Break-Even Analysis

What Is a Break-Even Analysis?

Break-even analysis involves calculating and evaluating the margin of safety for an entity founded on the revenues obtained and related costs.

In other words, the analysis shows how many sales it takes to pay for the cost of doing business.

Evaluating different price levels relating to many levels of demand, the break-even analysis assumes what level of sales is essential to cover the business's total fixed costs. A demand-side calculation would give a seller significant insight into selling capacities.

How Break-Even Analysis Works

Break-even analysis helps assume the level of production or a targeted desired sales mix. The study is for a business's management’s use only, as the metric and computations are not employed by outside parties, such as investors, regulators, or financial institutions.

This type of analysis includes a computation of the break-even point (BEP). The break-even point is computed by dividing the total fixed costs of production by the price per individual unit less the variable costs of production. Fixed costs are costs that stay the same regardless of how many units are sold.

Break-even analysis looks at the level of fixed costs relative to the profit earned by each more unit produced and sold. In general, a business with lower fixed costs will have a lower break-even point of sale. For instance, a company with $0 of fixed costs will automatically have broken even upon the sale of the first product assuming variable costs do not exceed sales revenue.

Unique Considerations

Although investors are not especially interested in an individual business's break-even analysis on their production, they may utilize the computation to specify at what price they will break even on a trade or investment.

The computation is valuable when trading in or creating a strategy to buy options or a fixed-income security product.

Contribution Margin

The theory of break-even analysis is related to the contribution margin of a product. The contribution margin is the surplus between the selling price of the product and the total variable costs.

For instance, if an item sells for $200, the total fixed costs are $35 per unit, and the total variable costs are $120 per unit, the contribution margin of the product is $80 ($200 - $120). This $80 indicates the amount of revenue obtained to cover the remaining fixed costs.

Computations for Break-Even Analysis

The computation of break-even analysis may use two equations. In the first computation, divide the total fixed costs by the unit contribution margin. In the illustration above, presume the value of the entire fixed costs is $30,000.

With a contribution margin of $80, the break-even point is 375 units ($30,000 divided by $80). Upon the sale of 375 units, the expenditure of all fixed costs are exact, and the company will report a net profit or loss of $0.

Alternatively, the computation for a break-even point in sales dollars occurs by dividing the total fixed costs by the contribution margin ratio.

The contribution margin ratio is the contribution margin per unit divided by the sale price.

Returning to the illustration above, the contribution margin ratio is 40% ($80 contribution margin per item divided by $200 sale price per item).

Accordingly, the break-even point in sales dollars is $75,000 ($30,000 total fixed costs divided by 40%). Confirm this estimated by multiplying the break-even in units (375) by the sale price ($200), which equals $75,000.

Overview: • break-even examination says you how many units of a product must be sold to cover the fixed and variable costs of production. • the break-even point is assumed a gauge of the margin of safety.