What is break even analysis?

Break Even Analysis

Break even analysis is a method of determining the sales volume required for an item to be sold at a specified profit or loss. A break even analysis enables you to determine what price per unit you must sell an item for in order to meet a profit goal, or what price per unit you must sell an item for in order to meet a maximum loss goal.

Why is break even analysis important for companies?

Break even analysis is important to companies for two reasons:

  1. It helps them to make better business decisions on whether to produce a product or not.
  2. It helps them to make better pricing decisions for selling a product.

For example, let’s say a company is expected to make $100,000 in revenue in year 1. They may be tempted to sell their product for $100,000 to make the most amount of money. However, if the product costs $90,000 to make, the business will lose $10,000.

Instead, if the company can sell its product for $105,000, they will break even on their expenses, but will still make a profit of $5,000.

One important thing to note about break even analysis is that the data must be calculated correctly. For example, if you are calculating a break even analysis for a company, the sales revenue must reflect the exact amount of revenue that you expect to make. The same thing applies to production costs. If you are not careful, you may end up calculating a break even point that is completely different than what you expected.

How can you use this information?

You use break even analysis to determine whether you will meet a profit goal or a loss goal. If you are planning to invest in a new product or as part of your budgeting process, you can use break even analysis to determine how much you can afford to invest.

How do you calculate the break even volume?

The break even point is the sales volume at which total revenue equals total cost. The break even volume is calculated as the point where the total revenue line intersects the total cost line.

How to Calculate Break Even Analysis

The following is an example of a break even analysis for a company that makes and sells guitars.

Step 1: Calculate the break even point in units

The break even point in units is the number of guitars the company must sell to breakeven. This number is calculated by dividing the total cost by the contribution margin per unit.

  • Total cost = $1 million
  • Contribution margin per unit = $200
  • Break even point in units = $1 million/ $200 = 5000 guitars

Step 2: Calculate the break even point

The break even point in dollars is the amount the company needs to sell to breakeven, calculated by multiplying the number of guitars by the contribution margin per unit.

$1 million/ $200 = $5000 guitars x $200 = $1 million

Step 3: Calculate the total cost

Total cost includes the following costs:

  • Direct materials
  • Direct labor
  • Variable overhead
  • Fixed overhead

Total cost = $400,000 + $300,000 + $200,000 = $800,000

Step 4: Calculate the contribution margin per unit

The contribution margin is the selling price minus the variable cost per unit.

Contribution margin per unit = $500 – $300 = $200

Step 5: Calculate the contribution margin ratio

The contribution margin ratio is the contribution margin as a percentage of the total revenue.

Contribution margin ratio = $200/$500 = 40%

Step 6: Calculate the break even point in units

The break even point in units is the number of units the company must sell to breakeven, calculated by dividing the total cost by the contribution margin ratio.

Break even point in units = $800,000/ $200 = 4,000 guitars

Step 7: Calculate the break even point in dollars

The break even point in dollars is the amount the company needs to sell to breakeven, calculated by multiplying the number of guitars by the contribution margin ratio.

$800,000/ $200 = $4,000 guitars x $200 = $800,000

Step 8: Calculate the contribution margin ratio

The contribution margin ratio is the contribution margin as a percentage of the total revenue.

Contribution margin ratio = $1000 – $600 = $400/$1000 = 40%

Step 9: Calculate the break even point in units

The break even point in units is the number of units the company must sell to breakeven, calculated by dividing the total cost by the contribution margin ratio.

Break even point in units = $1,000,000/ $400 = 2,500 guitars

Step 10: Calculate the break even point in dollars

The break even point in dollars is the amount the company needs to sell to breakeven, calculated by multiplying the number of guitars by the contribution margin ratio.

$1,000,000/ $400 = $2,500 guitars x $400 = $1,000,000

Wrap up

This article has provided an overview of break even analysis and how it can be used by business owners. Break even analysis is an important tool in determining the intersection of profit and loss. It’s the point after which a business starts becoming more viable. Use the insights from performing the analysis to perfect your business model.