What is Break-Even Analysis? Importance, limitations & How to Calculate Break-Even Points?

People familiar with investments or follow business news will recall media reports on new companies or startups mentioning break-even. The promoters assure their investors and the general public of achieving break-even within three years with an excellent action plan. However, many of us have also heard friends and acquaintances in business quoting, things are down, not breaking even, during difficult times.

While we all understand the spirit of break-even, sometimes we miss out on the details when we need them most. So let us find out the exact meaning of break-even, its business implications, how to find out the break-even point, and how good is break-even analysis as a strategic tool in management.

What is meant by the break-even point?

Break-even is that point in the business cycle when a company’s sales value equals the expense incurred. A little more technically, in accounting terms, it indicates the production level at which the total production income is equal to the total production cost.

Similarly, in the field of investments, when the market price of an asset is equal to the original cost of acquisition, break-even is said to be achieved.

It is imperative to understand that a business does not profit in break-even, but it does not incur a loss.

Calculating the break-even point

When you divide the total fixed cost of production by the price of one individual unit, less the variable cost per unit, you get the break-even point.

(You can work out the variable cost per unit by dividing the total variable cost by the units produced)

A simple Illustration to explain the definition-

1. Assumptions

• The total fixed cost for a small pen manufacturing unit is Rs.10000 per month;
• The sales price of a pen is Rs.5 per piece;
• The variable cost of production is Rs. 2 per piece.

2. Break-even in units

FC divided by (Sales price per unit – VC per unit) or,

10000 / (5 – 2); or, 10000 / 3 = 3333.33 (3334)

The unit needs to sell 3334 pens in a month to achieve break-even.

3. Break-even in value terms

We consider the same example as above. Again, we divide the fixed cost by the contribution margin (Unit sales price – unit VC) / unit sales price.

This means,

5 -2 = 3;

3 / 5 =0.6 (contribution margin)

10000 / 0.6 = 16666.66 (16666)

The result implies the unit needs to sell a pen worth Rs.16666 to break even in the month.

What is Break-even Analysis?

Break-even analysis is a financial tool that enables you to ascertain the number of units or the value of services a company must sell to cover its cost (fixed cost primarily).

The break-even analysis involves studying the relation between the two cost elements of a business (fixed and variable), revenue, and contribution.

Before we look into the details of break-even analysis, a quick recap of the various elements:

• Fixed Cost (FC): The cost that remains the same with an increase or decrease in a company's production volume is fixed cost. It (fixed cost) is independent of business operations and is payable even without any productive activity.
• Variable Cost (VC): The cost directly linked to the unit of production and fluctuates with the increase/decrease of the production volume is called the variable cost.
• Revenue: The total value of income generated by the sale of goods and services by a company is known as revenue.
• Contribution: The sales revenue less the variable cost is the contribution margin for a company.

Break-even Analysis -Importance, Advantages, Limitations

The break-even analysis enables a comparative study of the critical elements of the cost of your company or business. More importantly, such analysis can help a company’s strategic planning for profits.

Advantages

1) Break-even brings out an accurate picture of the profit-earning capability of a business.

2) Provides critical input for improving the performance of a company. A break-even analysis enables an enterprise to decide on the strategy- either enhancing the production volume or increasing the unit sales price, reducing the fixed or the variable cost.

The most effective strategy in all cases turns out to be a combination of all the above factors.

3) The management can do a course correction in the desired direction with break-even analysis. Certain assumptions considered in the original business plan may be insufficient under the actual situation, which the management can correct.

4) A clear understanding of break-even facilitates the management to implement a practical pricing policy in line with competitors.

Limitations

1. Costs are constant

A significant disadvantage of break-even analysis is considering the same price assumption for calculation purposes. The constant cost concept is irrelevant since as the company increases its production volume, economies of scale will lower the input cost. Thus, all businesses benefit by way of lower cost of purchase with increased volumes.

Assuming that the sale price remains unchanged, reducing costs will lower the unit break-even volume from the original analysis.

2. Unchanged Sales Price

The analysis also assumes that the unit sales price remains the same. The sale price of any product is market-driven, and a company’s management may have to adopt a dynamic pricing policy to survive the market's uncertainties.

3. Single product

The break-even model suits businesses with a single product. The model does not function accurately for multi-product calculations as it assumes the relative proportion of each product produced and sold to be constant.

4. The complexity of cost heads

There are many semi-variable costs. For a multi-product company, it is difficult to apportion the cost product-wise; the break-even calculation becomes complex and unreliable.

5. Does not factor Inventory

The analysis considers that the quantity produced equals quantity sold in the case of a business enterprise.

In reality, however, there is always an opening and closing inventory of goods to be considered. For example, goods produced at the beginning of the analysis period and the closing stock at the end of the study period will impact the real situation.

Conclusion

A business operates in a dynamic environment. As a successful business owner or a company manager, you know very well that a flexible strategic approach is the best way to manage (the business). A break-even analysis is not a universal solution to the operational issues of a company. Still, it is a necessary tool that discusses two significant aspects of a business, cost, and volume.

Your experience and business sense will enable you to use the analysis in the most effective way for your company.

Also read:

1) How to Use Google Adwords for Digital Marketing?
2) Tips & Tricks to optimise the Google Maps Listing for Your Business
3) Is Market Research Useful for a Small Business?
4) Top-10 Things & Technologies that will be trending in the year 2021

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FAQs

Q. How break-even analysis can help a company grow?

Ans. Break-even is a method of finding out the minimum sales both in terms of units and value, which is necessary to cover the additional investment in production. The firm’s marketing can plan and gear up suitably with the projected additional numbers. The company can also restructure and optimize the costs to meet the higher production volume.

The most important use of break-even, however, is in organising finance for the additional capacity. Banks and financiers will require detailed business expansion plans, and break-even is a simple yet effective tool for projecting the planned production/sales volumes.

Q. For a small firm, why is it said that break-even analysis is not very effective?

Ans. Break-even analysis is one of many tools available for managing a business. Each method will have strengths as well as weaknesses. In the case of break-even, the accuracy depends on using correct data of various cost elements.

A small firm may have a limitation of resources (human, technical, financial) for identifying the various costs precisely and classify them (cost) under the required heads (fixed, variable). Some costs appear as semi-variable, which requires specific expertise for the proper identification.

Q. I am a retailer; is break-even a helpful calculation for the retail business, or is it only for a manufacturing company?

Ans. Break-even is a primary concept of cost accounting, and its use is not limited to a particular business segment. Typically a retailer deals with many products. The analysis can come in handy to determine the total sales strategy of the retail business. The break-even value (the other mode is units) can indicate the situation regarding costs/sales. You need to include business acquisition costs (promotion, discounts offered, and the like) for a realistic picture.

When you have the cost heads identified, you can also evaluate a decision to include a new product through a break-even analysis.