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A break-even analysis determines the sales volume needed to cover fixed and variable costs, indicating the point at which a business neither makes a profit nor incurs a loss.
What Is a Break-Even Analysis?
A break-even analysis compares income from sales to the fixed costs of doing business. The five components of a break-even analysis are fixed costs, variable costs, revenue, contribution margin, and the break-even point (BEP).
When companies calculate the BEP, they identify the amount of sales required to cover all fixed costs before profit generation can begin. The BEP formula can determine the BEP in product units or sales dollars.
Key Takeaways:
- A break-even analysis is used for different reasons, from stock and options trading to corporate budgeting for various projects.
- Using the break-even point (BEP) formula, businesses can determine how many units or dollars of sales cover the fixed and variable production costs.
- Once a company meets the BEP, subsequent sales will exceed expenses and profits can be generated.
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Investopedia / Paige McLaughlin
How a Break-Even Analysis Works
A break-even analysis looks at fixed costs relative to the profit earned by each additional unit produced and sold.
A firm with lower fixed costs will have a lower break-even point of sale, while one with $0 of fixed costs will automatically have broken even with the sale of the first product, assuming variable costs don’t exceed sales revenue.
Fixed costs remain the same regardless of how many units are sold. Examples of fixed and variable costs include:
| Fixed Costs | Variable Costs |
| Rent | Raw materials |
| Taxes | Production supplies |
| Insurance | Utilities |
| Wages or salaries | Packaging |
Break-Even Point (BEP) Formula
A break-even analysis involves a calculation of the break-even point (BEP). The BEP formula divides the total fixed production costs by the price per individual unit less the variable cost per unit.
BEP = Total fixed costs / (Price per unit – Variable cost per unit)
Calculating Contribution Margin and BEPs
Contribution Margin
A product’s contribution margin is the difference between the selling price of the product and its variable costs. So, relative to the BEP formula above, you could also say that the BEP = Total fixed costs / Contribution margin.
Contribution margin = Item price – Variable cost per unit
For example, if an item sells for $100, with fixed costs of $25 per unit, and variable costs of $60 per unit, the contribution margin is:
$40 = $100 – $60
This $40 reflects the revenue collected to cover the remaining fixed costs, which are excluded when figuring the contribution margin.
BEP in Units
To find the total units required to break even, divide the total fixed costs by the unit contribution margin.
BEP (Units) = Total fixed costs / Contribution margin
Assume total fixed costs are $20,000. With a contribution margin of $40 (shown above), the BEP is:
500 units = $20,000 / $40
Upon selling 500 units, the payment of all fixed costs is complete, and the company will report a net profit or loss of $0.
BEP in Dollars
To calculate the BEP in sales dollars, you’ll need to divide the total fixed costs by the contribution margin ratio. So, first, you must determine the ratio:
Contribution margin ratio = Contribution margin per unit / Item price
Continuing with the example above, the contribution margin ratio is:
40% = ($40 / $100) x 100
Now, as noted just above, to calculate the BEP in dollars, divide total fixed costs by the contribution margin ratio.
BEP (Sales dollars) = Total fixed costs / Contribution margin ratio
$50,000 = $20,000 / 40%
Important
In accounting, the margin of safety is the difference between actual sales and break-even sales. Managers utilize the margin of safety to know how much sales can decrease before the company or project becomes unprofitable.
Who Calculates BEPs?
- Entrepreneurs
- Financial analysts
- Investors
- Stock and option traders
- Businesses
- Government agencies
Although investors may be uninterested in an individual company’s break-even analysis of production, they may use the calculation to determine at what price they’ll break even on a trade or investment. The calculation is useful when trading in or creating a strategy to buy options or a fixed-income security product.
Why a Break-Even Analysis Matters
- Performance metric: The break-even analysis is a financial performance tool that helps businesses ascertain where they stand in achieving their goals.
- Pricing: With a clear understanding of their cost structure and break-even numbers, companies can set prices for their products that cover their fixed and variable costs and provide a reasonable profit margin.
- Decision-making: When it comes to new products and services, operational expansion, or increased production, businesses can chart their profit to sales volume and use a break-even analysis to help them make informed decisions about those activities.
- Cost reduction: A break-even analysis helps businesses to pinpoint areas where they can reduce costs to increase profitability.
What Are Some Limitations of a Break-Even Analysis?
A break-even analysis assumes that the fixed and variable costs remain constant over time. However, costs may change due to factors like inflation, changes in technology, and changes in market conditions. It also assumes that there’s a linear relationship between costs and production. A break-even analysis ignores external factors such as competition, market demand, and changes in consumer preferences.
What Are the Components of a Break-Even Analysis?
There are five components of a break-even analysis: fixed costs, variable costs, revenue, contribution margin, and the break-even point (BEP).
Why Is the Contribution Margin Important in a Break-Even Analysis?
The contribution margin represents the revenue required to cover a business’ fixed costs and contribute to its profit. With the contribution margin calculation, a business can determine the BEP and where it can begin earning a profit.
How Do Businesses Use the BEP in a Break-Even Analysis?
The BEP helps businesses with pricing decisions, sales forecasting, cost management, and growth strategies. A business wouldn’t use break-even analysis to measure its repayment of debt or how long that repayment will take.
The Bottom Line
The break-even analysis, or the comparison of sales to fixed costs, is a tool used by businesses and stock and option traders. It’s essential for determining the minimum sales volume required to cover total costs and break even. Beyond the break-even point (BEP), it’s all profit. That is, sales will exceed expenses.
A break-even analysis helps businesses choose pricing strategies, and manage costs and operations. In stock and options trading, a break-even analysis helps determine the minimum price movements required to cover trading costs and make a profit. Traders can use a break-even analysis to set realistic profit targets, manage risk, and make informed trading decisions.
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