BREAK EVEN ANALYSIS-Why you need to determine it.
Looking in the direction of economics and business, specifically when referring to cost accounting, the break-even point (BEP) is the point at which the cost or expenses of providing either goods or services and revenue derived from selling such product or service are equal. In this sense, there is no loss or gain, and one has broken even. A profit or loss has not been made. Even though opportunity costs have been rewarded and capital has established the risk-adjusted, expected return. In other words, it is the point at which the total revenue of a business exceeds its total costs, and the business begins to create wealth instead of consuming it. We can represent as seen on BEP graphs; it is graphically seen as the point where the total revenue and total cost curves meet. In the linear case the break-even point is equal to the fixed costs divided by the contribution margin per unit.
The break-even point is attained when the made profits is same with the total costs accrued until the date of profit generation. Creating the break-even point aids businesses in setting plans for the levels of production it is required to maintain so as to be profitable in his chosen industry.
In another way we can say a company’s break-even point is the quantity of sales or revenues that it is essential for him to generate in order to meet up with its expenses. In other words, it is the point at which the company neither makes a profit nor suffers a loss on the transaction they embark on. Break-even analysis deals with the calculation and investigation of the margin of safety for an entity based on the revenues gathered and the costs associated to it. When different price level Analysis relating to various levels of demand matters, a business uses break-even analysis to fix what level of sales are needed to cover the company’s total fixed costs. A demand-side analysis would give a seller noteworthy insight regarding selling competences.
When we calculate break-even point (through break-even analysis) it is done to provide a simple, yet powerful quantitative tool for finance experts who needs the information. In its meekest form, break-even analysis delivers consciousness into whether revenue from a product or service has the capability to cover the related costs of production of the product or service. This information can be used in making a wide range of business decisions, including, applying for loans, preparing competitive bids, and the setting of product or service prices.
Looking into the background of Break-Even point, the Encyclopedia on social sciences and business made it known that break-even point has its origins in the economic concept of the point of indifference. From an economic perspective, this point indicates the quantity of some good at which the decision maker would be indifferent (i.e., would be satisfied without reason to celebrate or to opine). At this quantity, the costs and benefits are precisely balanced.
In the same way, the managerial concept of break-even analysis seeks to find the quantity of output that just covers all costs so that no loss is generated. Managers can determine the minimum quantity of sales at which the company would avoid a loss in the production of a given good. If a product cannot cover its own costs, it inherently reduces the profitability of the firm.
When looking into Break-even Analysis, here are the meaning of the terms we would come across:
Fixed costs are production cost that are not changing in regards to the production level. These cost stays fixed as they will surely be incurred no matter the activity of the company that is either they produce any out-put or not. 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.
Fixed cost examples that a company will incur are:
– Office rent
– Assets Depreciations
– Research and development
– Cost of Marketing
– Administration costs
Variable costs are said to be the cost that changes directly with the level of product output of a company. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.
It is very imperative to clarify that there is difference between “Direct” variable costs and “Indirect” variable costs.
Indirect variable costs are referred to as cost which does not by any means relates directly to production but they change with production output. They include depreciation (where it is calculated related to output – e.g. machine hours), maintenance costs etc.
Direct variable cost talks about those cost which relates and can be directly related to the production of a certain product or service and assigned to a particular cost centre. Raw materials and the wages those working on the production line are good examples of Direct Variable Cost.
Despite the fact that business cost is majorly said to either be a fixed cost or variable cost, costs goes beyond that cause in reality there are some costs which are fixed in nature but which rise when output grasps certain levels. These are principally associated to the total “scale” and/or difficulty of the business. For example, when a business has comparatively little 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 (for example output, number people employed, number and complexity of dealings) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these conditions, we say that part of the cost is variable and part fixed.
How do you calculate break even?
Break-even point can be expressed as an equation:
Fixed costs / (price – variable costs) = break-even point in units
The break-even point is when the total costs equal total revenue generated. The total cost comprises both the fixed and the variable cost. For any business, it’s important to determine their break-even point to help them in the decision-making process.
Here are some of the objectives/importance of Break-even Analysis listed as follows:
- Assistances in Budgeting and Setting Targets
This is done as a way to know at which point there can be break-even, as this will accordingly aid budget setting. In another way, break-even analysis can be used in setting SMART targets for the business. This is conceivable because you know at which point a business is able to realize profits and therefore, one can use this break-even analysis to set benchmarks or standard for the firm. If you are not well-versed in analyzing your finances, then hire a financial expert who understands the nitty-gritty of finance with many years of finance excellence. Qeeva Advisory Limited will help you make a budget and set achievable targets for your firm.
- Controls the unit of goods to be sold
The knowledge of break-even analysis will abreast us with the necessary information on the number of products to sell in order to get beyond lost. Such that the revenue will swallow up the cost of the product produced.
- Enables cost control and measures
Managers are saddled with the responsibility to know that the fixed and the variable costs affect the profitability of the business, as a result, they should be able to manage cost properly with the help of break-even analysis. It aids them to govern the extent of variations in costs which may affect the profitability of the company transaction.
- Regulate the Margin of Safety
You can calculate the margin of safety and that can be calculated by deducting the present level of sales less the break-even point and then dividing it by the selling price per unit. In the event of a recession or an economic downturn, sales tend to decline. So, with the help of the break-even analysis, you can tell the minimum level of sales mandatory to guarantee you make profits. By having on record the margin of safety for a particular product or service, by so doing, managers can make better business decisions and set SMART targets and goals.
- Assist to Plan a Pricing Strategy
The break-even point can be highly influenced by the selling price of the product or services under review. For illustration, if the selling price is increased, the number of units to be sold to break-even will be reduced. Likewise, if the selling price is reduced, a firm needs to sell more to break-even. Thus, with the help of break-even analysis, managers can decide whether they need to modify the selling price or devise another pricing strategy.
The above mentioned are some of the importance that may be traced to the break-even point analysis. Break-even analysis helps businesses make quick financial decisions and so, the importance cannot be ruled out in critical business decision. For additional information on objectives and creating break-even analysis for your firm, consult a professional accounting firm like MOC Accountants (www.mocaccountants.com) or hire a financial controller who will aid you in formulating your business decisions.
Three assumptions of the break-even analysis
The break-even analysis depends basically on three key assumptions as recognized by bplan:
- 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 one dollar and enter your costs as a percent of a dollar. The most common questions about this input relate to averaging many different products into a single 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 percent margin would have a per-unit cost of .5, and a 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 will be a rough estimate, but it will provide a useful input for a conservative break-even analysis.
How do you use break even analysis?
Break even analysis is a significant tool for business owners be it start up or established as it allows them to evaluate the practicability of their business or a business they intend going into. Start-ups can discover the feasibility of their business by taking into consideration the balance of cost against the price and expected sales volumes. Does the business require unrealistic levels of sales to achieve break even? Do costs need to be reduced to make the business model viable?
Your knowledge about the break-even point of your business is a crucial step in exploring and setting the price point. The best way to set your price is by establishing the value that your customer places on your product. Once you’ve recognized your preferred pricing level, break even analysis will allow you to ensure that your price is realistic in relation to your costs and the probable volume of sales for your product.
Break even calculations are a significant component of cost-volume-profit analysis. They are also an essential element in any financial forecasting to articulate the risk that any variance in cost or price modification could have on profitability.
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