Tutorials – Page 16 – Financial Memos

Break-even analysis is a powerful tool in the management of any business. Still, as a business tool, we must understand the break even analysis assumptions that our decisions are based on. This article will first look at the break-even analysis definition or be more precise with the break-even point. We'll then come to assumptions and limitations later. The break-even point is the point where the total contribution of the sales is 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 performed to identify how many sales a company needs to make to cover its 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 quite simple! Let's say that company A is producing SuperGlass and ExtraGlass and that the company is expected to sell two units of SuperGlass for every unit of Extraglass (2:1). The table below summarises 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 add the contribution for both products to create a "combo" that consists of these two products—the total contribution for this combo is $10 (4 + 6). Therefore, the break-even point is 100,000/10 or 10,000 units. Thus, the company will need to produce 10,000 * 2 from SuperGlass and 10,000 * 1 from ExtraGlass to break even. Break-Even Analysis Chart Chart Set-up It is pretty easy to create a chart for a simple break-even analysis. The first thing to do is put the fixed costs on the Y-axis and the Contribution generated for different sales levels 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 expenses. The example below provides a tidy working model of 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. The table on the right shows the units sold, sale proceeds, total costs (i.e. fixed + variable costs), and the profit or loss generated at that unit sold level. All of these figures come from the initial variables tables on the right-left. And finally, we have the cost v sales chart, or a break-even analysis chart. The blue line represents the revenue or sales, and the green line represents the total costs—both variables coming from the table on the right. Chart Analysis So let's 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 a total loss of $8,140. On the chart, this 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, i.e. $0 profit. And what is the number of units to achieve this? Well, eyeballing on the graph, one could say about 125 units. But let's get the pencil out and use the formula we learned above, where the 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 an exact figure. Uses Break-even analysis can only help you identify the sales level you need to make to avoid being in a loss-making position. It can help you understand if the product you are developing can be profitable by indicating how many units you need to sell to break even. If the level of sales is easily achievable, you should develop the product in your opinion. If the necessity to break-even level of sales seems too 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 summarised as follows: Can only help you analyze straightforward scenarios and it is hard to apply it in more complex scenarios;Is based on expected sales prices, expected variable and fixed costs which and expectations will not be objective;Does not account for the synergies that products can bring, and;Not all benefits that a product can bring are accounted for (such as diversified portfolios, enhanced brand name etc). Break-Even Analysis Assumptions Like any business tool, several assumptions break-even analysis has to make for the calculations to work. Below we run through some of these so you better understand the information the study 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.Variables and fixed costs are assumed to remain constant in relation to availability at a specific price.Where there is more than one product, the production and sales mix is assumed to remain fixed.With the assumptions of costs and production levels there are set assumptions with efficiencies and use of new technology.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 We learned a business tool many years ago during high school economics, but it is still as applicable now as it was then. However, as good as break-even analysis is in the business setting, the assumptions and limitations need to be understood. This is to ensure we then better understand the limitations and assumptions of the decisions we are making.