Definition of 'Break-Even Analysis'

An analysis to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point.

Investopedia.com explains 'Break-Even Analysis' as:

Break-even analysis is a supply-side analysis; that is, it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels. For example, if it costs Rs. 50 to produce a widget, and there are fixed costs of Rs. 1,000, the break-even point for selling the widgets would be: If selling for Rs. 100: 20 Widgets (Calculated as 1000/ (100-50) =20) If selling for Rs. 200: 7 Widgets (Calculated as 1000/ (200-50) =6.7) In this example, if someone sells the product for a higher price, the break-even point will come faster. What the analysis does not show is that it may be easier to sell 20 widgets at Rs. 100 each than 7 widgets at Rs. 200 each. A demand-side analysis would give the seller that information.

What is a break-even analysis?

A break-even analysis is a valuable calculation that is helpful with both large and small business accounting. Essentially, the break-even analysis is a process that allows an entity to determine the amount of generated revenue must be produced in order to cover all the costs of operating the business. Conducting a periodic break-even analysis helps a company to position itself so that the business is competitive, is able to reach a point where the company becomes profitable, and also help the business prepare for expansion. The elements that go into a break-even analysis are very straightforward. The first step is to identify and account for all expenses associated with the business venture. This will include both fixed costs and variable costs. For purposes of arriving at the break-even analysis, taxes certainly are taken into consideration. Factors such as the cost of raw materials, labor, management of labor, plant operations and machinery, sales,

marketing, and packaging all go into the calculation. Even costs such as electricity and other utilities that are needed to operate facilities are considered to be costs associated with the overall business operation. The total cost of operation is compared to the total amount of sales that result as a part of the effort. Breaking down the sales into unit price increments, it becomes possible to determine how many individual units of the goods or services offered by the company must be sold in a given period to cover the production costs for that same period. The hope is that the break-even analysis will demonstrate that the company is selling enough units to not only cover all expenses, but also enough additional units to result in a net profit for the corporation. Performing a break-even analysis is helpful for several other reasons as well. The analysis can be used as a tool in forecasting overall projections for upcoming periods. Adjustments in operation or production can be made as a response to the findings of the analysis. In the event of a possible new product launch, the break-even analysis can use historical data to determine how many units of the new product will need to be sold in order to maintain the current level of profitability. In general, the break-even analysis can use past data as an important calculator of what could happen in the future.

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of production activity ("output"). OB represents the total fixed costs in the business. As output increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At low levels of output, Costs are greater than Income. At the point of intersection, P, costs are exactly equal to income, and hence neither profit nor loss is made.

How to do a break-even analysis?

If you can accurately forecast your costs and sales, conducting a breakeven analysis is a matter of simple math. A company has broken even when its total sales or revenues equal its total expenses. At the breakeven point, no profit has been made, nor have any losses been incurred. This calculation is critical for any business owner, because the breakeven point is the lower limit of profit when determining margins.

Defining Costs
There are several types of costs to consider when conducting a breakeven analysis, so here's a refresher on the most relevant. Fixed costs: These are costs that are the same regardless of how many items you sell. All start-up costs, such as rent, insurance and computers, are considered fixed costs since you have to make these outlays before you sell your first item. Variable costs: These are recurring costs that you absorb with each unit you sell. For example, if you were operating a greeting card store where you had to buy greeting cards from a stationary company for $1 each, then that dollar represents a variable cost. As your business and sales grow, you can begin appropriating labor and other items as variable costs if it makes sense for your industry.

Setting a Price
This is critical to your breakeven analysis; you can't calculate likely revenues if you don't know what the unit price will be. Unit price refers to the amount you plan to charge customers to buy a single unit of your product.

Psychology of Pricing:

Pricing can involve a complicated decision-making process on the part of the consumer, and there is plenty of research on the marketing and psychology of how consumers perceive price. Take the time to review articles on pricing strategy and the psychology of pricing before choosing how to price your product or service.

Pricing Methods:

There are several different schools of thought on how to treat price when conducting a breakeven analysis. It is a mix of quantitative and qualitative factors. If you've created a brand new, unique product, you should be able to charge a premium price, but if you're entering a competitive industry, you'll have to keep the price in line with the going rate or perhaps even offer a discount to get customers to switch to your company. One common strategy is "cost-based pricing", which calls for figuring out how much it will cost to produce one unit of an item and setting the price to that amount plus a predetermined profit margin. This approach is frowned upon since it allows competitors

who can make the product for less than you to easily undercut you on price. Another method, referred to by David G. Bakken of Harris Interactive as "price-based costing"encourages business owners to "start with the price that consumers are willing to pay (when they have competitive alternatives) and whittle down costs to meet that price." That way if you encounter new competition, you can lower your price and still turn a profit. There are always different pricing methods that can be used.

The formula:
Don't worry, it's fairly simple. To conduct your breakeven analysis, take your fixed costs, divided by your price, minus your variable costs. As an equation, this is defined as: Breakeven Point = Fixed Costs/(Unit Selling Price - Variable Costs) This calculation will let you know how many units of a product you'll need to sell to break even. Once you've reached that point, you've recovered all costs associated with producing your product (both variable and fixed). Above the breakeven point, every additional unit sold increases profit by the amount of the unit contribution margin, which is defined as the amount each unit contributes to covering fixed costs and increasing profits. As an equation, this is defined as:

Unit Contribution Margin = Sales Price - Variable Costs

Recording this information in a spreadsheet will allow you to easily make adjustments as costs change over time, as well as play with different price options and easily calculate the resulting breakeven point. You could use a program such as Excel's Goal Seek, if you wanted to give yourself a goal of a certain profit, say $1 million, and then work backwards to see how many units you would need to sell to hit that number. (This online tutorial will show you how to use Goal Seek.)

Calculators
There are several online calculators to assist you with your breakeven analysis: Case Western Reserve University offers a breakeven analysis calculator that includes a review of relevant microeconomic terms. This financial calculator allows you to chart your costs and profits appear in a graph.

 Inc.com offers a breakeven analysis calculator that requires a user to enter in total annual overhead and annual year-to-date sales and cost of sales, and lets the user delineate the period for the YTD calculations in terms of weeks.

Limitations
It is important to understand what the results of your breakeven analysis are telling you. If, for example, the calculation reports that you would break even when you sold your 500th unit, decide whether this seems feasible. If you don't think you can sell 500 units within a reasonable period of time (dictated by your financial situation, patience and personal expectations), then this may not be the right business for you to go into. If you think 500 units is possible but would take a while, try lowering your price and calculating and analyzing the new breakeven point. Alternatively, take a look at your costs - both fixed and variable - and identify areas where you might be able to make cuts. Lastly, understand that breakeven analysis is not a predictor of demand, so if you go into market with the wrong product or the wrong price, it may be tough to ever hit the breakeven point.