Break-Even Analysis

Break-even analysis compares income from sales to the fixed costs of doing
business. Five components of break-even analysis include fixed costs, variable
costs, revenue, contribution margin, and break-even point (BEP). When
companies calculate the BEP, they identify the amount of sales required to
cover all fixed costs to begin generating a profit. The break-even point formula
can help find the BEP in units or sales dollars.

Break-Even Point Formula

Break-even analysis involves a calculation of the break-even point (BEP). The

break-even point formula divides the total fixed production costs by the price
per individual unit, less the variable cost per unit.

BEP = Fixed Costs / (Price Per Unit - Variable Cost Per Unit)

Break-even analysis looks at the 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 and $0 of fixed costs will automatically have
broken even with the sale of the first product, assuming variable costs do not
exceed sales revenue. Fixed costs remain the same regardless of how many
units are sold.

Calculating BEP and Contribution Margin

Break-even analysis and the BEP formula can provide firms with a product's
contribution margin. The contribution margin is the difference between the
selling price of the product and its variable costs. 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.
Contribution Margin = Item Price - Variable Cost Per Unit

To find the total units required to break even, divide the total fixed costs by the
unit contribution margin. Assume total fixed costs are $20,000. With a
contribution margin of $40 above, the break-even point is 500 units ($20,000
divided by $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 (Units) = Total Fixed Costs / Contribution Margin

To calculate the break-even point in sales dollars, divide the total fixed costs by
the contribution margin ratio. The contribution margin ratio is the contribution
margin per unit divided by the sale price.

Contribution Margin Ratio = Contribution Margin Per Unit / Item Price

BEP (Sales Dollars) = Total Fixed Costs / Contribution Margin Ratio

The contribution margin ratio is 40% ($40 contribution margin per item divided
by $100 sale price per item). The break-even point in sales dollars is $50,000
($20,000 total fixed costs divided by 40%).

Why BEP Analysis Matters

Pricing: Businesses get a comprehensible perspective on their cost structure

with a break-even analysis, setting 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 break-even analysis to help them make informed decisions
surrounding those activities.

Cost Reduction: Break-even analysis helps businesses find areas to reduce costs
to increase profitability.

Performance Metric: Break-even analysis is a financial performance tool that

helps businesses ascertain where they are in achieving their goals.

What Are Some Limitations of Break-Even Analysis?

Break-even analysis assumes that the fixed and variable costs remain constant
over time. Costs may change due to factors such as inflation, changes in
technology, or changes in market conditions. It also assumes that there is a
linear relationship between costs and production. Break-even analysis ignores
external factors such as competition, market demand, and changes in consumer
preferences.

What Are the Components of Break-Even Analysis?

There are five components of break-even analysis including fixed costs, variable
costs, revenue, contribution margin, and the break-even point (BEP).

Why Is the Contribution Margin Important in Break-Even Analysis?

The contribution margin represents the revenue required to cover a business'

fixed costs and contribute to its profit. Through the contribution margin
calculation, a business can determine the break-even point and where it can
begin earning a profit.
How Do Businesses Use the Break-Even Point in Break-Even Analysis?

The break-even point (BEP) helps businesses with pricing decisions, sales
forecasting, cost management, and growth strategies.