Break-Even Analysis Definition: Analysis Explained
What is break-even point analysis?
Break-even analysis entails calculating and checking the margin of safety for an entity based on the revenue collected and associated costs. In other words, the analysis shows the number of sales needed to pay the cost of doing business. By analyzing different price levels related to different levels of demand, break-even analysis determines the level of sales necessary to cover the total fixed costs of the firm. A demand side analysis would give the seller an insight into the selling capabilities.
The main takeaway:
- Break-even analysis tells you how many units of a product must be sold to cover both fixed and variable production costs.
- The break-even point is a measure of the margin of safety.
- Break-even analysis is used extensively, from stock and options trading to corporate budgeting for various projects.
How does break-even analysis work?
Break-even analysis is useful in determining the desired target level of production or sales mix. The study is for company management use only, as the metrics and calculations are not used by outside parties, such as investors, regulators or financial institutions. This type of analysis involves the break-even point (BEP) calculation. The break-even point is calculated by dividing the total fixed costs of production by the price per individual unit minus the variable costs of production. Fixed costs are costs that remain the same regardless of the number of units sold.
Break-even analysis looks at the level of fixed costs in relation to the profit generated by each additional unit produced and sold. Generally, a firm with lower fixed costs will have a lower selling point. For example, a company with $0 in fixed costs will automatically break even when the first product is sold assuming that the variable costs do not exceed sales revenue.
Although investors are not particularly interested in an individual firm’s break-even analysis on their output, they may use arithmetic to determine what price they will come up with in a trade or investment. The account is useful when trading or creating a strategy to buy options or a security product with a fixed income.
The concept of break-even analysis is concerned with the contribution margin of the product. Contribution margin is the increase between the selling price of a product and the total variable costs. For example, if an item sells for $100, the total fixed costs are $25 per unit, the total variable costs are $60 per unit, and the product contribution margin is $40 ($100 – $60). The $40 amount reflects the amount of revenue collected to cover remaining fixed costs, which are excluded when the contribution margin is determined.
Calculations for break-even analysis
The break-even analysis calculation may use two equations. In the first calculation, divide the total fixed costs by the unit contribution margin. In the example above, suppose the value of all fixed costs is $20,000. With a contribution margin of $40, the break-even point is 500 units ($20,000 divided by $40). When 500 units are sold, the payment of all fixed costs has been completed, and the company will report a net profit or loss of $0.
Instead, the break-even point in sales dollars is calculated by dividing the total fixed costs by the contribution margin ratio. Contribution margin ratio is the contribution margin per unit divided by the selling price.
Going back to the example above, the contribution margin is 40% ($40 contribution margin for each item divided by the $100 sale price for each item). Therefore, the break-even point in sales dollars is $50,000 ($20,000 total fixed costs divided by 40%). Confirm this by multiplying the break-even point in units (500) by the selling price ($100), which equals $50,000.