Break even analysis is used by organizations to know the time period it will take them to recover the initial cost of setting up the business. Let us know more about it.
When a company’s expenses are equal to its total revenues, this stage is defined as ‘break even’. At the break even point, no profits are made, neither are any losses incurred. This analysis is based on comparison of the fixed and variable costs with the sales revenue, to determine the financial position of the company.
Some of the important parameters to be considered are:
- Average per unit revenue – This is the profit that you earn after selling every unit of the product. This can be gauged by analyzing your sales forecast.
- Average per unit cost – This is the average cost of producing one unit of a product. This includes the manufacturing cost, transportation cost, marketing cost, etc.
- Fixed cost – These are the constant expenses that have to be borne by a business. A change in the units of production does not impact the fixed cost.
Formula
Let us take a look at the formula to calculate the break even point of an enterprise.
Break even point = Fixed costs / (Selling price per unit – variable cost per unit).
Let us take an example to illustrate this. Suppose, your fixed costs include USD 100 as rent and USD 20 as insurance, and your variable cost per unit which includes the material and production costs is USD 10. The selling price per unit is USD 12. Then, according to the above formula,
Break even point = 120 / (12-10) = 120 / 2 = 60
Which means that in order to break even, the company must sell 60 units per month.
Let us take a look at a simple break even analysis template.
| Company Name | |
| Break Even Analysis for January 2011 | |
| Variable Costs | |
| Cost Description | Amount |
| Cost of goods sold | $250 |
| Inventory | $200 |
| Raw materials | $400 |
| Labor | $100 |
| Total variable costs | $950 |
| Fixed Costs | |
| Repairs and Maintenance | $1000 |
| Advertising | $300 |
| Rent | $1000 |
| Telephone | $200 |
| Insurance | $250 |
| Taxes | $200 |
| Miscellaneous | $5000 |
| Total fixed costs | $7950 |
| Selling price per unit | $1000 |
| Break even point (no. of units) | 159 |
Accountants often use more complex and detailed templates to calculate the break even point of the organization. This analysis is very helpful for people who are thinking about starting a new business, as it helps them to calculate the number of units they need to sell in order to break even and once they know this, they can easily figure the time it will take them to start earning profits.
Limitations
The break even analysis is totally dependent on numbers; it does not take into account the other factors that affect the production costs. So, if the numbers are not precise, this study can provide wrong results. It is purely a supply-side analysis and does not take into account, factors affecting demand and pricing. It assumes that the output that is produced is successfully sold, but the reality is that not all output produced is sold. It is static in nature, that is, it can be categorized as a technical analysis and does not take into account the changes that occur on a daily basis.