Everything you need to know about break-even analysis

Break even analysis is a vital part of a business. It is a valuable part of cost accounting and extends to include a larger analytical model called cost-volume-profit (CVP) analysis. Whenever you need to draft marketing assignments determining the profit and loss percentage of a business, you need to know ‘what is a break-even analysis’. This post aims to discuss everything about break-even-analysis and its significance in business. Read on to know more about break-even-analysis and how to do it.

What is Break-Even Analysis and How to Do It?

A break-even analysis can be referred to as a financial tool that helps you to understand the profitability of a product. It will analyse the condition of your business related to a new product or service. In other words, it’s a financial calculation for determining the number of products or services a company should sell to cover its costs (particularly fixed costs). Break-even is a situation where you are neither making money nor losing money, but all your costs have been covered. There is a definite mathematical formula to calculate break-even-analysis of a business. Scroll down to know break-even analysis definition in details.

Components of break-even analysis:

To understand the break-even analysis in details, you need to know about the two most essential components of the same.

Fixed cost: It is also known as an overhead cost. It determines the level of production in terms of quantity. The fixed costs include interests, salaries, rent, depreciation cost, labour etc.
Variable cost: The production costs that keep on fluctuating are known as variable costs. The costs of raw materials, packaging, fuel and miscellaneous can be referred to as variable in break-even analysis.

Now, as you know the two most essential components of the break-even margin, let us discuss the methods used to calculate the same.

Calculation of break-even analysis:

The main formula of the calculation is dividing the total fixed cost by the contribution per unit (price per unit less the variable costs). The formula of break-even analysis is mentioned below.

“Break-even point in quantity (BEP) = FC/ contribution per unit or FC/P-VC”

Contribution Margin:

Contribution margin is also an important part of break-even analysis. It deals with the contribution margin of different products and calculates the excess price between fixed cost and variable cost. The excess cost is known as the contribution margin. For example, if the price of a product is Rs.100, total variable costs are Rs. 60 per product and fixed cost are Rs. 25 per product, the contribution margin of the product is Rs. 40 (Rs. 100 – Rs. 60). This Rs. 40 represents the revenue collected to cover the fixed costs. In the calculation of the contribution margin, fixed costs are not considered.

As you know the definition of break-even analysis, read on to know the purpose of this analysis in the business.

What is the purpose of break-even analysis?

The purpose of break-even analysis is to boost the business process by analysing the cost accurately. It plays a significant role in different aspect of the business. Keep reading the next section to gain relevant insights.

While starting a new business: A break-even analysis is a must when you wish to start a new business. The purpose of the analysis is to find out whether the idea of starting a new business is viable. The analysis will help you to be realistic about the costs. It will also help you to decide your pricing strategy.
Launching a new product: Even if your business is quite old and experienced, a break-even analysis is a must. If you plan to launch a new product and realise that it requires significant expenditure, the analysis will help you to understand the assumed profit and loss margin.
Changing the business model: If you are about to change your business model (switch from wholesale business to retail business), you should do a break-even analysis. The costs would change considerably, and this will help you to figure out the selling prices that need to be changed.

Thus, it can be said that break-even analysis is an inevitable part of a business. Importance of break-even analysis cannot be denied at any cost.

Limitations of break-even analysis

There are certain limitations of break-even analysis that can determine the success or failure of an enterprise. Although you cannot deny the benefits of break-even analysis, the limitations do exist and can create different problems in a business. Some of the limitations of break-even analysis are discussed below.

Unrealistic assumptions:

Sometimes, the assumption of fixed and variable cost gets confusing. The result of the analysis can also be wrong, especially when the products are not sold at the same price at different levels of output. Therefore, the break-even analysis often fails to find out the actual fixed and variable price.

Lack of accurate results due to changing pricing strategies:

According to many reports, entrepreneurs often do not get the accurate results of break-even analysis after modifying the pricing strategy. This is indeed a limitation of the process.

Despite its limitations and other shortcomings, break-even analysis is an indispensable part of a business. The importance of break-even analysis is widely agreed upon by leading businessmen the world over.

Break-even analysis acts as a thin boundary between profit and loss in marketing:

Break-even analysis plays a significant role in marketing as it helps to find out the ‘target profit’ of a business based on the cost of operations. It is essential to calculate the volume of sales required to achieve the targeted profit. Here is how it acts as a deciding factor:

The break-even analysis helps the management to take appropriate decisions by revealing how the fixed cost of marketing will influence BEPs. It helps businesses to understand the implications of business expansion.
It helps the management to consider and examine those marketing activities that stimulate consumer purchasing and dealer effectiveness.
The break-even point helps the marketers to determine the extent up to which the advertisement cost will push up the total cost curve by the amount of advertisement expenditure.

The break-even analysis can be referred to as the thin boundary between profit and loss as a company’s marketing plans depend on it. Starting from the changes in price to techniques of production, every decision of a firm is based on the break-even analysis.

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