Break Even Analysis: Benefits and Limitations

A break-even analysis is a financial method for evaluating when a business, a new service, or a product will become profitable. 

 

To put it another way, it's a financial formula that determines how many things or services a business should sell or offer to pay its costs (particularly fixed costs).

 

 

Understanding Break Even analysis

 

Break-even analysis is the process of calculating and evaluating an entity's margin of safety based on collected revenues and corresponding costs. To put it another way, the research demonstrates how many sales are required to cover the cost of doing business.

 

The break-even analysis establishes what level of sales is required to cover the company's total fixed expenses by analyzing various pricing levels in relation to various levels of demand. 

 

A demand-side study would provide a seller with a lot of information about their selling ability. From stock and options trading to corporate planning for various initiatives, break-even analysis is widely utilized.

 

(Related blog: Cost-benefit Analysis)

 

 

What is the Break-Even Point?

 

The breakeven point (break-even price) for trade or investment is computed by comparing the market price of an item to its initial cost; the breakeven point is reached when the two values are equal.

 

In a corporate accounting, the breakeven threshold is derived by dividing all fixed manufacturing costs by revenue per individual unit minus variable expenses per unit. 

 

In this case, fixed expenses are those that do not change depending on the number of units sold. The breakeven point, to put it another way, is the point at which a product's total revenues equal its total costs.

 

The formula for BEP Break-Even point (Units)= Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit).

 

(Also read: Cost of production)

 

 

How does break-even analysis work?

 

A break-even analysis is a financial calculation used to identify a company's break-even point (BEP).It's an internal management tool, not a calculation, that's typically shared with outsiders like investors or regulators. 

 

Financial institutions, on the other hand, could ask for it as part of your bank loan application's financial forecasts. In terms of unit pricing and profit, the calculation considers both fixed and variable costs. 

 

Fixed costs are those that do not change regardless of how much of a product or service is sold. Fixed costs include facility rent or mortgage, equipment expenditures, salaries, capital interest, property taxes, and insurance premiums, to name a few.

 

Variable expenses grow and decrease in response to sales fluctuations. Variable expenses include direct hourly worker payroll costs, sales commissions, and raw material, utility, and shipping costs, to name a few. The total of the labor and material expenses required to create one unit of your product is known as variable costs.

 

By multiplying the unit cost by the number of units produced, the total variable cost is calculated. For example, if producing one item costs $20 and you make 50 of them, the total variable cost is $20 x 50 = $1000

 

The contribution margin is the difference (more than zero) between the product's selling price and its total variable cost. If a suitcase is sold for $125 and the variable cost is $15, the contribution margin is $110. This margin aids in the offset of fixed expenses. (source)

 

 

8 Benefits of Break-even analysis

 

1. Pricing

 

Break-even analysis is a very valuable technique for a corporation, and it has a lot of benefits. It demonstrates how many things they must sell in order to make a profit. It determines if a product is worth selling or is too dangerous to sell. It indicates how much money the company will make at each level of output.

 

2. Gaining funds

 

When it comes to collecting financing, break-even analysis is usually an important part of a company's strategy. If you want to get funding for your firm or startup, you'll almost certainly need to do a break-even study. Furthermore, a low break-even point will likely help you feel more at ease about taking on extra debt or funding.

 

 

3. Setting revenue targets

 

A break-even analysis may also be a useful tool for determining precise sales goals for your team. When you have a precise quantity and a timeframe in mind, it's typically easier to decide on revenue goals.

 

 

4. Reduce risk

 

Some company concepts are simply not intended to be followed. Break-even analysis can help you reduce risk by guiding you away from investments or product lines that are unlikely to be successful.

 

 

5. Relying on accurate data

 

Costs can sometimes be classified as both fixed and variable. This can make computations difficult, and you'll almost certainly have to fit them into one of the two.

 

Correct data is required for your break-even point to be accurate. You won't obtain a trustworthy result if you don't enter good data into the calculation.

 

 

6. Competitors are ignored

 

As a newcomer to the market, you will have an impact on rivals and vice versa. They might modify their pricing, affecting demand for your goods and forcing you to adjust your prices as well. If they expand swiftly and a raw resource that you both use becomes scarce, the price may rise.

 

Finally, break-even analysis will provide you with a firm knowledge of the prerequisites for success. It's a must-have. However, it isn't the only study you should conduct before beginning or changing a firm.

 

 

7. Pays of fixed expenses

 

Most people think about price in terms of how much it costs to make their product. These are referred to as variable costs. You must still pay for fixed expenditures like insurance and web development. You may achieve this by performing a break-even analysis.

 

 

8. Make better choices

 

Entrepreneurs frequently make decisions based on their emotions. If they are enthusiastic about a new enterprise, they will pursue it. It's necessary to know how you feel, but it's not enough. 

 

Entrepreneurs that are successful make judgments based on facts. When you've put in the effort and have meaningful data in front of you, making a decision will be much easier.

 

(Suggested blog: Types of Trade Barriers and their effects)

 

 

Some Limitations of Break-even analysis

 

1. The assumption behind break-even analysis is that all costs and spending can be clearly divided into fixed and variable components. In reality, however, a clear distinction between fixed and variable expenses may be difficult to make.

 

2. Assuming that the selling price remains constant results in a straight revenue line, which may or may not be accurate. The selling price of a product is determined by a variety of factors such as market demand and supply, competition, and so on, and it seldom remains constant.

 

3. In actuality, it's rare to discover the assumption that just one product will be created or that the product mix would remain stable.

 

4. It presupposes that production and sales quantities will be equal, and that there would be no change in the opening and closing stock of completed goods; however, this is not true in actuality.

 

5. The quantity of capital used in the firm is not taken into account in the break-even analysis. In reality, the amount of capital utilized is a key factor in determining a company's profitability.

 

6. It is proven to be inappropriate in sectors such as shipbuilding. If fixed expenditures are not taken into account while valuing work in progress, losses may occur each year until the contract is finished. It may result in income tax issues.

 

7. A corporation may choose to place an excessive order at a cheaper price based on the marginal cost concept, ignoring plant capacity. It may entail extra labor and the expansion of manufacturing capacity, both of which might raise production costs and cause changes in fixed expenses. Often, the company will lose money.

  

8. Fixed costs are assumed to be constant at all levels of activity. Fixed expenses, it should be mentioned, tend to vary after a given degree of activity.

 

9. It is assumed that variable costs are proportional to output volume. They move in correlation with production volume in practice, although not always in exact proportions.

 

10. Sales income and variable expenses do not grow in lockstep with the production value. They are less proportional than they should be at greater levels of output. This is due to trade discounts, bulk buying economies, concessions for bigger sales, and so on. (source)

 

11. The distribution of fixed costs across a number of items is problematic, and it believes that business circumstances will remain constant, which is not the case. 

 

(Suggested blog: What is Impact Analysis?)