Break Even Analysis

Introduction

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorising production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

A breakeven analysis is used to determine how much sales volume your business needs to start making a profit.
The breakeven analysis is especially useful when you're developing a pricing strategy, either as part of a marketing plan or a business plan.
To conduct a breakeven analysis, use this formula:
Break Even Point = Fixed Costs divided by / (Revenue per unit - Variable costs per unit)
Fixed costs are costs that must be paid whether or not any units are produced. These costs are "fixed" over a specified period of time or range of production.
Variable costs are costs that vary directly with the number of products produced. For instance, the cost of the materials needed and the labour used to produce units isn't always the same.
For example, suppose that your fixed costs for producing 100,000 widgets were $30,000 a year.
Your variable costs are $2.20 materials, $4.00 labour, and $0.80 overhead, for a total of $7.00.
If you choose a selling price of $12.00 for each widget, then:
$30,000 divided by ($12.00 - 7.00) equals 6000 units.
This is the number of widgets that have to be sold at a selling price of $12.00 before your business will start to make a profit.