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Breakeven analysis is a commonly used tool that helps you to evaluate the economic feasibility of a new product or a new business.
This is because it is a point where you do not make any profit or incur any losses. It is where your business revenues equate to total costs.
In other words, the breakeven point tells you the level of sales that you need to achieve to cover the total costs of running your business. That is, you must earn a minimum amount so that you can operate your business venture.
Thus, the breakeven point is a point where your business earns zero economic profit. However, it helps you to understand that you need to rise above this point to maximize economic profits.
You can maximize profits either by reducing costs or increasing sales. Accordingly, you cannot determine in advance the level of out where your firm’s profits are maximized. Even if you know this level of output, it is difficult to earn profits at such a large scale at the outset.
Therefore, the break even analysis helps you to plan your production in a better way. This so because you can determine the level of output at which your costs equate to the total revenue.
In this article, we will discuss the breakeven formula and how to calculate the breakeven point.
What is the Breakeven Point?
The break even point refers to that level of output where your firm’s total revenues are equal to its total costs. Economic profit refers to a situation where the total revenue of your business at a given level of output exceeds its total cost.
Thus, the breakeven point is a situation of zero economic profit where your firm neither earns profit nor incurs losses. So, your business incurs a loss if it operates below such a level of output.
However, your business needs to operate at a production capacity above the breakeven point to earn supernormal or economic profits.
Thus, calculating the breakeven point helps your business to plan its production in a better way. It lets you know the level of output that you need to produce in the short-run. Where the total revenues of your business just cover the total costs.
Therefore, breakeven analysis is a technique where you analyze the relationship between the volume of production and cost of production on one hand. And helps you to analyze the relationship between sales proceeds and profit on the other hand.
Remember, the break even analysis is based on classifying production costs into fixed and variable costs. Therefore, the level of output at the breakeven point covers both the fixed and variable costs.
The following diagram illustrates the concepts related to the breakeven analysis.
As you can see, your business earns profit if its level of output is above the breakeven quantity represented by QBE. However, it suffers a loss if it produces the output below the breakeven quantity.
What is Breakeven Analysis?
Breakeven analysis is a financial tool to determine the stage at which your business, new services, or your product will be profitable. That is, it helps you to determine the units of products your company should sell. Or the total services your business must render to cover its total cost.
As mentioned above, the break even point is the level of total revenue where the economic profit of your business is nil. That is the level of sales at which you are neither earning nor losing money. However, your total costs are covered.
Thus, the break even analysis helps you to determine the relationship between variable cost, fixed cost, and total sales of your business.
It helps you in evaluating the economic feasibility of a new product or venture. It also helps you to quantify the level of production that is required for a new business or a new product.
Further, it is important to note that many new business ventures or products operate at a loss in the early development stages. Thus, the breakeven price or volume is important to calculate the time period for which your business will have to bear losses.
Furthermore, the break even analysis is an excellent financial tool. This is because it provides a benchmark level of sales which helps the company to measure its short-term goals. It also helps your business to analyze your fixed cost and variable cost.
How to Calculate Breakeven Point?
Break Even Point Formula
To calculate the breakeven point, you need to first calculate or ascertain the following components.
- Total Fixed Cost
- The Total Variable Cost
- Total Output in Quantity
- Price Per Unit of Output
- Variable Costs per Unit of Output (AverageVariable Cost i.e. AVC)
Now, the following method is used to calculate the breakeven point.
Under this method, we first need to calculate the breakeven quantity. That is the quantity of output where total revenue is equal to the total cost.
Once you calculate the breakeven quantity, you can then calculate the breakeven sales. Thus, the formula for the breakeven quantity is as follows.
Breakeven Quantity (Q) = Fixed Cost (FC)/(Price (P) – Average Variable Cost (AVC))
Let’s understand how the above equation is derived.
Total Revenue (TR) = Total Output (Q) x Price Per Unit of Output (P) = Q x P
The Total Costs (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)
Total Variable Cost (TVC) = Total Output (Q) x Variable Costs per Unit (Average Variable Cost (AVC))
Therefore, TC = TFC +TVC
= TFC + Q(AVC)
Breakeven Point (B) = (TR = TC)
Or Q(P) = TFC + Q(AVC)
Or Q(P) – AVC = TFC
Q (P – AVC) = TFC
Or Q = TFC/((P – AVC))
Breakeven Point Example
Jack and Co manufacture mobile phones. The fixed cost of manufacturing mobile phones is $1,4000. While the variable cost of manufacturing one mobile phone is $400. The selling price per mobile phone is $600.
Therefore, Jack and Co’s breakeven point in quantity would be calculated as follows.
Q = FC/(P – AVC)
= $1,4000/($600 – $400)
= 70 units
If Jack and Co. produced 70 units of mobile phones, the company’s Total Revenue is as follows.
Total Revenue = Q x P
= 70 x $600
Total Cost = TFC + TVC
= TFC + (Q x AVC)
= $14,000 + (70 x $400)
= $14,000 + $28,000
As we can see, Total Revenue is equal to the Total Cost of the mobile phones produced by Jack and Co. Therefore, the economic profit of Jack and Co. at 70 units of sales is 0.
Components of Breakeven Point
The following are the components of the break even point.
Fixed Costs refer to the costs that remain the same as the level of output changes. For instance, factory rent, electricity, depreciation, insurance, etc are the fixed costs. These are the costs that your business would have to pay irrespective of the output generated or sales made.
Thus, your business has different types of costs that can be categorized into direct, indirect, and capital costs. Both fixed costs and variable costs tantamount to the total cost of our business.
Typically, costs are important criteria that impact the total profitability of your business. Thus, you need to analyze the fixed cost and variable cost of your business.
It is important to note that the fixed cost does not change with the change in the production levels. However, such a cost varies on a per-unit basis. Furthermore, the fixed costs once established do not change over the life of the contract. However, these may change over time if you engage in additional contracts.
Variable costs refer to the costs that change with the change in the level of output. This means that the variable cost increases when the level of production increases. And decrease with the decrease in the level of production. Cost of raw material, packaging, direct labor cost, commissions, etc are examples of the variable cost.
It is important to note that the per-unit variable cost of production remains constant. However, the total variable cost of production increases with the increase in the level of output. And decrease with the decrease in the production volume.
Thus, the formula for calculating the total variable cost of your business is as follows.
Total Variable Cost = Quantity of Output Produced x Variable Cost per-unit of Output
Thus, variable costs are short-term costs that can be modified quickly. Also, your business can increase its profits by reducing its variable costs. It is quite challenging for you to bring down your fixed costs.
Thus, your business can seek to increase its profits by reducing variable costs like that of raw material, direct labor, etc.
Total Revenue refers to the total money that flows into the business as a result of selling goods and services at a specific price. In other words, it is the total amount of money that your business generates from its core operations.
It also includes sales returns and discounts offered to sell your goods or services. Total revenue is also referred to as the top line of your business. Thus, the net income of your business is calculated after deducting all the costs from the total revenue of your business.
The following is the formula for the Sales Revenue.
Sales Revenue = Selling Price per-unit of Output x Number of Units Sold
Typically, the total revenue is calculated using the accrual accounting method. Under this method, credit sales are also included in the total revenue of your business. However, you can also use the cash accounting method to calculate total sales. Under this method, sales are included in the total revenue only when the cash payment is received for the goods and services sold.
Average Variable Cost
Average Variable Cost refers to the variable cost per unit of output. This cost includes the cost of material, labor, and other short-term costs of production. Typically, the average costs of your business decrease with the decrease in the level of output. However, average costs increase with the increase in the level of out.
The following is the formula to calculate the average variable cost.
Average Variable Cost (AVC) = Total Variable Cost (TVC)/Total Number of Units of Output (Q)
Thus, you can use the AVC to determine the level of output where you should stop producing more goods in the short-term to maximize your profit. Accordingly, your business covers all its variable costs and a proportion of the fixed costs. This is if the price of a good is higher than its AVC.
As a result, a business should continue its production to maximize profits. However, your business should stop producing more goods to prevent additional variable costs. This is if the price of a good is lower than its average variable cost.
Price refers to the current or the most recent price at which you sell goods or services to your customers. In other words, it is the compensation that you receive from your customers in exchange for goods or services that you provide.
Furthermore, the production costs, product demand, and supply influence the price of your goods or services.
Total Cost is nothing but the sum of Total Variable Cost and Total Fixed Cost of producing a given batch of goods. Thus, the formula for Total Cost is as follows.
Total Cost = (Average Fixed Cost + Average Variable Cost) x Number of Units of Output
Thus, the total cost is an economic parameter that includes all the expenses that you incur to manufacture a product or sell a service.
Total Costs help you to track the costs of operations of your business. Furthermore, it also helps you to determine the pricing for your products and services and total revenue.
Besides this, you can even track the components of the total cost (fixed cost and variable cost) and alter your business operations accordingly.
When is Breakeven Analysis Used?
Breakeven analysis is an important financial tool that helps you to determine the level of output where total revenue would cover your total cost.
Besides this, there are other areas where breakeven analysis helps you to make important decisions.
Determine Targeted Sales Volume
You can use breakeven analysis to determine the volume of sales you need to make to achieve a given level of profit.
Ascertain Margin of Safety
The Margin of Safety refers to the difference between total actual sales and the sale at the breakeven point. It represents the minimum level of sales that your business can make. Where it doesn’t have to incur any loss. The following are the formulas of the Margin of Safety.
Margin of Safety = (Profit x Sales)/PV Ratio
= (Actual Sales – Breakeven Sales)/Actual Sales
= Profit/PV Ratio
Undertaking Make or Buy Decisions
The breakeven analysis helps you to decide whether you have to manufacture all the components of the finished product yourself. Or purchase them from third-parties. If the variable costs of a product are more than the buying price, then you buy the product from the market or vice-versa.
Accepting Price Below Cost
In times of depression, you have to fix prices at a level that may not be enough to cover your total cost. Though the price is above the variable cost, it is not sufficient to cover the total fixed cost. That is, you are able to partially cover the fixed cost. Thus, you have to accept a price less than the total cost to take additional export orders.
If the difference between the additional revenue and additional cost is positive, then you accept the order.
Determining Sales to Offset Price Reduction
You will have to increase your sales volume to avoid loss arising from reduced selling prices. The break even analysis helps you to determine the required increase in the sales volume.
Determining Sales to Meet Proposed Expenditure
The break even analysis also helps to know the volume of sales required to meet the proposed expenditure. That is, increased sales can only help you in meeting such an expenditure. Thus, the break even analysis helps you to determine the increase to be made in sales.
You can determine whether to increase or decrease your production capacity with the help of breakeven analysis. Factors like the possibility of change in profit, sale price, etc are considered to calculate the same.
If the change in any of the factors has a positive effect, then it will be accepted or vice-versa.
Impact of Different Prices
The breakeven chart can help you to determine the level of profit at different price levels under the given demand conditions and cost.
Deciding Product Mix
The break even analysis helps you to determine whether to introduce a new product or not. Furthermore, it also helps you to decide whether to continue or discontinue an existing product.
Choosing the Promotion Mix
The break even analysis tool helps you to ascertain the different kinds of incentives that you can offer in various proportions to your customers. You should choose such a promotion mix so that it helps you in maximizing the profit.
Determining Most Profitable Option
As a business, you can choose the most profitable alternative from the different alternatives or factors of production through the breakeven analysis. In other words, you can choose the most economical alternative of producing goods on the basis of information available regarding such alternatives.
Comparison With Other Firms
You can compare your firm’s profitability with that of the competitor firms with the help of breakeven analysis. Thus, firms having a high PV ratio are better than the ones with a lower ratio.
With the help of breakeven analysis, your firm can determine the level of production capacity where the cost of production is minimum and the level of contribution is maximum.
Benefits of Breakeven Analysis
The break even analysis offers you the following benefits.
- Price your products or services effectively
- Cover fixed costs of your business like rentals, insurance, salaries, etc
- Consider all our financial expenses including the ones you overlooked
- Determine the amount of sales revenue to be profitable
- Take managerial decisions like add a new product line or start a business venture or discontinue an existing product
- Undertake funds from investors or other financial institutions
- Analyze the relationship between fixed and variable costs
- Estimate profits and losses at various levels of sales
- Anticipate the impact of cost and efficiency changes on the profitability
- Determine the effect of change in any factor on sales price
- Estimate margin of safety
- Prepare a budget for the firm
What Happens To the Breakeven Point if the Sales Change?
Your business revenue or sales may change due to changes in the economy. For instance, your sales revenue may decrease due to a recession in the economy. In such a case, your business may not be able to make enough sales to achieve its breakeven point.
As a result, you will not be able to meet all of your expenses. Considering the breakeven point formula, there can be two ways to resolve this problem.
You can either reduce your fixed costs or variable costs. Or increase the price of your product.
Let’s understand this with the help of the Jack and Co. example mentioned above.
Say, Jack and Co. makes use of only 3000 square feet of space instead of 5000 square feet. Further, the landlord rents out the remaining 2000 square feet of space to some other manufacturing unit.
As a result, Jack and Co’s rentals are reduced by $2000. Thus, the fixed cost for Jack and Co reduces from $14,000 to $12,000. The breakeven point using the same break even point formula and holding other variables as constant is as follows.
= $12,000/($600 – $400) = 60 units
As we can see, the breakeven point reduces from 70 units to 60 units. This is because of the reduction in fixed costs.
Now suppose that you reduce the variable costs of manufacturing a mobile phone. This is done by cutting costs of goods sold from $400 to $350.
= $14,000/($600 – $350) = $14,000/$250 = 56 units
Thus we can see that the breakeven point gets reduced in case you reduce the variable cost of manufacturing goods. This way you do not have to increase your price to lower your breakeven point.