Break-even analysis is used in cost accounting and capital budgeting to evaluate projects or product lines in terms of their volume and profitability relationship. At its simplest, the tool is used as its name suggests: to determine the volume at which a company's costs will exactly equal its revenues, therefore resulting in net income of zero, or the "break-even" point. Perhaps more useful than this simple determination, however, is the understanding gained through such analysis of the variable and fixed nature of certain costs. Break-even analysis forces the small business owner to research, quantify, and categorize the company's costs into fixed and variable groups.
"Understanding what it takes to break even is critical to making any business profitable," Kevin D. Thompson stated in Black Enterprise. "Incorporating accurate and thorough break-even analysis as a routine part of your financial planning will keep you abreast of how your business is really faring. Determining how much business is needed to keep the door open will help improve your cash-flow management and your bottom line."
The basic formula for break-even analysis is as follows:
BEQ FC /(P-VC)
Where BEQ Break-even quantity
FC Total fixed costs
P Average price per unit, and
VC Variable costs per unit.
Fixed costs include rent, equipment leases, insurance, interest on borrowed funds, and administrative salaries—costs that do not tend to vary based on sales volume. Variable costs, on the other hand, include direct labor, raw materials, sales commissions, and delivery expenses—costs that tend to fluctuate with the level of sales. A key component of break-even analysis is the contribution margin, which can be defined as a product or service's price (P) minus variable costs (VC) per unit sold. The contribution margin concept is grounded in incremental or marginal analysis; its focus is the extra revenue and costs that will be incurred with the next additional unit.
The first step in determining the level of sales needed for a small business to break even is to compute the contribution margin, by subtracting the variable costs per unit from the selling price. For example, if P is $30 and VC are $20, the contribution margin is $10. The next step is to divide the total annual fixed costs by the contribution margin. For example, a company with FC of $50,000 and a contribution margin of $10 would need to sell 5,000 units to break even. This number can easily be converted to the dollars of revenue the company would need to break even for the year. Simply multiply the break-even point in units by the average selling price per unit. In this case, a BEQ of 5,000 units multiplied by a P of $30 per unit yields break-even revenue of $150,000.
Break-even analysis has numerous potential applications for small businesses. For example, it can help managers assess the effect of changing prices, sales volume, and costs on profits. It can also help small business owners make decisions regarding whether to expand their operations or hire new employees. Break-even analysis would also be useful in the following situation: a small business owner is skeptical of her marketing manager's projection for sales of 15,000 units of a new product, and wants to know what minimum quantity of units must be sold to avoid losing money, assuming a selling price of $25, fixed costs of $100,000, and variable costs of $15. The equation tells her that these parameters will require a break-even volume of 10,000 units; fewer than that level yields losses, more than that level yields profits. This perspective of analysis may be employed where the analyst is highly confident of the estimates for price and costs, but feels less certain about the assessment of market demand. In this case, the small business owner might be interested in how low sales could fall below the marketing manager's forecast without causing an embarrassment at year-end reporting time.
Another scenario may involve the question of how to manufacture a product, in terms of the nature of operations and how they will affect fixed costs. Here, a small business owner may have a good handle on the quantity expected, the likely selling price, and the variable costs involved, but be undecided about how to structure the new operation. If the volume is expected to be 10,000 units, at a selling price of $5 and variable costs of $3.50, the break-even equation tells him that fixed costs can be no greater than $15,000. "The bottom line is that, especially for small businesses, the margins for error are much too narrow to make business decisions on gut instinct alone," Thompson concluded. "Every idea, whether it is the introduction of a new product line, the opening of branch offices, or the hiring of additional staff, must be tested through basic business analysis."