The break even point refers to that point in business where the total cost is equal to the total revenue. At this point, a business makes neither profit nor loss. There are several benefits to calculating the break even point in terms of analyzing the success of any business. For instance, a break even analysis helps in determining when a business will generate a positive return.
Break Even Calculation
There are two primary methods for calculating the break even point. One is the equation method, and the other is the contribution margin method. Basically, both methods will compute when the total sales are just equal to the sum of the fixed expenses and the variable expenses. The equation method is based on the contribution approach to the income statement. The contribution margin is a short-cut variation of the equation method.
Break even analysis helps with studying the relationship between returns, variable costs and fixed costs. It helps with calculating the volume of production at a specified price necessary to cover all related costs. Fixed costs are business expenses, such as capital, that do not change and bear no direct relationship to the production level. Variable costs, on the other hand, are expenses that change in relation to output volume.
Time for Recovering Investment
Break even analysis helps determine the time necessary for recouping the amount of money invested in a business. Determining this period is important considering that the benefits gained early in the life cycle of a business are usually more than out-year benefits. Therefore, break even analysis helps decision makers determine when they can expect to start generating profit. Every business needs some time from the period it starts operating to the time it begins to generate a profit.
Break even analysis also helps determine the minimum amount of business activity required to prevent any losses. Its greatest benefits come when it is used with either capital budgeting or partial budgeting. In addition, break even analysis can be used to indicate how the changes in variable cost/fixed cost relationships affect profit levels. However, it is best to use a break even analysis in relation to one product at a time.