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What is break-even analysis? Break-even analysis is one of the most common tools used to evaluate economic feasibility of an organization or a product line. In accounting, break-even point is the point at which revenue exactly equals to cost. At this point a company has no gain or no losses. The company simply earned enough to pay for all its expenses. Sales above break-even point will earn profit and below will lead to loss.
Break-even point can be calculated in terms of quantity or dollar sales. It is important to understand that a company or organization will not simply produce items just to break even. In reality, profit is a part of break even analysis. Thus, we have included profit to our calculators above.
There are several components associated with calculating Break-even point which are explained below in detail.
Fixed Costs
Total fixed costs are a major component of break-even analysis. Fixed costs are business expenses that do not vary with the level of production. They tend to be time related such as rents paid per month, insurance cost, employee salary etc. Fixed costs are also known as overhead of a company. Fixed cost is usually denoted by FC.
Variable Costs
Variable costs are business expenses that fluctuate with level of production. These types of costs are generally not time related such as raw materials and direct labor cost. Variable cost is generally denoted by v.
Profit
Although, profit is generally isn’t used in break even analysis, we have included it here to mimic reality. You can enter 0 for profit in the calculators above. Profit is generally known as the different between Sales and total cost. Profit is usually denoted by the letter u.
Formulas for Break even analysis
Break even analysis simply states that Total Revenue equals total cost. If total revenue exceeds total costs then we have a profit. If total revenue is below total costs then we have a loss. Total revenue is denoted by TR and total cost is denoted by TC. Total revenue is Price multiplied by quantity (Q) sold. Total cost is fixed cost plus variable costs.
Total Revenue = Total Cost
Price * Quantity = Fixed Cost + Variable Costs.
By using the formula above we can figure out Break Even Quantity (Q) or break even amount (TR)
Formula for Break even Quantity: Here we are looking for the quantity at which the total revenue will be equal to total cost.
Price * Quantity = Fixed Cost + Variable Costs
P * Q = FC + V * Q
P * Q - V * Q = FC
Q (P – V) = FC
Q = FC/P-V
Quantity = Fixed Cost / (Price – Variable Cost)
Below is with profit.
Quantity = Fixed Cost + Profit / (Price – Variable cost)
Note: Price minus variable cost is also known as contribution margin c.
Formula for Break Even Revenue: Here we are looking for the revenue at which there will be no profit or loss.
Total Revenue = Fixed Cost / (Contribution Margin / Price)
TR = FC / (C/P)
Below is with profit
Total Revenue = Fixed Cost + Profit / (Contribution Margin / Price)
TR = FC + U / (C/P)
Example:
A company is planning to introduce a new line of hard-drive. The hard-drive sales price will be $200/unit. After analyzing the cost structure, the management came to a decision that raw materials will cost $20/unit; direct labor will be $10/unit. The company needs to allocate a current portion of their factory dedicated toward producing the hard drives. The overhead will be $600,000 and insurance will be $100,000 to cover all equipment. The management also expects to get a profit of $200,000 as a buffer for any other cost that they might have missed. What is the break-even quantity for the company to also cover the profit/buffer cost?
Step 1:
Calculate the total Fixed Costs.
Overhead $600, 000
Insurance $100, 000
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Total Fixed Cost $700,000
Step 2:
Calculate the Variable Cost
Raw Materials $20.00
Direct Labor $10.00
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Total Variable Cost $30.00
Step 3:
Find the Contribution Margin. Contribution Margin is sales price minus variable costs.
C = $200 – $30 = $170
Step 4:
Plug in all the values into the formula
Quantity = Fixed Cost + Profit/ (Contribution Margin)
Q = $700,000 + $200,000 / $170
Q = 5294.1
So the company needs to produce and sell 5294.1 or 5295 quantities in order to break even.
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