Break Even Analysis: A Quick Overview
Are you interested in implementing a break even analysis (BEA) for your goods and services? In this post, you’ll learn what a BEA is and how you can use it to determine the best product strategies to implement.
BEA isn’t usually required for financial reports but can be useful to banks and other lenders when applying for loans. Lenders may perform a break even analysis on your business when you apply for funds. Having this information available could increase your chances of being approved, as it shows lenders that you’re considering the risks involved.
What is a Break Even Analysis?
Break even analysis is a tool used by managers to determine the effectiveness of a sales strategy. Some managers may use it to gauge the rate at which one product sells when compared to other products in the pipeline. If one product takes longer to reach the break even point than certain thresholds set by management, this is useful information in their production strategy.
Break even analysis is considered a risk management strategy, as it evaluates the risk associated with making certain investments in product pipelines. Product managers rely on risk management strategies to determine not only the right mix of products to sell but also on the amount to produce.
When performing a break even analysis, small business owners should consider both fixed and variable costs. This is essential when analyzing what-if scenarios to optimize their production cycles. Then, this information can be used to cut costs or replace obsolete equipment.
A break even analysis can also be used to determine worst-case scenarios. In other words, what happens if the investments that managers make only break even? This can be a useful tool when monitoring the performance of their campaigns and product strategies. The breakeven point represents a minimum investment required not to lose money.
The Break Even Analysis Formula
It might seem like a break even analysis formula is a simple calculation. The dynamics are to find the point at which the sales you generate is equal to the amount spent on producing the product. That would serve as a benchmark.
However, the actual formula is more complicated. This complication arises in finding the fixed costs and variable costs associated with the production of the products. Costs that rise with an increase in sales and fall with a decrease in sales are considered variable, while costs that stay the same irrespective of sales are fixed.
To calculate the break even point, start with a contribution margin. This is the number of units in excess of the variable costs that would be used to contribute to fixed costs. The calculation is as follows:
Contribution Margin = Total revenue prices per unit – variable costs per unit
Once you determine the contribution margin, you divide that into the total fixed costs as follows:
Break Even Point = Fixed Costs / Contribution Margin
This determines the number of units required to produce to break even. Each additional unit sold represents net operating income.
Feel free to use this as a break even analysis template.
Break Even Analysis Examples
Let’s say that your business sells coffee cups online, so you decide to purchase blank coffee cups and add artwork to them. Then, you markup the price of the coffee cup to sell them in your business’s online store.
Because you don’t want to fill your house with harsh chemicals from art supplies, your friend rents you space in his art studio for $600 per month. This is your only fixed cost.
The e-commerce selling platform alerts you that 200 people have ordered your coffee cups. You purchase the 200 coffee cups from your supplier for $2.00 per cup and determine that your artwork costs $2.00 per cup. Your total variable costs are $4.00 per cup. Therefore, you decide the selling price for the cups will be $12 at this time.
E-commerce platform costs and shipping costs are not factored into this example. This is likely not a realistic assumption.
First, determine the contribution margin per unit. This is:
Revenues per unit – variable costs per unit = $12.00 – $4.00.
The contribution margin therefore, is $8.00.
Next, divide the fixed costs by the contribution margin:
$600 divided by $8.00 = 75.
This represents the number of units to produce to break even. Any sales beyond 75 units will represent a profit of $8.00 per unit.
Another example is with options investors. Break even analysis is used heavily by this group of investors. They calculate probabilities of reaching the break even point, which is a crucial measure as time isn’t on the side of an option buyer.
Remember, options have an expiration date; the premiums that option buyers pay are part of the consideration for break even analysis in options investing.
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How Do You Interpret a BEA?
A big challenge with interpreting BEA is in determining the true product costs of what you’ve sold. On the surface, that may seem easy; however, complications arise in what costs should be considered in the calculations.
It’s best to quantify as many variable costs as possible. Fixed costs aren’t usually a problem, although there could be discrepancies as to what should be considered fixed costs.
It could be argued that fixed costs can vary over time, for example, when corporate tax rates change. However, this situation can be handled by averaging the costs over a period. Sales taxes in different states can be problematic, though, as these are related to sales volumes.
Some expenses could be split into fixed and variable expenses. An example would be a salesperson in at your business. If the salesperson receives a base salary, that would be considered a fixed cost, and the commission generated for selling the product would be variable.
Depreciation is another wrinkle that adds to the interpretation woes of a company. It’s not a cash cost and is likely to be either subtracted or added depending on the department interpreting the results.
The nuances of break even analysis, i.e., depreciation, allocations of costs, etc., are challenging. The effort of BEA will be worthwhile, however, as it can help formulate a strategy for your product pipelines. The calculation may evolve as you use it, and different scenarios may emerge that can help determine how to make changes.
Has this guide helped you understand this type of financial analysis? At Fora Financial, we’re constantly publishing educational posts for business owners. To get more helpful blog posts that’ll help you with your business plans sent straight to your inbox, simply sign up for our blog newsletter.
Editor’s Note: This post was updated for accuracy and comprehensiveness in December 2020.
Frequently Asked Questions
How often should managers perform a break even analysis (BEA)?
Managers can use BEA to run what-if scenarios. Therefore, they should run the calculations whenever they want to test changes in their strategies. In addition, accounting departments may use BEA to estimate taxes that will need to be paid.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.