The break-even point (BEP) analysis is the evaluation of the minimum revenue required for a company to continue its operations.
At BEP, a company neither makes profit nor loss. It helps a company set budgets and targets for a minimum production level. However, finding that point in terms of units produced and sales is difficult.
Let us discuss the BEP analysis and its uses with the help of an example.
What is Break-Even Point Analysis?
Break-even point (BEP) analysis refers to finding a point for an entity where its revenue and costs are equal. In cost accounting terms, that point is called the break-even point.
The break-even point can be calculated in terms of units required to achieve equal revenue and costs. It can also be calculated in dollar terms for an entity.
The BEP analysis is closely linked with the contribution margin concept. The contribution margin is the gross profit after deducting variable costs of producing a product or service.
Thus, the BEP analysis would lead to a point where the entity recovers all of its fixed costs apart from covering the variable costs. Hence, the total costs and revenue will be equal and the entity will be at a no profit-loss point.
How to Calculate the Break-Even Point?
An entity can calculate its break-even point in terms of units required and dollar terms.
Break-even point (in units) = Fixed Costs / (Sales per unit – Variable Cost per unit)
Revenue per unit less variable cost per unit is also called the contribution margin.
Once you know the BEP in units, you can calculate the BEP in dollar terms with a similar formula.
Break-even Point (dollar terms) = Fixed Costs / (Contribution margin Ratio)
Break-even point (in dollars) = BEP in units × Sale Price Per Unit
Important components of the BEP calculation are:
Fixed Costs: These costs do not change with a change in the production level or sales volume.
Variable Costs: These costs directly change with a variation in the production level or sales volume.
Suppose a company ABC produces a product P1. The following data is available.
Fixed Costs for the company ABC = $ 130,000
Variable Cost per unit of P1 = $ 20
The Sale Price of P1 = $ 60
Break-Even Point = Fixed Costs / Sale price per unit – variable costs per unit
Break-even point = 130,000/ (60-20) = 3,250 Units.
Break-even Point (dollar terms) = (sale price per unit × BEP in units)
Break-even point = (60 × 3,250)
Break-even point = $ 195,000
Practically, a production facility will produce more than one product to generate economies of scale and higher profits.
Suppose ABC company produces three products P1, P2, and P3. Total fixed costs for the company are $ 500,000. The Following data is available.
|Sale Price||$ 30||$ 40||$ 50|
|Variable Costs||$ 10||$ 15||$ 30|
|Contribution||$ 20||$ 25||$ 20|
The calculation of BEP requires to find a weighted average contribution to sales ratio first.
The Weighted Average Contribution Ratio = Total Contribution / Total Revenue
The Weighted Average Contribution = (20 × 10,000) + (25 × 15,000) + (20 × 10,00) / (30 × 10,000) + (40 × 15,000) + (50 × 10,000)
The Weighted Average Contribution Ratio = $ 775,000 / 1,400,000 = 0.553 or 55.3%
Break-even Revenue = Fixed Costs / Weighted Average Contribution Ratio
Break-even Revenue = 500,000/55.3% = $ 904,159.
The weighted average contribution ratio requires the proportion of the sales mix to remain constant.
Contribution Margin and the BEP analysis
The contribution margin is calculated by deducting variable costs from the sale price per unit of a product. For example, if a product sells at $ 50 and its variable costs per unit are $ 20, its contribution margin is $ 30.
The BEP analysis is directly associated with the contribution margin practice. An entity can analyze its contribution margins to eventually calculate its BEP.
An entity can dig deeper to analyze factors affecting its contribution margin. For instance, it compares its selling prices with its competitors as a starting point.
Next, the entity can evaluate its operational efficiency. An efficient production system will lower its variable costs. Thus, the contribution margin will increase.
Important Considerations with the BEP Analysis
The BEP analysis is hardly used by external stakeholders of a company. The primary user of the BEP analysis is the management of the company.
Once a company figures out its BEP, it can add a target profit to it. Thus, it’s important to understand factors affecting an increase or decrease in its break-even production.
Increasing the BEP
Here are a few factors affecting an increase in the break-even point.
If the customer demand increases, the sales will increase. It means the company will need to produce more units to satisfy the increased customer demand. Thus, the break-even point will rise.
Increased Production Costs
Increased sales and customer demands would also mean higher production costs. The variable costs will increase with an increase in the production level. That will also increase the BEP.
Lower Production Volume
For any reason, if the company cannot maintain its production levels, its BEP in dollar terms will increase. The company will be unable to generate sufficient sales, hence, it will increase the break-even point.
Decreasing the BEP
If a business can reduce its break-even point, it can generate more profits. It can use different measures to reduce its BEP and increase profits.
One way of reducing the BEP is to increase the product sale price. However, the company must stay competitive with its pricing otherwise it will reduce the sales significantly.
Reduce Production Costs
Another way of achieving the objective is to reduce variable production costs. The company can look for cheaper raw materials, labor, etc. It can also consider outsourcing production.
Increase Operational Efficiency
Replacing damaged or obsolete machinery and deploying a skilled workforce can increase operational efficiency. That in turn will increase the contribution margin and hence will reduce the BEP.
Advantages of BEP Analysis
The break-even point analysis offers several advantages to the management.
- It helps a company is setting realistic targets and budgets.
- It helps in improving operational efficiency and reducing production costs.
- The company management can use BEP analysis for evaluating its margin of safety. It will lead the management to consider long-term plans.
- The company can calculate its minimum production requirements.
- It can help the management to make a correct pricing decision. The management can devise a competitive pricing strategy after calculating the BEP.
Disadvantages of BEP analysis
The Break-Even Point analysis has some limitations as well.
- It is useful in a single-product production environment.
- For a multi-product scenario, it relies on the consistent sales mix production that is difficult to achieve practically.
- It does not consider semi-variable costs or indirect costs that can significantly change the profitability of the product.
- It is not useful for a low-production facility that does not generate economies of scale.
The break-even point analysis offers useful information to a company about its minimum production requirements. It also offers valuable insights into a company’s contribution margin and efficiency. A company can use the BEP analysis to set targets and budgets to achieve a margin of safety.