A break-even analysis, which calculates at which point the revenue generated by a product or service matches the costs incurred, is essential when creating a business plan.
Discovering this break-even point helps companies assess risks and calculate the margin of safety required to ensure all costs are covered. Tweaking these metrics can also offer invaluable insights into the viability of individualproducts or which costs are eating into a company's profits the most.
Calculating the Break-Even Point (and Other Metrics)
There’s more than one way to calculate the break-even point,according to James R. Martin, Professor Emeritus, University ofSouth Florida. And it’s possible to use the analysis for a single product, multiple products or to determine the health of an organization as a whole.
Break-Even Analysis for a Single Product
Of the break-even analysis, Martin explained, “The equation indicates that total revenue, less fixed and variable costs, equals total contribution margin, and the break-even point is where total contribution margin is equal to totalfixed cost."
Written, the equation looks like this:
S = TFC + TVC
S is the target sales dollars, TFC represents total fixed costs and TVC is total variable costs.
This is the simplest way of looking at a break-even analysis — though the equation becomes more complex when involving multiple products. Plus, this equation does not factor in taxes when considering the target level of total revenue.
Break-Even Analysis for Multiple Products
The key difference between performing an analysis on a single versus multiple products, according to Martin, is the way the contribution margin is calculated.
He noted that, when working with multiple products, "we must use a weighted average contribution margin ratio to find the total mixed sales dollars." Then, you can find sales dollars for individual products by multiplying total mixedsales dollars by the mix ratios for each product.
The break-even equation for multiple products looks like this:
(WCMR)(S) = TFC
WCMR is the weighted average contribution margin ratio, S is total mixed sales dollars and TFC is total fixed costs.
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Determining Margin of Safety With the Break-Even Analysis
One of the key reasons businesses calculate the break-even point for their products or services is to identify the margin of safety.
Investopedia’s James Chen defined margin of safety as "the difference between actual sales and break-even sales."Companies rely on this metric to determine the number of sales needed to turn a profit — or how much of a decrease in sales could cause the business to become unprofitable.
Identifying Price Points With the Break-Even Analysis
Businesses can experiment with differing prices by altering the price they feed into the break-even analysis and graphing the results. This can also be done with costs — for instance, to determine whether ordering a higher volume ofmaterials at a lower price per item is advantageous.
To get a visual representation of the break-even point, draw a line marking out fixed costs. Next, add the total costs curve and the total revenue lines for each price point on the graph, with costs on the Y-axis and sales quantities onthe X-axis.
The break-even point is the point at which the revenue line intersects the costs curve. This information can be used alongside market research and sales projections to identify the most attractive pricing options.
The Limitations of a Break-Even Analysis
The break-even analysis helps determine whether a product will be commercially viable. Companies should note that there are some limitations to this calculation, and you cannot use it on its own.
According to Harvard Business Review’s Amy Gallo, break-even analysis operates on theassumption that a business will sell all of its stock. In addition, it relies on the company either having fixed costs or giving an accurate estimate of variable costs. If a business imports a lot of its materials, variable exchangerates could make it much harder to get a clear idea of costs.
Plus, the more extensive range of products sold and the more complex the supply chain, the less accurate a break-even analysis is likely to be. For this reason, it should be a tool for planning, not for making decisions.
Other assumptions the break-even analysis operates on include:
- Products have a single, fixed price with no discounts for bulk orders
- Costs and revenues are a straight line
- Taxes are assumed to be a fixed level
- The model is static, and variables change independently
- Competitors will not change their pricing strategy
- Costs and revenues are the only factors considered
These assumptions can become problematic for a business that's trying to analyze the break-even points of multiple products simultaneously. If multiple products use the same materials and the company is getting a discount for purchasingthose materials in bulk, the model may fall apart with smaller batches or fewer products.
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Using the Break-Even Analysis as a Tool for Your Business
As with many other forecasting tools, the results from a break-even analysis cannot be any more accurate than the information it's based on. Inaccurate estimates or optimistic sales predictions will be reflected in the results.
The primary use of the break-even analysis should be to model what-if scenarios rather than make decisions about the broader business. The fewer products the model focuses on, and the simpler the product is to produce, the more accurateit will be.
If a business has a good idea of the level of demand for its products — and that demand is stable throughout the year — the break-even analysis becomes more useful for calculating target profits and revenues.
Consider a business selling shoes at $100 per pair. It can purchase the required materials to make 1,200 pairs of shoes for $80,000. If the company sells 800 pairs of shoes, it will break even on those costs. The remaining 400 pairswill produce $100 of pure profit each, or $40,000.
This simplistic model doesn't consider taxes or the possibility of some shoes not selling and then getting discounted toward the end of the fashion season. However, it does give insight into how the model can be applied and why acompany may be willing to deeply discount some products later in the financial year, knowing their costs have already been covered.