Break-Even Analysis

This blog began with a description of how costs behave and showed how costs can be classified as variable of fixed. These classifications are particularly useful when a firm is considering the introduction of a new product as they can be used to predict the number of units needed to make profit.

Most organisations will conduct market research before launching a new product to give them some idea of how many items they can expect to sell. Break-even analysis techniques enable management to quickly work out whether it is worthwhile launching the new product.

All manufactured goods will have some variables costs in the form of materials, direct labour and possibly direct expenses. They will also have to make some contribution by adding on a set amount to variable costs.

Contribution

The term "contribution" has great significance in cost accounting but simply means the selling price less the variable costs. For example, suppose a firm has a product  which it sells for $20.00 and the variable costs involved in making this product amount to $12.00 then the contribution is $8.00. If the fixed costs are $20,000 then each product sold is said to be contributing $8 towards the fixed costs. If this firm sells 2,500 units it will have covered all of its fixed costs and any additional units sold will be making $8 profit. This is what is involved in break-even analysis and it is usually calculated from the following formula:

Break-even point = Fixed Costs /  ( Selling price - variable costs )

The break-even point is defined as that point where all costs have been covered but no profit has yet been made. If the firm in the above example thought that it could only sell 200 units them it would not bother to make the product because it would not be able to cover its fixed costs. This is the basic break-even formula but it can be altered slightly to calculate various factors.

Margin of safely

This is useful figure which compares the break-even point with the expected level of sales. In the example used so far the break-even point was 2,500 units and the expected level of sales was 3,000 units. The Margin of Safely is the difference between the two figures.

                Expected sales       3,000

                Break-even point    2,500

                Margin of safely          500

This gives the firm some idea of how close it is to the break-even point. In this example, the margin of safely is not particularly large and some unforesceen circumstances may mean that sales are lost, in which case they will come dangerously close to making a loss.