When there is neither loss nor gain in a financial situation, you will often hear the term "break even." For businesses, break-even analysis is a useful financial planning tool, assisting managers in setting price structures and helping them predict when a business -- or product -- is likely to start producing profits. The ability to determine the break-even point -- and use that information to make measured decisions -- is essential to every business.
A business achieves a break-even position when its accumulated contribution margin -- sales revenues less all costs directly associated with those sales -- equals the fixed costs of running the business. This situation is known as the break-even point, when a business is covering its costs but making neither a profit nor a loss. Once this point is reached, each additional unit sale produces a profit for the business. To establish at what point it will break even, a business must accurately determine the nature and extent of its costs.
Costs directly associated with sales are known as variable costs because they vary according to production and sales activity. Variable costs include raw materials, hourly wages, packaging and delivery expenses. As sales volumes increase, the variable unit cost could increase or decrease. For example, a business employs 10 workers producing a combined total of 100 units a day. To meet increased orders, requiring an extra daily output of five units, the business takes on an additional worker. At this point, the variable cost per unit increases -- sales have increased by 5 percent but wages have risen by 10 percent. If sales continue to grow, the variable cost per unit decreases until all workers are, again, working to full capacity.
Fixed costs do not vary in line with production levels or the number of units sold. Fixed costs include management salaries, rent, insurance and depreciation. If sales volumes go up or down but all else remains constant, there is no change in fixed costs. If the business is using the break-even tool to establish when a single product will turn a profit, it will apportion fixed costs across its product range. Similarly, to determine the break-even point for a branch location, a portion of head-office costs will be added to the fixed costs of the local operation.
Once unit prices and costs have been established, the math involved in calculating the break-even point is not complicated. The break-even sales volume, in units, is equal to fixed costs divided by the unit contribution margin. Using this formula, a business with fixed costs of $100,000, a unit price of $1,500 and a variable cost per unit of $500 -- giving a unit contribution margin of $1,000 -- would need to produce 100 units to break even. To establish the relevant sales figure in dollars, multiply break-even unit volume by unit price. In this example, the financial value of break-even sales is $150,000.
By scrutinizing its break-even analysis, a business gets an indication of whether it needs to increase sales activity, reduce production costs, cut fixed overhead or adjust its prices to obtain the level of profit its owners or investors require. The business may perform sensitivity analyses by changing the variables in the break-even calculation. With new ventures in particular, as well as those expanding or diversifying, lenders and potential investors will ask at what point a profit is likely to be achieved. Business managers never base decisions on a single calculation or tool, but the assessed break-even point can provide useful information that, together with other financial tools, can assist managers in optimizing business profits.
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