Break Even Analysis is used in financial management, accounting and marketing components of business intelligence systems.
The break-even is the point where a business’ expenses and revenue are equal ( i.e. no loss and no profit) and provides an important sales target that an organisation needs to achieve before they will start to generate any profit. Expressed another way, it provides a simple view of the relationship between profits, sales and costs.
The break-even point can also be considered as the point when a investment begins to generate a positive return.
From a business intelligence perspective, its often used to determine:
- Product strategies over the product life cycle (eg. advertising, pricing, continue/discontinue, volume)
- The shortfall in sales before profitability is reached for a business unit, division or even company. Often expressed as a percentage of B/E required sales divided by actual (or budgeted) sales
- Sales targets and performance bonus criteria.
- Pricing points for bids, tenders
- The respective impacts of fixed and variable costs when choosing new capital plant and machinery, or entering into supplier negotiations.
It must be kept in mind that reaching break-even point does not make up for any past losses, it does not allow one to build future reserves to protect against losses, and it does not provide any return on an investment.
In addition, the accuracy of business intelligence / break even analysis is determined by assumptions that may result in incorrect conclusion.
Calculating Break-Even Point
Let’s take the example of a car oil change business. Such a business incurs both variable expenses and fixed expenses.
Variable Expenses: These expenses change in proportion to revenue. Some of the variable expenses that a car oil change business incurs per vehicle, are the following:
- Motor oil cost – $10.00
- Oil filter cost – $5.00
- Grease/washer fluid cost – $1.00
- Other supplies – $0.50
Therefore, total variable cost per car = $16.50. Note that variable expenses will increase proportional to the amount of cars serviced. ie. If instead of servicing 1 car a day, the same company starts servicing 10 cars a month; their variable expenses will rise to $165.00 per month.
Fixed Expenses: These expenses do not change with increases or decreases in revenue, they remain the same. In this example, the car oil change business may incur some of the following fixed costs per month:
- Rent – $1000
- Labor costs – $1500
- Utilities – $500
- Depreciation, trainings, other – $500
Therefore, total fixed costs per month = $3,500
Formula for Break-Even Point
If we take a look at the graph above, we see that break-even point is where Total Costs (Fixed Costs + Variable Costs) = Total Revenue. The formula is:
Break-Even Point = Total Fixed Costs / (Selling Price per unit – Variable Costs per unit)
Thus, suppose the car oil change company charges $25 for a single oil change. In this case, its break-even point would be:
Break-Even Point = $3,500/($25 – $16.50)
Break-Even Point = 411.76, rounded up to 412 services per month.
Limitations of Break-Even Analysis
Some of the main limitations of break-even point include the following:
- It is best suited for analysing one product, at a time
- In practical terms, it is difficult to categorize certain costs as completely fixed or completely variable
Other Readers Also Read:
- Activity Based Costing
- Cash Flow ROI
- Cost-Benefit Analysis
- Free Cash Flow
- Economic Value Added
- Net Present Value