units sold	1,550	1,705	1,875	2,060	2,270
Revenue	$155,000	$170,500	$187,500	$206,000	$227,000
Less: Variable costs	(31,000)	($34,100)	($37,500)	($41,200)	($45,400)
Contribution margin	$124,000	$136,400	$150,000	$164,800	$181,600
Less: Fixed costs	($150,000)	($150,000)	($150,000)	($150,000)	($150,000)
Net income	($26,000)	($13,600)	0	$14,800	$31,600
	Loss	Loss	Break-even	Profit	Profit

As the number of units sold increases, the fixed costs become a smaller percentage of total income while variable costs remain a constant percentage.