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Break-Even Analysis Definition
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.
In manufacturing, the aim is to decide the number of products that need to be sold at a certain price to cover the costs.
In the financing of a project, the goal objective is to determine the number of months or years needed by the forecasted total net flow of money to come out the same as the estimated total cost for a project.
An essential part of financial planning involves drawing a break-even graph or using a break-even formula.
A Little More on Break-Even Analysis
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 product’s 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.
References for Breakeven Analysis
Academic Research on Breakeven Analysis
- • Advanced breakeven analysis of agricultural enterprise budgets, Dillon, C. R. (1993). Agricultural Economics, 9(2), 127-143. This paper presents advanced breakeven methods with computational formulas using different budget components, such as total cost, variable cost, fixed cost, output price, input price, input requirement, and yield.
- • Study Guide to Accompany Managerial Economics in a Global Economy, Brooker, R. F. (2007). Study Guide to Accompany Managerial Economics in a Global Economy. OUP Catalogue. This study guide is intended to help students be more productive with the time they spend studying. Included in the study guide are true-false questions and answers, learning objectives, multiple-choice questions and answers, software tools, and more. With the software, students will be able to find solutions to problems with statistical and quantitative techniques outlined in the textbook. Of the models, breakeven, linear programming, descriptive statistics, time value of money, market analysis, and regression analysis and forecasting are included.
- • A new dimension to breakeven analysis, Manes, R. (1966). Journal of Accounting Research, 87-100. The author discusses two periods of great literary outpouring regarding breakeven analysis or cost-volume-profit analysis, which occurred during the period of industrial engineering between the world wars and during the period of accounting for the decade following World War II.
- • Breakeven analysis with semifixed costs, Powers, T. L. (1987). Industrial Marketing Management, 16(1), 35-41. This article addresses how breakeven analysis is used often as a decision-making tool used by industrial marketers. Aside from traditional breakeven methods, the author outlines a process that includes semi-fixed costs, which takes into consideration normal situations industrial marketing managers experience.
- • Breakeven Analysis under Absorption Costing, Solomons, D. (1968). The Accounting Review, 43(3), 447-452. The author acknowledges how many find the simplistic assumptions that are fundamental to the traditional breakeven chart to be unsatisfactory. This article attempts to clarify those assumptions and applies the breakeven chart to a scenario when absorption costing is in use. The author discusses how breakeven analysis builds on direct costing, which is not universally accepted. The author feels that not understanding the implications of the philosophy behind the breakeven analysis is cause for misunderstandings.
- • Linear breakeven analysis under risk, Starr, M. K., & Tapiero, C. S. (1975). Journal of the Operational Research Society, 26(4), 847-856. Detailed probability distributions are given for the breakeven points with correlated parameters. In the case when analytical expressions cannot be found for the distributions, the suggestion is provided for a multivariate characteristic function approach.
- • Inverted breakeven analysis for profitable marketing decisions, Kortge, G. D. (1984). Industrial Marketing Management, 13(4), 219-224. This article forms an altered model of breakeven analysis which if it is used by industrial marketing management in specific situations, it could be a viable conceptual tool for determining whether certain products should be produced and marketed.
- • Adapting traditional breakeven analysis to modern production economics: Simultaneously modeling economies of scale and scope, Hanna, M. D., Newman, W. R., & Sridharan, S. V. (1993). International journal of production economics, 29(2), 187-201. This paper attempts to show that the simple tool, cost-volume-breakeven-analysis (CVBA) is insufficient in justifying modern automation technologies as equipment alternatives. Because of the inadequateness of CVBA, the authors introduce cost-volume-flexibility-breakeven-analysis (CVFBA) and show its benefit in the context of advanced manufacturing technologies. CVFBA is an approach which includes economies of scope and economies of scale in consideration for first comparisons between the alternatives of equipment.
- • Cost benefit analysis of information systems: A survey of methodologies, Sassone, P. G. (1988, April). In ACM SIGOIS Bulletin (Vol. 9, No. 2-3, pp. 126-133). ACM. Sassone believes that the chief problem in cost justification is assessing benefits. This paper presents and examines eight methodologies which have developed to quantify the advantages of information systems. They include the work value model, decision analysis, time savings times salary, cost displacement/avoidance, breakeven analysis, cost of effectiveness analysis, subjective analysis, and structural models.
- • The feasibility study as a tool for venture analysis, Justis, R. Y., & Kreigsmann, B. (1979). Journal of Small Business Management (pre-1986), 17(000001), 35. When a small business is headed in a new direction, the company is vulnerable to many external circumstances, which forces management to become experts of the things within control. The author believes a feasibility study will show what resources are needed for the venture, reveal strengths and weaknesses, and in an objective manner, assess the potential for success. This article describes the type of information that a feasibility study should include.
- • Breakeven under capitation: Pure and simple?, Boles, K. E., & Fleming, S. T. (1996). Health care management review, 21(1), 38-47. The author expands the usual two dimensions of the breakeven analysis into three, which are cost, enrollment, and utilization as it’s applied to managed care under capitation using three-dimensional graphics.
- • Applications of quantitative techniques in large and small organizations in the United States: An empirical analysis, Kathawala, Y. (1988). Journal of the operational research Society, 39(11), 981-989. Kathawala assessed data from manufacturing and service Fortune 500 organizations and 500 small companies relative to their use of different quantitative methods. A survey was conducted which recorded opinions about any specific hindrances to using the techniques. The results suggest there has been little progress in the last decade with the use of quantitative methods and the survey revealed that barriers to the application of such procedures are because of management’s lack of knowledge regarding them.