It is easier to start with the definition of the break-even analysis or to be more precise with the break-even point.
The break-even point is the point where the total contribution of the sales equal to the fixed costs. In other words, the break-even point is the point where the total revenue less the variable costs from the sales made equal to the total fixed costs.
Break-even analysis is the analysis that is performed to identity how many sales a company needs to make to cover it’s fixed cost base.
A simple example might be more helpful. Let’s say that company A sells one product only which is called SuperGlass. The price is the same ($10 per unit) for all customers and it is not expected to change. The material cost $6 per unit while the company has fixed costs of $10,000.
The contribution per unit is $4 ($10-$6) and therefore, the company will need to sell 10,000/4=2500 units to break-even.
Break even Analysis Formula
Break even Analysis for two or more products
A more realistic scenario is that a company is producing more than one product. So the question is how to perform a break even analysis for two, three or fifty products. It is actually quite simple!
Let’s say that company A is producing SuperGlass and ExtraGlass and that the company is expected to sell 2 units of SuperGlass for every unit of Extraglass (2:1). The table below summarizes the price per unit, the variable costs and the fixed costs.
|Contribution (Sales Price-Variable)||$4||$6|
The first thing to do is do to add the contribution for both products so that we can create a “combo” that consists of these two products. The total contribution for this combo $10 (4+6).
Therefore, the break even point is 100,000/10 or 10,000 units. The company will therefore need to produce 10,000 * 2 from SuperGlass and 10,000*1 from ExtraGlass to break even.
Break-even Analysis Chart
It is quite easy to create a chart for a simple break even analysis. The first thing to do is to put the fixed costs in Y axis and the Contribution generated for different levels of sales on the X axis. The result is going to be the same as the photo featured in this post.
It is clear from the graph the break even point is where the total income less the variable costs equal the fixed costs.
Break-even Analysis Uses
Break even analysis can only help you to identify the level sales you need to make to avoid being in a loss making position. It can help you to understand if the product you are thinking to develop can be profitable by indicating how many units you need to sell to break even. If in your opinion, the level of sales is easily achievable then the product should be developed. If the necessary to break even level of sales seem to high, then the investment might not be worthwhile.
Break-even Analysis Limitations and Disadvantages
Break-even analysis has as any other similar analysis tool flaws. Some of them can be summarized as follows:
- It can only help you analyze straightforward scenarios and it is hard to apply it in more complex scenarios.
- It is based on expected sales prices, expected variable and fixed costs which and expectations will not be objective.
- It does not account for the synergies that products can bring.
- It does not account for certain benefits that a product can bring (such as diversified portfolios, enhanced brand name etc.