Break-Even Analysis

The concept of break-even

The concept of break-even

• The break-even point is the number of units that need to be sold for total costs to equal the sales revenue

  • It helps businesses understand the minimum level of sales or output they need to achieve in order to cover all costs

  • This helps business managers to make informed decisions about pricing and production volumes

Elements of a break-even analysis

• Fixed costs do not change, regardless of the level of production or sales

  • E.g. rent, salaries and insurance

• Variable costs vary with the level of production or sales

  • E.g. raw materials, direct labour costs, packaging and shipping costs

• Sales revenue is money gained from selling products, calculated using the formula

$\mathrm{Sales} \mathrm{revenue} = \mathrm{Number} \mathrm{of} \mathrm{items} \mathrm{sold} \times \mathrm{Selling} \mathrm{price}$

The break-even chart

The break-even chart

• Break-even charts show the number of units a business must sell in order to break-even

• In order to construct a break-even chart, the business needs to know the estimated fixed costs, variable costs and sales revenue

Calculating break-even output

Calculating break-even output

• The break-even point can be calculated using the formula

$\mathrm{Breakeven} \mathrm{point} = \frac{\mathrm{Fixed} \mathrm{costs}}{\left(\mathrm{Selling} \mathrm{price} - \mathrm{Variable} \mathrm{cost} \mathrm{per} \mathrm{unit}\right)}$

The margin of safety

The margin of safety

• The margin of safety is the amount by which the number of units sold is greater than the break-even point

  • The margin of safety provides useful information to a firm on how many sales they could lose before they start making a loss

• The margin of safety can be calculated using the following formula:

$\mathrm{Margin} \mathrm{of} \mathrm{safety} =\mathrm{Quantity} \mathrm{of} \mathrm{sales} - \mathrm{Break}-\mathrm{even} \mathrm{level} \mathrm{of} \mathrm{sales}$ 

• Businesses want their margin of safety to be as large as possible

  • This means that if demand for their products drops unexpectedly, the business will continue to make a profit