Break-Even Analysis: Introduction, Assumptions and Limitations

The chart helps to fix the selling price, which would give desired profit. The chart helps the management to find the profitability of products and most profitable product mix. The key to using this tool is to be realistic in your expected revenues and conservative (high) in your expected costs.

Another reason why break-even analysis is important to stock and option traders is that break-even analysis provides insight into their positions’ profitability. In the break-even analysis, we keep everything constant. The selling price is assumed to be constant and the cost function is linear. Fixed costs and variable costs added together are called…

Calculating the breakeven point

Margin of safety is the difference between the current level of output and the breakeven level of output. It means that company E produces and sells 6 units or 40% more than it has to in order to reach the break-even level. In spite of the above limitations, the break-even chart helps the management to take valuable and quality decisions. E.g. the following changes in the business environment can be shown in a break even chart. 2) It shows profit and loss at different levels of output.

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. To apply the formula, let’s take a simple example. A company reports a sales volume of 1,000 units.

Break-Even Analysis

Also, by understanding the contribution margin, businesses can make informed decisions about the pricing of their products and their levels of production. Businesses can even develop cost management strategies to improve efficiencies. Let’s see how that works in an example where we estimate we can sell 1,200 widgets per month at $10 each, resulting in sales revenue of $12,000.

Profit graph shows the profit/loss at different levels of output/sales. Sales units/rupees are plotted on the X axis and profit/loss is measured in y axis. Profit increases with increase in sales volume and decreases with decrease in sales volume. In stock and option trading, break-even analysis is important in determining the minimum price movements required to cover trading costs and make a profit.

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The margin of safety is the difference between the current level of output and the breakeven level of output. It considers the number of units produced and the number of units that need to be produced in order to achieve the break-even level of output. In other words, it is the amount sales can decrease before a company reaches the break-even level of output and break even analysis advantages and disadvantages fails to make a profit. Sensitivity analysis involves changing one variable at a time, such as the fixed cost, the variable cost, or the selling price, and observing how it affects the break-even point and profit. In this case, we assume variable costs are unchanged. Also, changes in sales volume are not determined by the law of demand but within its control.

It’s a good idea to add a cushion to your projected fixed costs because there will always be miscellaneous expenses that you can’t predict. • Sales revenue is the total dollars from sales activity that you bring into your business each month or year. To perform a valid break-even analysis, you must base your forecast on the volume of business you really expect — not on how much you need to make a good profit.

Table of Contents

It is crucial to understand some basic concepts before doing a break-even analysis. In this case, the difference between the selling price per unit and the variable cost per unit (average variable cost) represents the contribution margin per unit. Businesses use breakeven analysis to provide information in decision making. Management knows how much they have to sell to cover all production costs.

• This is ignored and it is assumed that policies of the management do not change.
• Thus, the accuracy of the assumptions affects the results you get.
• Thus, to make a profit, the contribution margin must be higher than the fixed cost.
• Margin of safety can be known by deducting break­even sales from the actual sales.