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. 2. 3. 4. 5. 6. 7. 8.
Definition of Break Even Point Calculation by Equation Method Calculation by Contribution Margin Method Advantages / Benefits of Break Even Analysis Assumptions of Break Even Point Limitations of Break Even Analysis Review Problem 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. Sales price per unit = $250 variable cost per unit = $150 Total fixed expenses = $35,000

Calculate break even point

Calculation:
Sales = Variable expenses + Fixed expenses + Profit $250Q* = $150Q* + $35,000 + $0** $100Q = $35000 Q = $35,000 /$100 Q = 350 Units
Q* = Number (Quantity) of units sold. **The break even point can be computed by finding that point where profit is zero

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. Break even point in units = Fixed expenses / Unit contribution margin $35,000 / $100* per unit 350 Units
*S250 (Sales) $150 (Variable exp.)

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. Break even point in total sales dollars = Fixed expenses / CM ratio $35,000 / 0.40 = $87,500 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: Break Even Point = [$35,000 / 1 (150 / 250)] = $35,000 / 1 0.6 = $35,000 / 0.4 = $87,500

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 estimateit 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: Total Sales Less variable expenses Contribution margin Less fixed expenses Net operating income $1,200,000 900,000 -------300,000 240,000 -------$60,000 ====== Per unit $60 45 -------15 ====== Percent of sales 100% ?% -------?% ======

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

Solution:

Sales = Variable expenses + Fixed expenses +Profit $60Q = $45Q + $240,000 + $0 $15Q = $240,000 Q = $240,000 / 15 per unit Q = 16,000 units; or at $60 per unit, $960,000 Alternative solution: X = 0.75X + 240,000 + $0 0.25X = $240,000 X = $240,000 / 0.25 X = $960,000; or at $60 per unit, 16,000 units

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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

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1.

Break-even (economics)
From Wikipedia, the free encyclopedia Jump to: navigation, search This article is about Break-even (economics). For other uses, see Break-even (disambiguation).

The Break-Even Point'

In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been "paid", and capital has received the risk-adjusted, expected return.[1] For example, if a business sells fewer than 200 tables each month, it will make a loss, if it sells more, it will be a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could:
1. Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs) 2. Try to reduce variable costs (the price it pays for the tables by finding a new supplier) 3. Increase the selling price of their tables.

Any of these would reduce the break even point. In other words, the business would not need to sell so many tables to make sure it could pay its fixed costs.

Contents

[hide]

1 Computation 2 Margin of Safety 3 Break Even Analysis o 3.1 Application 4 Limitations 5 Notes 6 See also 7 References 8 External links 9 Further reading

[edit] Computation
In the linear Cost-Volume-Profit Analysis model,[2] the break-even point (in terms of Unit Sales (X)) can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as:

where:

TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost.

The Break-Even Point can alternatively be computed as the point where Contribution equals Fixed Costs.

The quantity is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

In currency units (sales proceeds) to reach break-even, one can use the above calculation and multiply by Price, or equivalently use the Contribution Margin Ratio (Unit Contribution Margin over Price) to compute it as: R=C, Where R is revenue generated, C is cost incurred i.e. Fixed costs + Variable Costs or Q * P(Price per unit) = TFC + Q * VC(Price per unit), Q * P - Q * VC = TFC, Q * (P - VC) = TFC, or, Break Even Analysis Q = TFC/c/s ratio=Break Even

[edit] Margin of Safety

Margin of safety represents the strength of the business. It enables a business to know what is the exact amount it has gained or lost and whether they are over or below the break even point.[3] margin of safety = (current output - breakeven output) margin of safety% = (current output - breakeven output)/current output x 100 When dealing with budgets you would instead replace "Current output" with "Budgeted output". If P/V ratio is given then profit/ PV ratio

[edit] Break Even Analysis

By inserting different prices into the formula, you will obtain a number of break even points, one for each possible price charged. If the firm changes the selling price for its product, from $2 to $2.30, in the example above, then it would have to sell only (1000/(2.3 - 0.6))= 589 units to break even, rather than 715.

To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging. The break even points (A,B,C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break even quantity at each selling price can be read off the horizontal axis and the break even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.

[edit] Application
The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual salescan give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). The break-even point is a special case of Target Income Sales, where Target Income is 0 (breaking even). This is very important for financial analysis.

[edit] Limitations

Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices. It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise.

It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales. (i.e. linearity) It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period). In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

The Break-Even Analysis by Michele Cagan, C.P.A.

The break-even analysis provides you with a crucial piece of data: your company's break-even point. The break-even point occurs when your company's revenues exactly equal its costs and expenses, resulting in neither a profit nor loss. When sales fall below the break-even point, your business incurs a loss; when sales climb higher, you see profits. To come up with your break-even point, you need three pieces of infor-mation: the total expected fixed costs, projected variable costs, and projected sales. Fixed costs include both administrative expenses (a.k.a. overhead) and interest, all of which must be paid whether or not you make a single sale. Variable costs include cost of goods sold and selling expenses; total variable costs naturally go up as sales volume increases. Your projected sales volume should be based on how much you realistically expect to sell at a particular price. Keep in mind, those projected sales are what you expect to sell, not your break-even point. To calculate a break-even point for your service business, use service salaries as your cost of goods sold. When employees perform services on behalf of the company, divide up their salaries into units that match your revenue units (whatever basis you use to determine customer prices, such as hours). Don't forget to include a rate for yourself when you perform services. If your break-even analysis doesn't pan out, which indicates loss potential, you may be inclined to keep working the numbers until you get a favorable outcome. Your energy may be better spent on rethinking this plan or considering a different direction for your company. When you start pulling numbers out of the air to make an analysis come out the way you want, you could be setting yourself up for losses. Break Down the Break-Even Equation Once you have those pieces, you have to do some math (you may even have to do a little algebra here). Here's the basic break-even equation: BE=FC + (VC/S BE) BE stands for break-even sales, FC stands for fixed costs, VC stands for your total projected variable costs, and S stands for your total projected sales. It's easier to look at with numbers. In this example, the fixed costs are $30,000. Total projected variable costs came to $50,000, and total projected sales are $100,000. Here's how to work the breakeven equation with these numbers. BE=$30,000 + ($50,000 / $100,000 BE) BE=$30,000 + (0.50 BE) BE (0.50 BE)=$30,000 BE=$60,000

In this example, the break-even point came to $60,000, which is less than the projected sales figure of $100,000. That means this analysis is favorable, and implementing this decision is likely to result in profits. When to Prepare a Break-Even Analysis Use this analysis every time you plan to make a major change in the business. Major changes include:

Adding a new product Expanding the business Taking on significant debt Entering a long-term contract (with either a supplier or customer) Setting or changing prices

Prepare a break-even before you definitively decide to make such a major change. This will let you know whether that change can be profitable; if it can't, reconsider your plans.