Introduction

Break-even analysis is a technique widely used by production management and management

accountants. It is based on categorizing production costs between those which are "variable"
(costs that change when the production output changes) and those that are "fixed" (costs not
directly related to the volume of production).

Total variable and fixed costs are compared with sales revenue in order to determine the level of
sales volume, sales value or production at which the business makes neither a profit nor a
loss (the "break-even point").

The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at various levels
of activity shown on the same chart as the variation of income (or sales, revenue) with the same
variation in activity. The point at which neither profit nor loss is made is known as the "break-
even point" and is represented on the chart below by the intersection of the two lines:

In the diagram above, the line OA represents the variation of income at varying levels of
production activity ("output"). OB represents the total fixed costs in the business. As output
increases, variable costs are incurred, meaning that total costs (fixed + variable) also increase. At
low levels of output, Costs are greater than Income. At the point of intersection, P, costs are
exactly equal to income, and hence neither profit nor loss is made.
Fixed Costs

Fixed costs are those business costs that are not directly related to the level of production or
output. In other words, even if the business has a zero output or high output, the level of fixed
costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of
investment in production capacity (e.g. adding a new factory unit) or through the growth in
overheads required to support a larger, more complex business.

Examples of fixed costs:

- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs

Variable costs are those costs which vary directly with the level of output. They represent
payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs
such as commission.

A distinction is often made between "Direct" variable costs and "Indirect" variable costs.

Direct variable costs are those which can be directly attributable to the production of a particular
product or service and allocated to a particular cost centre. Raw materials and the wages those
working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with output.
These include depreciation (where it is calculated related to output - e.g. machine hours),
maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of categorizing
business costs, in reality there are some costs which are fixed in nature but which increase when
output reaches certain levels. These are largely related to the overall "scale" and/or complexity of
the business. For example, when a business has relatively low levels of output or sales, it may
not require costs associated with functions such as human resource management or a fully-
resourced finance department. However, as the scale of the business grows (e.g. output, number
people employed, number and complexity of transactions) then more resources are required. If
production rises suddenly then some short-term increase in warehousing and/or transport may be
required. In these circumstances, we say that part of the cost is variable and part fixed.

 
The Break-even Analysis depends on three key assumptions:

Average per-unit sales price (per-unit revenue):

This is the price that you receive per unit of sales. Take into account sales discounts and special
offers. Get this number from your Sales Forecast. For non-unit based businesses, make the per-
unit revenue $1 and enter your costs as a percent of a dollar. The most common questions about
this input relate to averaging many different products into asingle estimate. The analysis requires
a single number, and if you build your Sales Forecast first, then you will have this number. You
are not alone in this, the vast majority of businesses sell more than one item, and have to average
for their Break-even Analysis.
 

Average per-unit cost:

This is the incremental cost, or variable cost, of each unit of sales. If you buy goods for resale,
this is what you paid, on average, for the goods you sell. If you sell a service, this is what it costs
you, per dollar of revenue or unit of service delivered, to deliver that service. If you are using a
Units-Based Sales Forecast table (for manufacturing and mixed business types), you can project
unit costs from the Sales Forecast table. If you are using the basic Sales Forecast table for retail,
service and distribution businesses, use a percentage estimate, e.g., a retail store running a 50%
margin would have a per-unit cost of .5, and per-unit revenue of 1.
 

Monthly fixed costs:

Technically, a break-even analysis defines fixed costs as costs that would continue even if you
went broke. Instead, we recommend that you use your regular running fixed costs, including
payroll and normal expenses (total monthly Operating Expenses). This will give you a better
insight on financial realities. If averaging and estimating is difficult, use your Profit and Loss
table to calculate a working fixed cost estimate—it will be a rough estimate, but it will provide a
useful input for a conservative Break-even Analysis
BREAK EVEN POINT---
The breakeven point is the point at which income and expenses are exactly equal. The business
has not made a profit or a loss, but you have recovered all business expenses

Another way to look at it, is that at the break even point each unit you have sold has paid for
itself (cost of goods sold (COGS) or variable costs) and contributed a share toward the total
operating expenses (fixed costs or overheads) for the period.

The break even analysis is critical for any business owner, because you will know exactly when
you begin to make a profit. The break even point is the lowest limit when determining profit
margins. You will know how low a price you can offer, and the effects of discounting on your net
profit.

You can calculate the break even for any period of time – a year, quarter, month, week, day –
just make sure all three estimates relate to the same time period.

The formula used to calculate the number of units for break even:

Number of units= Total fixed costs / (unit selling price minus variable unit cost)

The formula used to calculate the value in dollars for breakeven:

Dollar value = total fixed costs / (1 minus (total variable costs divided by total sales))

Fixed costs are paid whether or not you make any sales and are also known as business
expenses, overheads, outgoings or operating expenses. Fixed costs do not vary in proportion to
sales or production.
Variable costs vary directly with the volume of sales or production and are also known as the
cost of goods sold (COGS), cost of sales, or direct costs of sales.

Some costs are semi-variable, that is, they contain both a fixed component and a variable
component. Semi-variable costs can be incurred without sales, but are affected by volumes of
trade. For example, telephone charges have a fixed line rental component and a call charge
component that will increase with increased sales.

The graphic method of analysis (below) helps you in understanding the

concept of the break-even point. However, the break-even point is found
faster and more accurately with the following formula:

Q = FC / (UP - VC)

Where;

Q = Break-even Point, i.e., Units of production (Q),

FC = Fixed Costs,

VC = Variable Costs per Unit

UP = Unit Price

Therefore,

Break-Even Point Q = Fixed Cost / (Unit Price - Variable Unit Cost)

Margin of safety (MOS) is the excess of budgeted or actual sales over the break even
volume of sales. It stats the amount by which sales can drop before losses begin to be
incurred. The higher the margin of safety, the lower the risk of not breaking even.

Formula of Margin of Safety:

The formula or equation for the calculation of margin of safety is as follows:

[Margin of Safety = Total budgeted or actual sales − Break even sales]

The margin of safety can also be expressed in percentage form. This percentage is obtained
by dividing the margin of safety in dollar terms by total sales. Following equation is used for
this purpose.

[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales

MARGIN OF SAFETY----
Margin of safety represents the strength of the business. It enables a business to know what is the
exact amount he/ she has gained or lost and whether they are over or below the breakeven point.
[3]

Margin of safety = (current output - breakeven output)

Margin of safety% = (current output - breakeven output)/current output x 100

If P/V ratio is given then profit/ PV ratio

= In unit Break Even = FC / (SP − VC)

Where FC is Fixed Cost, SP is Selling Price and VC is Variable Cost

1.
 Breakeven Analysis

Breakeven analysis is an extremely powerful tool for any business manager.

Breakeven analysis estimates the minimum level of performance (breakeven
point) needed to cover all relevant costs.

Real world examples would include:

- a restaurant manager knowing how many customers he needs to serve per day
to cover his total costs
- a veterinarian knowing the she needs to pregnancy check at least 100 cows
per week to cover her costs

- a greenhouse manager knowing that she needs to sell at least 85% of her
poinsettias during December to cover the costs

- a cattleman knowing that he needs to get at least $95/cwt for his feeder
calves

- a dairyman knowing that he needs to get 200 cwts of milk per cow

- a landscaper knowing that she needs to do 75 jobs per year to justify buying a
tractor versus leasing one.

There are 100s of ways to calculate breakeven points, so there is not one standard
formula that fits all situations. But, in general, the formula is to divide total fixed
costs per unit of time (per year, per month) by the “margin”, or the per-unit profit
(or cost savings). Here are some general breakeven formulas:
 Profit = Price/unit x Units – VC/unit x Units – FC

Breakeven Units per year: Total Fixed Costs of Production

(Selling price/unit – VC/Unit)

Breakeven Acres Per Year (Owning vs Custom Hiring): Total Fixed Costs/year

(Custom Rate/acre – VC/acre)

Breakeven Weight per animal: Total Fixed Costs of Production per animal

(Selling price/lb – VC/lb)

Breakeven Yield per crop: Total Fixed Costs of Production

(Price/bushel – VC/bushel)

The following pages show several examples of calculating breakevens. This is a

very important aspect of management!! Learn how to calculate the breakevens
that are relevant to your industry or enterprise!