One of the primary concerns of any business, big or small, is when they will break even. The primary purpose of every business is to make a profit and break-even analysis is used to help design pricing models that can accomplish this.
Among the various analytical approaches to financial modeling and scenario analysis that business leaders take, break-even analysis has one of the largest impacts on decision-making. This is because the concept of breaking even is used to guide decision-making well before a business is even established. This is often a part of a cost-volume-profit analysis (CVP) because a CVP will reveal a break-even point.
What follows is a quick guide to break-even analysis and a break-even analysis formula.
What Is Break-Even Analysis?
Here’s a break-even analysis definition: analyzing the point at which revenue equals cost is referred to as break-even analysis. This type of analysis is concerned predominantly with how many units need to be sold at a specified price to cover all fixed and variable expenses. The process of both calculating and understanding the costs that impact the break-even point helps to determine the appropriate amount to charge for each unit of production.
In its simplest form, break-even analysis reveals the point at which a company or one of its revenue streams will become profitable, thus why many companies have break-even financial statements. At a glance, if revenue is below the break-even point, then the business is not profitable. Later in the article, we’ll discuss how to prepare a break-even analysis and discuss the assumptions of break-even analysis.
What Is Break-Even Analysis Good For?
Understanding the point at which your business becomes profitable is important in itself but there are other benefits to performing routine break-even analysis. Of course, it is most valuable when used to assess profitability or as part of a larger profitability analysis but it is helpful in other less obvious ways as well.
For example, most pricing models rely on break-even analysis to help gauge an appropriate price for each unit, and a break-even analysis assumes that. It is typically used in conjunction with market research performed on comparable goods or services to understand consumer sentiment and pricing indexes. If the market pricing for a particular product does not allow the business to break even, then the business should not pursue this as a source of potential profit.
Break-even point analysis is also typically performed during routine monitoring and profitability analysis. Business leaders look to the metric to gauge whether or not they should focus attention on increasing sales efforts or managing costs.
Another less obvious benefit of routine break-even analysis that demonstrates the importance of break-even analysis is that it helps to reveal if production on certain products or goods is better off in-house or if components should be purchased from a third party for less money. Often, production costs can be minimized by seeking out suppliers who specialize in a single area, translating to a reduced fixed or variable cost. Break-even analysis can be quickly referred to when assessing the benefit of seeking third-party suppliers by introducing the cost into the break-even equation and observing how it reacts.
How To Perform Break-Even Analysis
The process of calculating your break-even point and any subsequent analysis is iterative, meaning the process should be repeated regularly, especially as cost-saving initiatives are implemented. There are a few basic calculations that can be used to compute the break-even point. You can think about what follows as a break-even template or break-even calculator. Use these break-even practice problems to perform your own break-even analysis.
Here’s how to do a break-even analysis.
Calculating Break-Even Point In Terms Of Units
This approach is typically used when trying to assess the number of units required to break even. It is especially helpful when introducing new products as it will illuminate how many need to be sold at a specific price to break even.
To calculate the break-even point using units as a base, begin by calculating variable cost per unit with the break-even analysis formula below:
Once you have calculated your variable cost per unit, you can now use it in the break-even formula. To calculate the break-even point per unit uses the formula below:
Break-Even Analysis Example Using Units
Hanks Helmets makes helmets for motorcycle riders. Hank is considering selling helmets for bicycles as well as motorcycles and is trying to determine whether or not he should proceed. To help him do this, he has decided to calculate the break-even point so that he can decide whether these new helmets will be worth producing.
When reviewing his costs, he determines the following conditions will apply over the next month:
Fixed Cost = $5,000 (total for the month)
Variable Cost Per Unit = $50 (per helmet)
Sales Price = $75
Applying the formula above, Hank calculates the break-even point in units according to the below:
What this means, is that Hank will need to sell 200 units to break even over the next month.
Calculating Break-Even Point In Terms Of Sales Dollars
In certain circumstances, it might be easier or more applicable to calculate the break-even point in terms of sales dollars. This approach is often used when determining the necessary volume of units that needs to be sold during a specified time period.
To calculate the break-even point using sales dollars as a base, first, calculate contribution margin with the below formula:
The resulting ratio reveals how the portion of each dollar in unit revenue that “contributes” to paying for fixed overhead and profits. Once it is calculated, you can apply it to the break-even formula.
To calculate the break-even point using sales dollars as a base use the formula below:
Calculating Break-Even Point in Terms Of Sales Dollars
Continuing our example above, Hank now knows how many helmets he needs to sell to break even in the first month of production but he wants to know the revenue required to break even on the product line for the month.
In this case, he calculates the break-even point according to the below:
We can verify this is accurate by taking the break-even units from the above example (200) and multiplying it by the sales price ($75) to arrive at $15,000.
The Impact Of Production Volume On Break Even
The concept of a break-even point applies outside of a specified time frame. For example, Hank might be concerned with understanding how many units he needs to sell to break even on the entire production run of new helmets.
In this case, he would substitute the fixed cost for the month for the total fixed cost on the entire production run. Hank determines the entire production run will result in the below conditions:
Fixed Cost = $10,000 for 700 units
Variable Cost per Unit = $40 (per helmet)
Sales Price = $75
Applying the formula above, Hank calculates the break-even point in units according to the below:
This means that Hank needs to sell at least 286 bicycle helmets to break even on this production run. Since the run will result in 700 units, Hank has the option of reducing the price of the helmet which would increase the number of units required to break even but allow him to price his helmets competitively.
How does the production volume affect a break-even analysis? It can have significant and material impacts on profitability. Typically, the more production, the lower the cost, and without getting too deep into economic concepts, this example illustrates the benefits that production volumes can have on break-even points.
Multi-Product Break Even Analysis—How Product Mixes Impact Break Even
One of the more common applications of break-even analysis is used in larger profitability analysis when assessing optimal product mixes. Here’s how to do a break-even analysis with multiple products. Think of this as a break-even analysis chart or break-even analysis graph—a graphical method of break-even analysis.
Continuing our example, Hank has decided that he will pursue the new product of bicycle helmets. He is interested in understanding how many he should produce in conjunction with his normal motorcycle helmets.
He observes the following:
Fixed Cost = $5,000 (for the month)
Variable Cost Per Bicycle Helmet = $50
Price Per Bicycle Helmet = $75
Variable Cost Per Motorcycle Helmet =$265
Price Per Motorcycle Helmet = $300
In this case, the first thing Hank needs to do is calculate the total contribution margin for the product mix. He does this by combining the respective contribution margins for each product line according to the below:
He now uses this contribution margin in the break-even formula:
This means that Hank needs to sell at least $11,111 for the month to break even. One important thing to note is that if Hank was selling bicycle helmets alone, he would need to sell $15,000 to break even. If he was simply relying on his motorcycle helmets Hank would need to sell $42,857, or 143 motorcycle helmets, to break even. By introducing the new product line, he has significantly reduced the required revenue to break even.
Using Datarails, a Budgeting and Forecasting Solution
Datarails replaces spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location. This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal.
Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics.
Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails is an enhanced data management tool that can help your team create and monitor cash flow against budgets faster and more accurately than ever before.