Understanding financial flexibility is important for businesses. From here, we can look into the concept of Break-Even Analysis. It can be viewed as a key to interpreting the point at which your company pays its expenses and starts to make profits, guiding choices and planning strategies.
Let us go deep into knowing the basics of Break-Even Analysis and its significance in driving businesses toward their goals.
What is a Break-Even Analysis?
Break-even Analysis is a financial calculation used to determine how many goods or services a business should offer in order to cover its expenses, especially fixed expenses.
Break-even analysis is beneficial in understanding the connection between fixed costs, variable costs, and income. A business with little fixed expenses will typically have a low break-even point of sales. For instance, if two companies, Company A and Company B, are selling similar items and Company A has fixed expenses of $1,000 while Company B has fixed costs of $ 10,000, Company A will be able to break even with the sale of fewer products than Company B.
What are the Components of Break-Even Analysis?
The components of Break-even Analysis are as follows:
- Fixed Costs: These are constant costs that are non affected by production levels. Fixed costs form the baseline financial affirmation. These expenses are related to the production level and are incurred after starting a business, rather than being based on the quantity. Some examples include rent, salaries, and taxes.
- Variable Costs (overheard costs): Expenses associated with production, such as materials and labour. As production increases, expenses are impacted by the rise. They vary with output and are inversely correlated with manufacturing volume. Examples include the price of fuel, packaging, and raw materials.
- Break-Even Point: The breakeven point is when revenue equals costs. Selling above this point yields profit, while selling below it results in losses. It is crucial for planning profitability. When an organisation breaks even, it means that its revenue is equal to its expenses, resulting in neither profit nor loss.
Calculation of Break-Even Analysis
The break-even analysis formula divides total fixed costs by contribution per unit.
The Contribution per unit = Selling Price per unit – Variable Cost per unit
Break-Even Point (in quantity) = Total Fixed Costs / Contribution per unit
Break-Even Point (in quantity) = Total Fixed Costs / (SP – VC)
Assume there is a company called PQR.
Fixed Costs: ₹80,000
Selling Price per Unit: ₹50
Variable Costs per Unit: ₹30
Desired Profits: ₹60,000
Contribution Margin per Unit = Selling Price per unit – Variable Costs per unit
Contribution Margin per Unit = ₹50 – ₹30 = ₹20
Now, the break-even point in units will be as follows:
Break-Even Point = Fixed Costs / Contribution Margin per Unit
Break-Even Point = $80,000 / $20 = 4000 units
Now, to calculate the break-even sales in rupees, we do the following:
Break-Even Sales = Break-Even Point (in units) × Selling Price per Unit
Break-Even Sales = 4000 units × ₹50 = ₹200,000
Therefore, company PQR is required to sell products worth ₹200,000 to cover all of its costs. The sales above this break-even point would be profits for the company PQR.
When is Break-even analysis used?
Considering the events for using Break-even analysis can be as follows:
- Starting a new business: Good for beginning a new business. It aids in determining whether a new business idea is useful. It forces the organisation to be honest about costs and serves as a foundation for pricing strategy.
- Creating a new product: Before introducing a new product to an existing business, the corporation should still conduct a break-even analysis, especially if the new product will substantially increase costs.
- Changing the business model: For a business switching from wholesale to retail, a break-even analysis is essential because expenses could change dramatically, affecting the selling price.
Reasons Why Break-Even Analysis is Useful
Following are a few reasons why Break-Even Analysis is useful:
- Break-even analysis enables companies to comprehend their capacity for profit, with a point approaching maximum sales suggesting impracticality for a business.
- Determining the profit impact of switching from manual to automated processes when a fixed cost substitutes a variable cost is helpful.
- If a product’s price is changed, it can be used to calculate the change in earnings.
- Once breakeven is reached, it helps to determine the company’s remaining or not utilised capacity. This will demonstrate the greatest profit that may be made on a specific good or service.
- Finding out how much loss might be incurred in the event of a sales slump is possible by break-even.
Methods to Monitor Break-even Point
The following are some methods or ways to monitor the Break-even Point:
- Pricing analysis: One can either reduce or remove using coupons or other price reduction offers, which tend to increase the break-even point.
- Technology analysis: The use of zero additional cost technology for enhancing the business efficiency that results in increasing business breadth.
- Cost analysis: It can be helpful to continually assess all fixed costs to see if any can be cut. Review the total variable costs as well to determine if any can be cut. The margin will rise, and the break-even point will fall as a result of this analysis.
- Margin analysis: Reduce the break-even point and increase sales of high-margin items by closely monitoring product margins.
- Outsourcing: One can outsource any activity that comes with a fixed cost whenever possible to reduce the break-even point.
Benefits of Break-even Analysis
The benefits of Break-even analysis are as follows:
Set Revenue Targets
After completing the break-even analysis, you will learn how much you must sell in order to turn a profit. You and your sales staff will be able to set more specific sales goals because of this.
Better product prices will result. This method is frequently used to provide a product at the optimum price that will generate the greatest profit without raising the current pricing.
Detect Missing Expenses
A check of a new company’s break-even point can help examine financial commitments, minimise surprises, and get the business ready for new challenges.
Cover Fixed Costs
When a company does a break-even analysis, it helps cover all fixed costs.
Fund Your Business
A business plan must include an analysis to secure funding from outside investors and demonstrate the viability of the plan. A well-structured study ensures security and enables the company to consider various financing options.
Make Smarter Decisions
Entrepreneurs frequently base business judgements about their company on sentiment, which is vital but insufficient. Being a successful entrepreneur requires making judgements that are supported by data. Break-even analysis helps to make smarter decisions.
FAQs About Break-Even Analysis
1. What is the break-even point important?
The break-even point is the minimum level of sales required to make a profit.
2. How do you interpret the break-even ratio?
The break-even ratio is the ratio of gross operating income that a property must have in order to break even or for costs to equal expenses. Investors evaluate a property’s break-even ratio to assess its investment potential; a break-even ratio that is too high may be a warning sign.
The break-even ratio formula is given below:
Debt Service + Operating Expenses /Gross Operating Income
3. What is an example of break-even analysis?
Here is an example of a break-even analysis. If one increases the selling price of a product that must be sold, the break-even will decrease. In a similar way, if one decreases the selling price, a business must sell more in order to break even.
4. How do you do a break-even analysis in Excel?
One can use Microsoft Excel to calculate their break-even point in monetary value or units in the following steps:
- Calculate the break-even point by dividing total revenue by the difference between the selling price and the variable cost per unit.
- Determine the break-even point, and use MS Excel’s ‘Goal Seek’ feature.
- Produce a break-even chart by calculating the break-even point from your sales data using a sales table.