Breakeven Analysis is a widely known used technique and is the process of generating information that summarises various levels of profit or loss associated with various levels of production. It typically includes reflection, discussion, reasoning and decision making relative to seven major ingredients:
- Fixed Costs, i.e. those costs which do not vary with the level of production, for example, rent on premises.
- Variable Costs, i.e., expenses that fluctuate with the volume of production, i.e., raw materials.
- Total Costs, i.e., Fixed Costs + Variable costs.
- Total Revenue, i.e., all the monies received from external sales.
- Profits, i.e., the excess of total revenue over total costs.
- Loss, i.e., the excess of total costs over total revenue.
- Breakeven Point – this is a situation where the total revenue of an organisation equals total costs. The organisation is generating only enough revenue to cover it’s costs. The company is neither gaining a profit not is it incurring a loss.
“There are a number of types of breakeven analysis or cost volume profit analysis. There are two discussed here: Algebraic forms – the equation and contribution margin techniques and the graphic approach.”
John J Teeling & Frank W Roche
Every income statement may be expressed in the equation form as follows:
Sales = Variable Expenses + Fixed Costs + Net Income
Thus, if we know the variable expenses per unit, the price per unit and the fixed expenses, we can determine the number to be sold in order to breakeven.
Assume X = Each unit to be sold. Assume 5 euros is the selling price, fixed costs = 100 euros and the variable cost per unit = 1 euros.
These figures can calculated as follows:
- 5 X = 1X +100 +0
- 4X = 100 + 0, X = 100/4 +0 or X = 25 units.
The contribution margin is the excess of sales over the variable expenses figure. The unit contribution margin ( to cover fixed expenses and the desired net income figure) is determined by the unit sales price less the unit variable expense figure.
Unit Contribution Margin = Unit Sale Price – Unit Variable Expense
Substituting the above mentioned figures:
- Unit Contribution Margin = 5 euros – 1 euros = 4 euros.
The breakeven point in terms of units sold can be derived from the following equation:
B/E( Units) = Fixed Expenses + Desired Net Income/ Unit Contribution
B/E = (100 + 0)/4 = 25
As can be observed the equation method and the contribution margin methods are essentially the same. However, we are presented with a situation in which the information is presented in terms of money instead of units we will have to use the Contribution margin ratio.
Contribution Margin Ratio = Contribution Margin per Unit/Selling Price per Unit
CMR = 4 euros/ 5 euros = 0.8
The B/E can also be calculated by the following version of the contribution margin approach:
B/E = Fixed Expenses + Desired Net Income/Contribution Margin Ratio
- B/E = (100 euros + 0) /0.8 = 125 euros.
When a business is breaking even, it’s revenue is just enough to cover it’s total costs. It is neither in a profit or loss making situation. Breakeven can be calculated by using the Fixed costs/Contribution per unit formula.
- Total contribution = Total revenues less the Total variable costs.
- Contribution per unit = Selling price per unit less the Variable cost per unit.
Margin of Safety
- This is the difference between the actual output in units generated and the breakeven output figure. A negative margin of safety means a business is incurring a loss.
- A business that operates with a positive margin of safety is profitable.
- Profit= Margin of Safety( Units) x Contribution per unit (euros)
- Refer to table below: 1500 ( units sold) output figure.
- The breakeven output figure is: 2,000
- (1,500 –2000)= -500 units x 10.00 (20.00 – 10.00)= -5,000 (5,ooo) which a loss making figure.
The Margin of Safety can be improved by:
- Increasing the Contribution per unit figure.
- Increasing the selling price per unit.
- Decreasing the variable cost per unit.
- Lowering the fixed costs.
- Selling more units.
Strengths and Limitations of Breakeven Analysis
- Fixed and variable costs are immediately identified.
- It will identify if costs are at too a high a level.
- The margin of safety figure is highlighted.
- Management can set performance targets in terms of profits achieved and then monitor these performance measures.
- It assumes a constant selling price regardless of the output achieved.
- External factors are not considered. Prices and costs can change and it does not take into account of technological changes, competitor environment etc.
- The breakeven output level is not the same as the level of sales actually generated.