What is a 'Break-Even Analysis'

Break-even analysis entails the calculation and examination of the margin of safety for an
entity based on the revenues collected and associated costs. Analyzing different price
levels relating to various levels of demand, an entity uses break-even analysis to determine
what level of sales are needed to cover total fixed costs. A demand-side analysis would give
a seller greater insight regarding selling capabilities.

BREAKING DOWN 'Break-Even Analysis'

Break-even analysis is useful in the determination of the level of production or in a targeted
desired sales mix. The analysis is for management’s use only as the metric and calculations
are often not required to be disclosed to external sources such as investors, regulators or
financial institutions. Break-even analysis looks at the level of fixed costs relative to the
profit earned by each additional unit produced and sold. In general, a company with lower
fixed costs will have a lower break-even point of sale. For example, a company with $0 of
fixed costs will automatically have broken even upon the sale of the first product assuming
variable costs do not exceed sales revenue. However, the accumulation of variable costs
will limit the leverage of the company as these expenses are incurred for each item sold.
Contribution Margin
The concept of break-even analysis deals with the contribution margin of a product. The
contribution margin is the excess between the selling price of the good and total variable
costs. For example, if a product sells for $100, total fixed costs are $25 per product and
total variable costs are $60 per product, the product has a contribution margin of the
product is $40 ($100 - $60). This $40 reflects the amount of revenue collected to cover fixed
costs and be retained as net profit. Fixed costs are not considered in calculating the
contribution margin.

Formulas for Break-Even Analysis

The calculation of break-even analysis may be performed using two formulas. First, the total
fixed costs are divided the unit contribution margin. In the example above, assume total
company fixed costs are $20,000. With a contribution margin of $40, the break-even point is
500 units ($20,000 divided by $40). Upon the sale of 500 units, all fixed costs will be paid
for, and the company will report a net profit or loss of $0.

Alternatively, the break-even point in sales dollars is calculated by dividing total fixed costs
by the contribution margin ratio. The contribution margin ratio is the contribution margin per
unit divided by the sale price. Using the example above, the contribution margin ratio is 40%
($40 contribution margin per unit divided by $100 sale price per unit). Therefore, the break-
even point in sales dollars is $50,000 ($20,000 total fixed costs divided by 40%). This
figured may be confirmed as the break-even in units (500) multiplied by the sale price
($100) equals $50,000
Break-Even Point

Break-even point analysis is a measurement system that calculates the margin of safety by
comparing the amount of revenues or units that must be sold to cover fixed and variable costs
associated with making the sales. In other words, it’s a way to calculate when a project will be
profitable by equating its total revenues with its total expenses. There are several different uses
for the equation, but all of them deal with managerial accounting and cost management.

The main thing to understand in managerial accounting is the difference between revenues and
profits. Not all revenues result in profits for the company. Many products cost more to make than
the revenues they generate. Since the expenses are greater than the revenues, these products great
a loss—not a profit.

The purpose of the break-even analysis formula is to calculate the amount of sales that equates
revenues to expenses and the amount of excess revenues, also known as profits, after the fixed
and variable costs are met. There are many different ways to use this concept. Let’s take a look at
a few of them as well as an example of how to calculate break-even point.

Formula
The break-even point formula is calculated by dividing the total fixed costs of production by the
price per unit less the variable costs to produce the product.

Since the price per unit minus the variable costs of product is the definition of the contribution
margin per unit, you can simply rephrase the equation by dividing the fixed costs by the
contribution margin.

This computes the total number of units that must be sold in order for the company to generate
enough revenues to cover all of its expenses. Now we can take that concept and translate it into
sales dollars.
The break-even formula in sales dollars is calculated by multiplying the price of each unit by the
answer from our first equation.

This will give us the total dollar amount in sales that will we need to achieve in order to have
zero loss and zero profit. Now we can take this concept a step further and compute the total
number of units that need to be sold in order to achieve a certain level profitability with out
break-even calculator.

First we take the desired dollar amount of profit and divide it by the contribution margin per unit.
The computes the number of units we need to sell in order to produce the profit without taking in
consideration the fixed costs. Now we must add back in the break-even point number of units.
Here’s what it looks like.

Example
Let’s take a look at an example of each of these formulas. Barbara is the managerial accountant
in charge of a large furniture factory’s production lines and supply chains. She isn’t sure the
current year’s couch models are going to turn a profit and what to measure the number of units
they will have to produce and sell in order to cover their expenses and make at $500,000 in
profit. Here are the production stats.

 Total fixed costs: $500,000

 Variable costs per unit: $300
 Sale price per unit: $500
 Desired profits: $200,000

First we need to calculate the break-even point per unit, so we will divide the $500,000 of fixed
costs by the $200 contribution margin per unit ($500 - $300).
As you can see, the Barbara’s factory will have to sell at least 2,500 units in order to cover it’s
fixed and variable costs. Anything it sells after the 2,500 mark will go straight to the CM since
the fixed costs are already covered.

Next, Barbara can translate the number of units into total sales dollars by multiplying the 2,500
units by the total sales price for each unit of $500.

Now Barbara can go back to the board and say that the company must sell at least 2,500 units or
the equivalent of $1,250,000 in sales before any profits are realized. She can also take it a step
further and use a break-even point calculator to compute the total number of units that must be
produced in order to meet her $200,000 profitability goal by dividing the $200,000 desired profit
by the contribution margin then adding the total number of break-even point units.

These are just examples of the break-even point. You can use these as a template for your
business or course work.

Analysis
As you can see there are many different ways to use this concept. Production managers and
executives have to be keenly aware of their level of sales and how close they are to covering
fixed and variable costs at all times. That’s why they constantly try to change elements in the
formulas reduce the number of units need to produce and increase profitability.

For instance, if management decided to increase the sales price of the couches in our example by
$50, it would have a drastic impact on the number of units required to sell before profitability.
They can also change the variable costs for each unit by adding more automation to the
production process. Lower variable costs equate to greater profits per unit and reduce the total
number that must be produced. Outsourcing can also change the cost structure.

One of the most important concepts here is the margin of safety. That’s the difference between
the number of units required to meet a profit goal and the required units that must be sold to
cover the expenses. In our example, Barbara had to produce and sell 2,500 units to cover the
factory expenditures and had to produce 3,500 units in order to meet her profit objectives. This
1,000-unit spread is the margin of safety. It’s the amount of sales the company can afford to lose
but still cover its expenditures.

It’s also important to keep in mind that all of these models reflect non-cash expense like
depreciation. A more advanced break-even analysis calculator would subtract out non-cash
expenses from the fixed costs to compute the break-even point cash flow level.
PROVIT VOLUME RATIO
Definition: Profit Volume Ratio
The profit volume ratio for any product, shows the
relationship between the profits earned by the
company and the volume of sales generated. The chart
shows the profits generated by the company at
different levels of sales and the outcome is used to
determine the future of the business in the short run.

The PVR chart gives the profitability of the product,

the optimal price at which the product has to be sold,
the optimal quantity to generate maximum profits and
the breakeven point.

The PVR Graph is given as follows,

Profit Volume Ratio (With Formula and Calculation)

The Profit/volume ratio, which is also called the ‘contribution ratio’ or ‘marginal ratio’,
expresses the relation of contribution to sales and can be expressed as under:

P/V Ratio = Contribution/Sales

Since Contribution = Sales – Variable Cost = Fixed Cost + Profit, P/V ratio can also be
expressed as:

P/V Ratio = Sales – Variable cost/Sales i.e. S – V/S

or, P/V Ratio = Fixed Cost + Profit/Sales i.e. F + P/S

or, P/V Ratio = Change in profit or Contribution/Change in Sales

This ratio can also be shown in the form of percentage by multiplying by 100. Thus, if selling
price of a product is Rs. 20 and variable cost is Rs. 15 per unit, then

P/V Ratio = 20 – 15/20 × 100 = 5/20 × 100 = 25%

The P/V ratio, which establishes the relationship between contribution and sales, is of vital
importance for studying the profitability of operations of a business. It reveals the effect on profit
of changes in the volume.

In the above example, for every Rs. 100 sales, Contribution of Rs. 25 is made towards meeting
the fixed expenses and then the profit comparison for P/V ratios can be made to find out which
product, department or process is more profitable. Higher the P/V ratio, more will be the profit
and lower the P/V ratio, lesser will be the profit. Thus, every management aims at increasing the
P/V ratio.

The ratio can be increased by increasing the contribution. This can be done by:

(i) Increasing the selling price per unit

(ii) Reducing the variable or marginal cost.

(iii) Changing the sales mixture and selling more profitable products for which the P/V ratio is
higher.

The concept of P/V ratio is also useful to calculate the break-even point, the profit at a given
volume of sales, the sales volume required to earn a given (or desired) profit and the volume of
sales required to maintain the present profits if the selling price is reduced by a specified
percentage.

The formula for the sales volumes required to earn a given profit is:

P/V Ratio = Contribution/Sales

or, P/V Ratio = Fixed Cost + Profit/Sales

or, Sales = Fixed Cost + Profit/P/V ratio = F + P/P/V ratio

Illustration 1:

Find out:

(i) P/V ratio,

(ii) Fixed Cost

(iii) Sales Volume to earn a Profit of Rs. 40,000

Solution:

Proof:

Illustration 2:
Sale of a product amounts to 200 units per month at Rs. 10 per unit. Fixed overhead cost is Rs.
400 per month and variable cost is Rs. 6 per unit. There is a proposal to reduce prices by 10 per
cent. Calculate present and future P/V ratio. How many units must he sold to earn the present
total profits?

Solution:

Illustration 3:

The sales turnover and profit during two years were as follows:

You are required to calculate:

(i) P/V ratio

(ii) Sales required to earn a profit of Rs. 40,000.

(iii) Profit when sales are Rs. 1,20,000.

Solution:

Home ›› Marginal Costing ›› Management ›› Financial Management ›› Profit-

Volume RatioMarginal cost

Marginal cost is the additional cost incurred in the production of one more unit of a good or
service. It is derived from the variable cost of production, given that fixed costs do not change as
output changes, hence no additional fixed cost is incurred in producing another unit of a good or
service once production has already started.
Marginal cost is significant in economic theory because a profit maximising firm will produce up
to the point where marginal cost (MC) equals marginal revenue (MR).

Also, a firm’s supply curve is effectively the part of the MC curve above average variable costs
(from point B upwards, on the diagram below). A firm will not supply below this point as it will
not be covering its opportunity cost. Point B is also known as shut-down point. Point A
represents break-even point.
marginal cost
Definition
marginal cost http://w w w .busin marginal cost. Bu marginal cost. Bu marginal cost. Bu

The increase or decrease in the total cost of a production run for

making one additional unit of an item. It is computed in situations
where the breakeven point has been reached: the fixed costs have
already been absorbed by the already produced items and only the
direct (variable) costs have to be accounted for.

Marginal costs are variable costs consisting of labor and material

costs, plus an estimated portion of fixed costs (such as
administration overheads and selling expenses). In companies where
average costs are fairly constant, marginal cost is usually equal to
average cost. However, in industries that require heavy capital
investment (automobile plants, airlines, mines) and have high
average costs, it is comparatively very low.

The concept of marginal cost is critically important in resource

allocation because, for optimum results, management must
concentrate its resources where the excess of marginal revenue over
the marginal cost is maximum. Also called choice cost, differential
cost, or incremental cost.
 Advantages of Marginal Costing:

 It is simple to understand re:

variable versus fixed cost concept;

 A useful short term survival costing

technique particularly in very
competitive environment or
recessions where orders are
accepted as long as it covers the
marginal cost of the business and
the excess over the marginal cost
contributes toward fixed costs so
that losses are kept to a minimum;

 Its shows the relationship between

cost, price and volume;

 Under or over absorption do not

arise in marginal costing;

 Stock valuations are not distorted

with present years fixed costs;

 Its provide better information hence

is a useful managerial decision
making tool;

 It concentrates on the controllable

aspects of business by separating
fixed and variable costs

 The effect of production and sales

 policies is more clearly seen and
understood.

Cost Curves
The short-run marginal cost (MC) curve will at first decline and
then will go up at some point, and will intersect the average total
cost and average variable cost curves at their minimum points.

The average variable cost (AVC) curve will go down (but will not be
as steep as the marginal cost), and then go up. This will not go up as
fast as the marginal cost curve.

The average fixed cost (AFC) curve will decline as additional units
are produced, and continue to decline.

The average total cost (ATC) curve initially will decline as fixed
costs are spread over a larger number of units, but will go up as
marginal costs increase due to the law of diminishing returns.

The graph below illustrates the shapes of these curves.

Figure 3.8: Cost Curves