BREAKEVEN ANALYSIS

Learning Objectives:
• LO–1 Determine the break-even point.
• LO–2 Determine the level of sales needed to achieve a desired target profit.
• LO–3 Compute the margin of safety and explain its significance.
• LO–4 Compute the degree of operating leverage at a particular level of sales
and explain how it can be used to predict changes in net operating income.
• LO–5 Compute the break-even point for a multiproduct company and explain
the effects of shifts in the sales mix on contribution margin and the breakeven
point.

Breakeven point is a very important statistic in any business plan. It provides the planning team
with the tool to clearly define the way forward for any ongoing business or that which is still on the
drawing table. It helps to answer such questions as: what should be the ideal selling price of the
product, how many units of the product must be produced and sold to start making profit, how long
must the business be in existence to start making profit? The starting point of breakeven analyze
is to analyze the total costs of a business start up or executing an ongoing business; the two cost
variables – fixed and variable cost components must be identified. There are two approaches to
determining the breakeven point – the calculation and the graphical method. The calculation
method takes into account the contribution margin, the contribution margin ratio, the PV (profit-
volume) ratio, and the CVP (cost-volume-profit) analysis.

BREAKEVEN ANALYSIS
DEFINITION

Breakeven analysis is the business analysis performed to determine the probable point
when your business will be able to cover all its expenses and begin to make a profit.
Breakeven analysis can be done to determine either the breakeven point or the
breakeven volume.
 Breakeven Point:
It is the point in your business transactions when profit is exactly equal to the costs of
doing business. It is the point that above it, the business starts making profit (revenue
exceeds costs), all factors remaining constant. At the breakeven point: TOTAL
REVENUE = TOTAL COST

Breakeven point can be determined in terms of:

a. Time - how long will you be in business to be able to start making profit?
b. Units of sales – how many units of your product will you will be able to sell
before making profit?
c. Sales revenue – how much revenue do you need to generate to start
making profit?

NOTE: (1) All three perspectives are inter-related, therefore, the choice of which metric- time,
units of sales, or sales volume – to adopt is personal.
 (2) Breakeven point can be defined from the standpoint of each of these perspectives.

THE IMPORTANCE OF BREAKEVEN POINT:

1. It helps to identify your start-up costs

2. It also helps to determine the sales revenue needed to pay for ongoing business expenses.
3. Breakeven point analysis helps the business to determine its gross (or contribution)margin
4. Breakeven point analysis aids in developing proper product pricing strategy through
knowledge of its gross and contribution margin.
5. The breakeven point is an important reference point that enters into planning and carrying
out business activities.
6. A clear understanding of the sales volume needed to cover all costs (mentioned in point 2
above) helps the business to know:
(a) How many units the business must produce and sell in terms of
manufacturing business
(b) How many units to purchase and sell in the case of the merchandising
business
(c) In the services unit, the breakeven point indicates the number of billable
hours you must work in order to cover your costs.
7. It helps in examining the effects of on-going business processes or activities on the
organization’s profitability.
8. It helps in deciding about the substitution of new plants (and products).
9. It is an essential component of a business or marketing plan, and is normally incorporated
in the feasibility studies.

FACTORS TO BE CONSIDERED IN THE BEP ANALYSIS

CALCULATION OF BREAKEVEN POINT

To calculate the breakeven point,

1. You will need to identify your fixed and variable costs. As mentioned earlier, fixed costs
are expenses that do not vary with sales volume, such as rent and salaries. These
expenses must be paid regardless of sales, and are often referred to as overhead costs.
Variable costs fluctuate directly with sales volume, such as purchasing inventory, shipping,
and manufacturing a product. To determine your breakeven point, use the equation below:
Breakeven point = fixed costs/ (unit selling price – variable costs).
 This is the basic equation for determining the breakeven point.

2. You have to remember that Break-even is the point of zero loss or profit. At break-even
point, the revenues of the business are equal to its total costs and its contribution margin
equals its total fixed costs.
3. Break-even point can be calculated by
(a) equation method, which is also known as the contribution method,  
(b) graphical method.

4. The equation method: This is based on the cost-volume-profit (CVP) formula:

px = vx + FC + Profit

Where,
p is the price per unit,
x is the number of units,
v is variable cost per unit and
FC is total fixed cost.

Calculation

(a) BEP in Sales Units

At break-even point the profit is zero therefore the CVP formula is simplified to:
px = vx + FC

Solving the above equation for x which equals break-even point in sales units, we get:

FC
Break-even Sales Units = x =
p−v

(b) BEP in Sales Dollars

Break-even point in number of salesdollars is calculated using the following formula:

Break-even SalesDollars = Price per Unit × Break-even Sales
Units

(c) Example

Calculate break-even point in sales units and sales dollars from following information:
Price per Unit $15

Variable Cost per Unit $7

Total Fixed Cost $9,000

Solution
We have,
p = $15
 v = $7, and
FC = $9,000
Substituting the known values into the formula for breakeven point in sales units, we get:
Breakeven Point in Sales Units (x):
= 9,000 ÷ (15 − 7)
= 9,000 ÷ 8
= 1,125 units
Break-even Point in Sales Dollars = $15 × 1,125 = $16,875
(d) Cost Volume Profit Analysis

Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that is concerned with

the effect of sales volume and product costs on operating profit of a business. It deals with how
operating profit is affected by changes in variable costs, fixed costs, selling price per unit and the
sales mix of two or more different products.
CVP analysis has following assumptions:
1. All cost can be categorized as variable or fixed.
2. SALES PRICE per unit, variable cost per unit and total fixed cost are constant.
3. All units produced are sold.
Where the problem involves mixed costs, they must be split into their fixed and variable
component by High-Low Method, Scatter Plot Method or Regression Method.

CVP Analysis Formula:

The basic formula used in CVP Analysis is derived from profit equation:
px = vx + FC + Profit

In the above formula,

   p is price per unit;
   v is variable cost per unit;
   x are total number of units produced and sold; and
   FC is total fixed cost
Besides the above formula, CVP analysis also makes use of following concepts:

Contribution Margin (CM):

Contribution Margin (CM) is equal to the difference between total sales (S) and total variable cost
or, in other words, it is the amount by which sales exceed total variable costs (VC). In order to
make profit the contribution margin of a business must exceed its total fixed costs. In short:
CM = S − VC

Unit Contribution Margin (Unit CM)

Contribution Margin can also be calculated per unit which is called Unit Contribution Margin. It is
the excess of SALES PRICE per unit (p) over variable cost per unit (v). Thus:
Unit CM = p − v
Contribution Margin Ratio (CM Ratio)

Contribution Margin Ratio is calculated by dividing contribution margin by total sales or unit CM by
price per unit.
Break-even Point Contribution Margin Approach

The contribution margin approach to calculate the break-even point (i.e. the point of zero profit or
loss) is based on the CVP analysis concepts known as contribution margin and contribution
margin ratio. Contribution margin is the difference between sales and variable costs. When
calculated for a single unit, it is called unit contribution margin. Contribution margin ratio is the ratio
of contribution margin to sales.
In this method simple formulas are derived from the CVP analysis equation by rearranging the
equation and then replacing certain parts with Contribution Margin formulas.

Contribution Approach Formulas

(a) BEP in Sales Units

We learned that, at break-even point, the CVP analysis equation is reduced to:
px = vx + FC

Where p is the price per unit, x is the number of units, v is variable cost per unit and FC is total
fixed cost.
Solving the above equation for x (i.e. Break-even sales units):
Break-even Sales Units = x = FC ÷ ( p − v )

Since unit contribution margin (Unit CM) is equal to unit SALE PRICE (p) less unit variable cost
(v), So,
Unit CM = p − v

Therefore,
Break-even Sales Units = x = FC ÷ Unit CM

(b) BEP in Sales Dollars

Break-even point in dollars can be calculated via:

Break-even Sales Dollars = Price per Unit × Break-even Sales
; or
Units

Break-even Sales Dollars = FC ÷ CM Ratio

Example
Calculate the break-even point in units and in sales dollars when SALES PRICE per unit is $35,
variable cost per unit is $28 and total fixed cost is $7,000.
Solution
Contribution Margin per Unit = ( $35 − $28 ) = $7
Break-even Point in Units = $7,000 ÷ $7 = 1,000
Break-even Point in Sales Dollars = 1,000 × $35 or $7,000 ÷ 20% = $35,000

THE GRAPHICAL METHOD

Breakeven point analysis is very crucial to the success of a business venture. It determines the
point in the course of business processes when the business can afford to stand on its feet. It is the
point in time or units of sales, or cash flow when the profit is exactly equal to loss. All factors
remaining the same, the business is supposed to make profit from the breakeven point onwards.
The breakeven point is a probabilistic factor in analysing the health of a business.
From the foregone analysis, it can be appreciated that cost is a very important factor in the
determination of breakeven point. Therefore, any business venture, whether in proposition or
ongoing, must take pains to carefully analyse her costs variables to discover all cost components –
fixed and variable – so as to be sure that the breakeven point determined can stand the test of the
vagaries or uncertainties of the business world.