What is a Break-Even Analysis?

Break-even analysis is an economic assessment of the mathematical correlation between sales and expenses revenue, under a specified set of assumptions concerning variable and fixed costs. Plainly stated, it is a measure of how long it will take for a project or investment to pay for itself. 

How is a Break-Even Analysis Used?

A break-even analysis can be beneficial when determining the level of production or in a targeted desired sales mix. The analysis produces a metric and calculations not necessary to share with investors, financial institutions, or other third parties, so it used for managerial purposes only. 

Break-even analysis looks at the position of fixed costs as they relate to profit earned by each extra item sold or produced. For example, the break-even point of sale will be lower for a company with lower fixed costs. If fixed costs are $0, a company automatically breaks even with the purchase of the first product provided the variable costs are not more than the sales revenue. Since variable costs are expenses incurred for each sold item, accumulating them will limit a company's leverage. 

The idea of break-even analysis has to do with a products contribution margin, which is the excess between the sold price of a product and the total variable costs. Take for example a product that sells for $120. The total fixed costs are $30 per product. The total variable costs are $70 for each item. Therefore, the contribution margin is $50 because the total variable costs get subtracted from the selling price. When determining the contribution margin, the fixed costs are not considered. 

Two formulas can be used to calculate the break-even analysis. The first is to divide the total fixed costs by the contribution margin. Assume a company's fixed costs are $20,000 and you divide by a contribution margin of $40, the break-even point obtained is 500 units. Therefore, all fixed costs will be paid for after the sale of 500 products. The company can then record a net profit or loss of $0. The second formula to calculate the break-even point in terms of sales dollars is to divide the total fixed costs by the ratio of the contribution margin. To get the ratio, divide the contribution margin by the sale price. So, with the above example, assume the sale price for each product is $100. When the $40 contribution margin gets divided by the sale price of $100, the contribution ratio comes out to be 40 percent. 

Remember the fixed costs were $20,000. So that total divided by the 40 percent makes the sales dollars break-even point $50,000. To check, take the break-even point in units, which was 500, and multiply it by the sales price of $100 and it equals $50,000.

Related Topics

• Trend Analysis of Financial Statements
• Common-Size Analysis (Vertical Analysis) of Financial Statements
• Common-Size Financial Statement
• Net Dollar Retention
• Horizontal Analysis
• Per Share Basis
• Profitability Ratios
• Gross Margin Ratio
• Profit Margin
• After Tax Profit Margin
• Return on Assets
• Total Shareholder Return
• Cash on Cash Return
• Earnings Per Share
• Diluted Earnings Per Share
• Asset Turnover Ratio
• Berry Ratio
• Break-Even Analysis
• Liquidity Ratio
• Current ratio  (Working Capital Ratio)
• Working Ratio
• Quick Ratio
• Quick Assets
• Days Sales Outstanding
• Cash Ratio (Operating Cash Flow Ratio)
• Receivables turnover ratio (often converted to average collection period)
• Accounts Payable Turnover Ratio
• Inventory turnover ratio (often converted to average sale period)
• Solvency (Coverage Ratios)
• Leverage Ratio (Debt Ratio)
• Asset Coverage Ratio
• Debt to Equity
• Debt to Income Ratio
• Debt Coverage Ratio
• Times Interest Earned
• Market Capitalization
• Price to Equity Ratio
• Book-To-Market Ratio
• Price to Earnings Ratio
• Price to Earnings Growth (PEG) Ratio
• Price to Earnings Growth Payback Ratio
• CAPE Ratio
• Price to Cash Flow Ratio
• Capital Maintenance
• Book to Bill Ratio
• Asset Turnover Ratio
• Plowback Ratio 
• Days Inventory Outstanding
• Days Payable Outstanding
• Days Sales Outstanding
• Non-financial Performance Measures: The Balance Scorecard