Break-even analysis is a key concept in corporate finance that determines the point at which a company breaks even on its operations. It helps to determine the point at which total costs and total revenues intersect and is one of several measures of the company’s financial performance. This analysis is frequently used by managers to set sales goals, as well as assess operational efficiencies and customer demand.
In this article, we will be discussing what break-even analysis is, examples and how does it work.
What is Break-Even Analysis
Break-even analysis is a tool that helps managers assess a company’s production and sale capacity, as well as its profit potential. The break-even point refers to the volume of sales needed for a company to generate enough revenue to cover all of its cash outlays, which include fixed costs, variable costs, and departmental expenses.
As such, this analysis is used to determine the best prices for the company’s products. It is also useful in determining how much product should be produced.
Break-even analysis can be simple or complex, depending on whether one considers all of a company’s expenses, including taxes and depreciation costs. This complexity arises because firms must estimate their future cash outlays based on present or historical data.
How does break-even analysis work
In general, this analysis is used to assess a company’s ability to meet its financial obligations and remain sustainable. To make this assessment, analysts and managers must first determine the total fixed and variable costs of producing and selling their products. They can then determine how many sales must be made for expenses to equal income by using the formula:
Break-even point based on units
Break-Even point = Fixed Costs ÷ (Sales price per unit – Variable costs per unit)
Break-even point based on sales dollars
Break-Even Point = Fixed Costs ÷ Contribution Margin
Contribution Margin = (Price of Product – Variable Costs)
Examples of break-even analysis
Let’s say, for example, that you own a local coffee shop. You know that your monthly fixed costs (rent, electricity, salaries) amount to $2,000 and that each cup of coffee you sell is priced at $3. And let’s say it costs you $1 to produce each cup of coffee.
How much coffee must you sell in a given month to cover costs
Break-even point in units = $2,000/($3-$1) = 1000 cups of coffee
Now let’s find out the Break-even point based on sales dollars
We have to figure out the Contribution margin first.
Contribution margin = (Price of Product – Variable Costs)
Contribution Margin = $3 – ($1/cup) = $2 per cup
Break-even point in sales dollars = Fixed Costs ÷ Contribution Margin = 2000 ÷ 2 = $1000
The break-even points for this coffee shop are 1,000 cups of coffee or $1,000.
So there you have it. In this article, we have talked about break-even analysis in corporate finance. As you can tell by now, the break-even point is the volume of sales required to cover all of a company’s expenses. This is the point at which expenses equal income. Although we have discussed some very basic information here, this article should give you a good understanding of the concept.