Break even analysis (BEA) is used to determine when your business will be able to cover all its expenses and begin to make a profit. It is important to identify your start up costs, which will help you determine the sales revenue needed to pay ongoing business expenses and fund the working capital requirements of the firm in the longer run. A break even analysis is a key part of any good business plan; it can also be helpful even before you decide to write a business plan and figure out if a particular business opportunity is worth pursuing. Long after your company is up and running, it can remain helpful as a way to figure out the best pricing structure for your products. BEA, is a supply side analysis, which means it only analyzes the costs of sales, it does not analyze how demand may be affected at different price levels.
Breakeven point (BEP) is the point at which revenues equal expenses. In investing, BEP is the point at which gains equal losses. It is also more popularly known as “the point of indifference” Calculating the breakeven point of a company is proved to be a simple and quantitative tool for the manager, BEP is extremely useful to the managers when making important decisions in business, for example preparing competitive bids, setting prices and applying for loans. The manager can also take various decisions to discontinue the product, improve marketing strategies or even re-price the product to stimulate demand.
How does it work ?
The break even point can be explained through the following example:
Statement: A business produces a product, which it sells at £ 9 per unit. The variable cost of each unit is £ 4 and the business faces fixed costs per year of £ 1 million. The business currently produces and sells 500,000 units.
Question: What is the breakeven level of output and what profit will the business make if it sells all of its output ?
Solution: The B.E.P is = Total Fixed Cost/Contribution per unit
= £ 1 million/ £9 – £4
= 200,000 units.
In other words, the business will need to produce 200,000 units before it breaks-even.
Any level of output below 200,000 will yield a loss
Any level of output above 200,000 will yield a profit
The profit is equal to TR – TC (total revenue – total cost)
The total revenue is calculated by multiplying the selling price with number of units sold. In this example it is £ 9 x 500,000 = £ 4.5 million (TR)
The total cost is calculated by adding the total fixed costs and total variable costs, in this example the total variable costs is 4 x 500,000 = £ 2 million and total fixed costs is £ 1 million. Hence TC= TFC+TVC= £ 3 million.
The profit is determined by the formula TR – TC (total revenue – total cost)
= £ 4.5 million – £ 3 milli 1.5 million, based on the following conclusions we can draw a break even chart with the answers.
The ‘X’ axis is labelled as output
Tge ‘Y’ axis is labelled as Costs, Revenues and profits
Although, the BEA is an useful tool for any manager, it has several assumptions which may sound unrealistic, some of them are:
ü It assumes the TFC, TC and TR are assumed to be linear, which is highly unrealistic
ü It assumes the selling price is constant, in reality the selling price will vary from customer to customer and across different regions
ü It assumes the business has a single product line and sell all of its output, but in reality, very few businesses will be able to do this.
Since any company is trying to break even, they could adjust a number of these inputs to attempt to break even. The easiest input that can be changed is the unit price, by rising the unit price the BEP will come down. The other inputs cannot be adjusted as the prices of variable costs will tend to vary among different regions, labor and supply. Fixed costs remain the same during production, and by increasing equipments or by introducing a new technology the variable costs can be reduced, thereby controlling the unit price.
The break even analysis will help an enterpreneur to determine the sales quantity or number of products that need to be sold in order for the business to generate substantial revenues to cover its expenses. It allows an enterpreneur to know how much profit he can earn at different sales volumes, BEA allows the entrepreneur to set an optimum price for the product, by setting different price levels and evaluating the break even analysis at each level will help an entrepreneur to study the effect of each price level, in relation to other major factors such as consumer affordability, inventory management and price competitiveness.