How to Get the Most Out of Your Break-Even Analysis
According to Harvard Business School (2004), a break-even analysis is a financial tool that examines a company’s revenue and costs to determine the number of sales needed to make a profit. The number of sales is called the break-even point (BPE) (Noreen, et al, 2017) and can be calculated using the following formula:
Break-even Point = Fixed Costs / Contribution Margin
or
Break-even Point = Fixed Costs / (Net Unit Revenue – Unit Variable Costs)
A company can employ a break-even analysis for several purposes, including business plan projections, goal-setting, price-setting, cost analysis for materials, and new product analysis.
In order to account for all possible production levels, the break-even analysis must include both fixed and variable costs at a given production level. Variable cost per unit likely stays the same, but higher production means more total variable costs. At the same time, total fixed costs likely stays the same, but higher production will mean higher fixed costs per unit.
This distinction is important if a company wants to use break-even analysis to explore cost-cutting measures, price-changing strategies, or other efficiencies (Noreen, et al, 2017). As an example, let us say that a company has a relatively static market and can rely on a limited number of sales at a certain price. To be able to make a profit with these sales, they will need to lower costs to make sure the BPE is below the maximum sales point. But if they only lower variable costs, then it is likely that they will not be able to lower the BPE. They will need to lower fixed costs to ensure their BPE falls below the necessary threshold.
References
Harvard Business School (2004). Breakeven analysis and operating leverage: understanding cash flow. Retrieved from https://hbsp.harvard.edu/download?url=%2Fcourses%2F688826%2Fitems%2F5252BC-PDF-ENG%2Fcontent&metadata=e30%3D
Noreen, E., Brewer, P., Garrison, R. (2017). Managerial accounting for managers. Retrieved from McGraw Hill Connect
About Author
