Break even analysis has important assumptions you need to understand.

Break Even Analysis Assumptions Limitations

Break even analysis is a power tool in the management of any business, but it does come with a number of limitations and assumptions – which we are going to look at today.

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 is made equal to the total fixed costs.

Before we go on you may also want to check out our other article on breakeven analysis where we also have an online calculator you can use.

Why is Break Even Analysis Performed?

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

Breakeven Point = Fixed Costs / (Sales Price – Variable Costs)

or

Breakeven Point – Fixed Costs / Contribution Margin

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.

ProductSuperGlassExtraGlass
Expected Ratio21
Sales Price$10$20
Variable$6$14
Fixed Costs$50,000$50,000
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.

The example below provides a tidy working model of a simple breakeven analysis. In the box on the left we have the variable used to generate the table. We have the total fixed costs of $8,140. Then the additional or variable costs incurred by the business for every unit sold, being $13 per unit. A sale price of $77 per unit. And in this model sales can only move in batches of 15 units.

In the table on the right we have the units sold, sale proceeds, total costs (ie fixed + variable costs) and then the profit or loss generated at that units sold level. All of these figures coming from the initial variables tables on the left.

And finally we have the cost v sales chart, or a break even analysis chart. The revenue or sales represented by the blue line and the green line represents the total costs. Both variables coming from the table on the right.

So lets work through a few of the lines. On the top line, 0 units sold, we have no sales revenue, only fixed costs of $8,140 (there are no variable costs as no units have been sold) and so a total loss of $8,140. On the chart his is the first plot on the left side. Then say at 120 units we have sales of $9,240 (120 units x $77 per unit) and total costs of $9,700 (fixed costs $8,140 + variable costs (120 units x $13). This gives us a loss of $460, just below our break even, ie $0 profit.

And what is the number of units to achieve this? Well eyeballing on the graph one could say about 125 units. But lets get the pencil out and use the formula we learned above, where break even point ($0) is:

Fixed costs ($8,140) / (Sales ($77 per unit) – Variable Costs ($13 per unit)

= 127.18 units … or 128 units for rounding purposes. So the mark 1 eyeball guess of 125 wasn’t too far off, but you can see the formula gives us a very precise figure.

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.

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; and
  • It does not account for certain benefits that a product can bring (such as diversified portfolios, enhanced brand name etc).

Break-Even Analysis Assumptions

Like any business tool there are a number of assumptions break even analysis has to make in order for the calculations to work. Below we run through some of these so you have a better understanding if the information the analysis provides.

  • Semi-variable costs tend to be ignored. It is assumed costs fall into either fixed or directly variable to a specific sales range.
  • The relationship between sales revenue) and variables costs remain in a linear relationship.
  • Within a specific sales range the sales price is assumed to remain constant, in effect not being impacts by market movements.
  • The input prices into variables and fixed costs are assumed to remain constant in relation to availability at a specific price.
  • Where is more than one product the mix of these products in both production and sales is assumed to remain fixed.
  • With the assumptions of costs and production levels there are set assumptions with efficiencies and use of new technology changes having no impact.
  • The increase in variable costs per unit of sale is assumed to remain fixed, with no changes due to capacity or complexity.
  • The level of sales and production remains in balance, with changes in one being quickly changed in the other.

Conclusion

A business tool we learned many years during high school economics, but still as useful now as it was then. However, as good is break even analysis is in the business setting the assumptions and limitations that the models naturally have need to be understand so that the limitations and assumptions of the decisions being are also understood.

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