Break-even analysis is a method for determining how costs, profits and revenues are linked with volumes of sales.
Break-even point occurs when total revenues received are equivalent to the total costs associated with creating and selling a product or, in other words, the time at which it stops costing you money to produce a product and you start making money. This aids businesses in deciding whether it is lucrative to sell a product.
Break-even analysis is also sometimes referred to as cost-profit-volume analysis, or CPV.
What is it used for?
Break-even analysis is used for budgeting purposes. In this area, it can be used to figure out the number of sales required in order to break even. It can be used for forecasting, namely to calculate how costs, revenues and profits are linked to sales volumes.
It can also be used for important strategic decisions, such as pricing. For example, prices can be raised in order to break-even more rapidly or, if prices are raised, then production capacity could be increased, provided that sales can be maintained.
How do I use it?
To carry out a break-even analysis, you will need the following figures:
- Fixed costs – the total costs required to produce the first item
- Variable unit cost – any costs that vary, directly relating to the production of an additional item of the same product
- Expected unit sales – how many of the product you expect to sell over a given time period
- Unit price – the price of the product
- Total variable cost – this is expected unit sales multiplied by variable unit cost
- Total cost – fixed cost plus total variable cost
- Total revenue – expected unit sales multiplied by unit price
- Profit – total revenue minus total costs (this could also be a loss).
You can then determine the break-even point by figuring out the sum of unit price minus variable unit cost and dividing fixed cost by that figure.
What are its limitations?
Break-even analysis is not the only factor affecting whether companies should continue with or drop products. A company might decide to sell a product that might only just break-even or result in a loss – for example, as a loss-leader in order to generate more interest in the company’s other products. On the flip side, product lines may be stopped because they are not a good fit with the organisation’s product strategy.
There are other limitations with this type of analysis, as it relies on several assumptions which may not be correct:
- That fixed costs are constant
- That sales are constant, though it does not give you an idea of what sales will be like for products at different prices
- That the number of items sold will be the same as the number of items produced (a big assumption)
- That the sales mix is constant in companies which provide more than one product.
Other similar models