Don Honorio Ventura State University

Module 3

Break-Even Analysis

INTRODUCTION

Break-even analysis is of vital importance in determining the practical application of cost

functions. It is a function of three factors, i.e., sales volume, cost and profit. It aims at classifying
the dynamic relationship existing between total cost and sale volume of a company. Hence it is
also known as “cost-volume-profit analysis”. It helps to know the operating condition that exists
when a company ‘breaks-even’, that is when sales reach a point equal to all expenses incurred
in attaining that level of sales.

OBEJCTIVES

At the end of this module, students are expected to;

1. Define break-even analysis.

2. Understand the used and limitations of break-even analysis
3. Compute break-even and contribution margin.

1. What is Break-even Analysis

A break-even analysis is a financial tool which helps a company to determine the stage
at which the company, or a new service or a product, will be profitable. In other words, it is a
financial calculation for determining the number of products or services a company should sell
or provide to cover its costs (particularly fixed costs). Break-even is a situation where an
organisation is neither making money nor losing money, but all the costs have been covered.
Break-even analysis is useful in studying the relation between the variable cost, fixed cost and
revenue. Generally, a company with low fixed costs will have a low break-even point of sale.

Figure 3.1 Break-even Chart

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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

2. Components of Break-even Analysis

2.1.Fixed Cost

Fixed costs are those business costs that are not directly related to the level of
production or output. In other words, even if the business has a zero output or high output, the
level of fixed costs will remain broadly the same. In the long-term fixed costs can alter - perhaps
as a result of investment in production capacity (e.g. adding a new factory unit) or through the
growth in overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

2.2.Variable Cost

Variable costs are those costs which vary directly with the level of output. They
represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-
related costs such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable
costs.

Direct variable costs are those which can be directly attributable to the production of
a particular product or service and allocated to a particular cost centre. Raw materials and
the wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary
with output. These include depreciation (where it is calculated related to output - e.g. machine
hours), maintenance and certain labour costs.

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2.3.Contribution Margin

Contribution margin is a product’s price minus all associated variable costs,

resulting in the incremental profit earned for each unit sold. The total contribution margin
generated by an entity represents the total earnings available to pay for fixed expenses and
to generate a profit. The contribution margin concept is useful for deciding whether to allow
a lower price in special pricing situations. If the contribution margin at a particular price
point is excessively low or negative, it would be unwise to continue selling a product at
that price. It is also useful for determining the profits that will arise from various sales
levels.

2.4. Contribution Margin Ratio

The contribution margin ratio is the difference between a company's sales and
variable expenses, expressed as a percentage. The total margin generated by an entity
represents the total earnings available to pay for fixed expenses and generate a profit.
When used on an individual unit sale, the ratio expresses the proportion of profit generated
on that specific sale. The contribution margin should be relatively high, since it must be
sufficient to also cover fixed expenses and administrative overhead. Also, the measure is
useful for determining whether to allow a lower price in special pricing situations. If the
contribution margin ratio is excessively low or negative, it would be unwise to continue
selling a product at that price point, since the company would have considerable difficulty
earning a profit over the long term.

3. Assumptions of Break-even Analysis

The break-even analysis is based on the following set of assumptions:

a. The total costs may be classified into fixed and variable costs. It ignores semi-
variable cost.
b. The cost and revenue functions remain linear.
c. The price of the product is assumed to be constant.
d. The volume of sales and volume of production are equal.
e. The fixed costs remain constant over the volume under consideration.
f. It assumes constant rate of increase in variable cost.
g. It assumes constant technology and no improvement in labour efficiency.

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4. Calculation of Break-even Analysis

The break-even point formula is calculated by dividing the total fixed costs of production
by the price per unit less the variable costs to produce the product.

Formula:

Since the price per unit minus the variable costs of product is the definition of
the contribution margin per unit, simply rephrase the equation by dividing the fixed costs by the
contribution margin

Formula:

This computes the total number of units that must be sold in order for the company to
generate enough revenues to cover all of its expenses.

Next, the break-even formula in sales dollars is calculated by multiplying the price of
each unit by the answer from the first equation.

Formula:

This will provide the total dollar amount in sales needed to achieve in order to have zero
loss and zero profit. Now, compute the total number of units that need to be sold in order to
achieve a certain level profitability without break-even calculator.

First, take the desired dollar amount of profit and divide it by the contribution margin
per unit. The computes the number of units needed to sell in order to produce the profit
without taking in consideration the fixed costs. Then add back in the break-even point
number of units.

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Formula:

Example 1:

Barbara is the managerial accountant in charge of a large furniture factory’s production

lines and supply chains. She isn’t sure the current year’s couch models are going to turn a profit
and what to measure the number of units they will have to produce and sell in order to cover their
expenses and make at $500,000 in profit. Here are the production stats. Compute for the (a) break-
even point in unit, (b) break-even point in dollar sales, and (c) number of units to produce the
desired profit given the following data.

 Total fixed costs : $500,000

 Variable costs per unit : $300
 Sale price per unit : $500
 Desired profits : $200,000

Step 1: First, calculate the break-even point per unit, so we will divide the $500,000 of fixed
costs by the $200 contribution margin per unit ($500 – $300)
Formula:

Solution:

The Barbara’s factory will have to sell at least 2,500 units in order to cover its fixed and
variable costs. Anything it sells after the 2,500 mark will go straight to the CM since the fixed
costs are already covered.

Step 2: Next, Barbara can translate the number of units into total sales dollars by multiplying
the 2,500 units by the total sales price for each unit of $500.
Formula:

Solution:

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Now Barbara can go back to the board and say that the company must sell at least 2,500
units or the equivalent of $1,250,000 in sales before any profits are realized

Step 3: She can also take it a step further and use a break-even point calculator to compute
the total number of units that must be produced in order to meet her $200,000 profitability
goal by dividing the $200,000 desired profit by the contribution margin then adding the total
number of break-even point units.
Formula:

Solution:

5. Use of Break-even Analysis

 It helps to determine remaining/unused capacity of the company once the breakeven is

reached. This will help to show the maximum profit on a particular product/service that
can be generated.
 It helps to determine the impact on profit on changing to automation from manual (a fixed
cost replaces a variable cost).
 It helps to determine the change in profits if the price of a product is altered.
 It helps to determine the amount of losses that could be sustained if there is a sales
downturn.

Additionally, break-even analysis is very useful for knowing the overall ability of a
business to generate a profit. In the case of a company whose breakeven point is near to the
maximum sales level, this signifies that it is nearly impractical for the business to earn a profit
even under the best of circumstances. Therefore, it’s the management responsibility to monitor the
breakeven point constantly. This monitoring certainly reduces the breakeven point whenever
possible.

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