Disadvantages and Advantages of Break-Even Analysis
What Is Break-Even Analysis?
Break-even analysis is the relationship between cost volume and profits at various levels of activity, with an emphasis placed on the break-even point. This point is where the business receives neither a profit nor a loss, when total money received from sales is equal to total money spent to produce the items for sale.
Advantages and Uses
Break-even analysis enables a business organization to:
- Measure profit and losses at different levels of production and sales.
- Predict the effect of changes in sales prices.
- Analyze the relationship between fixed and variable costs.
- Predict the effect of cost and efficiency changes on profitability.
Even with its advantages and uses, there are also several demerits of break-even analysis.
- Assumes that sales prices are constant at all levels of output.
- Assumes production and sales are the same.
- Break even charts may be time consuming to prepare.
- It can only apply to a single product or single mix of products.
There are two ways to calculate the break-even point, in units and in sales revenue.
- The first way is to divide the fixed cost by the contribution per unit. This gives the result in units.
- Divide the fixed cost by the contribution-to-sales ratio. This gives the sales revenue.The contribution-to-sales ratio is given by dividing the contribution per unit by the selling price per unit.
Example of a Break-Even Point
ABC Ltd expects to sell 10,000 units at $10 each. The variable cost per unit is $5 and the fixed cost is $15,000 per annum. Calculate the break even point in units and in sale revenue.
- To calculate the break-even point in units, use the formula-fixed cost divided by the contribution per unit. In this example you would divide $1,000 by contribution (which is the selling price of $10 minus the variable cost per unit of $5). $15,000 divided by $5 is 3000 units
- To calculate the break-even point in sales revenue, divide the fixed cost by the contribution-to-sales ratio. In this example, $15,000 divided by ($5 divided by $10, or .5). The final answer is $30,000. We know this is the correct answer because when we multiply the break-even point in units by the selling price, we get the same answer.
Creating a Break-Even Chart
Unit selling price:
Unit variable expenses:
Total fixed expenses:
A break-even chart is a graphical representation of the break-even point, profits, losses and margin of safety. Using information from the example above, we will create a chart that shows:
- fixed cost
- total revenue line
- margin of safety
- loss region
- total cost line
- break-even point
- profit region
- Work out the total revenue by multiplying the unit selling price by the actual sales: 36 × 7,000 = 252,000
- Work out the total cost by multiplying the unit variable expenses by the number of units sold and adding that to to the fixed expenses: 28 × 7,000 = 196,000 + 50,000 = 246,000
- Now set up your chart. Note that when plotting, the first number in brackets is the x (horizontal) axis value and the second digit after the comma is the y (vertical) axis value. For this chart, you will show total unit sales along the x axis in thousands. Along the y axis you will show sales in tens of thousands of dollars, since there were 7,000 units sold and $50,000 in total sales.
- Now draw the fixed cost line. Make a dotted line from (0, 50,000) to (7,000, 50,000).
- Next you will make the Total Revenue line. Plot a point at (7,000, 252,000) and draw a line from zero to that point. Label the line.
- To create the Total Cost line, plot the point (7,000, 246,000) and draw a line from (0, 50,000) to that point. Label the line.
- Where the two lines meet is called the Break-Even Point and should to be labeled as such. The region below the break-even point should be labeled the Loss Region. The region above the break-even point should be labeled the Profit Region.
- Draw a dotted line from the break-even point to meet the x axis. From where it touches the x axis, to the actual sales, is the Margin of Safety in Units.
- To illustrate the margin of safety in dollars, draw a dotted line from the break-even point to the y axis. From where the line touches the y axis, to the total revenue line, is the Margin of Safety in Dollars.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.