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.
- Photo Credit Jupiterimages/Photos.com/Getty Images
How to Break Into Show Business
When you imagine a career in show business, becoming an actor or musician might be the first jobs that come to mind....
How to Calculate a Break-Even Point in Units
Calculating a break-even point in business determines the point during a specific period of time at which a company shows neither profit...
How to Calculate the Total Cost of a Product
In business, profitability occurs when revenue exceeds expenses. Using the total cost of a product to calculate expenses gives you a more...
How to Calculate Variable Costs Per Unit
Businesses live or die based on sales volume and how well they control costs. However, before you can effectively manage expenses and...
Does Operating Income Include Depreciation?
Financial statement users, such as investors and creditors, examine income reported on the income statement. Operating income, net income and gross income...
How Does Marginal Analysis Help Business People in Decision Making?
Marginal analysis is useful to highlight managerial issues and decision making. A company can use marginal analysis to evaluate business models. Management...
Is Labor a Fixed or Variable Cost?
Labor can be a fixed cost or a variable cost depending on the situation. This can be confusing, so it is important...
How to Calculate a Break-Even Point
The break-even point is what a company needs to calculate in order to determine how much they need to sell to break...
How to Calculate Debt to Equity Ratio
Calculating a debt to equity ratio means looking at total liabilities and dividing them by the amount of money that the owners...