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.