Break Even Analysis Formulas
What does breaking even mean? The break even point is where the total revenue on a product/service is equal to the total cost incurred. Let me explain this concept with the help of a simple example. Suppose it takes $10 to make a chocolate cake, the price at which the cake business will break even will be at $10. Simply put, the it's the point where the cost of manufacturing = selling price.
In terms of pricing, the break even point shows the no-profit-no-loss position. So if you decide to price your product below the point, then you will incur a loss. On the other hand, if you price your product above the break even point, you will earn a profit. Thus, the break even point is very crucial as in a way, it helps form one of the important bases of product pricing. It also helps you decide if the product is worth manufacturing. For example, if it takes $100 to manufacture a product, but your market research suggests that the people aren't ready to pay a cent over $56, you know that unless you can somehow achieve a breakthrough decrease in the price over a period of time, there is going to be no point in trying to sell such a commodity.
Break Even Calculation
Before we try to calculate it, we should learn the meanings of some terms that are included in the formulas.
Fixed Costs: For running your business, there are some costs that you will incur, irrespective of your productive capacity. Some charges such as rent, depreciation of machinery, etc, you incur, whether you produce or not. Such costs are called fixed costs as, as long as the productive capacity stays between a particular range, (example: unless you have to double the production area and therefore, rent) that cost will remain the same.
Variable Costs: There are other costs that will vary according to production, such as wages, cost of purchases, etc. Variable costs of production will change as you increase (or decrease) your production.
Price: Well, we all really know what price means, but just to be sure, price is the monetary value realized by your product. It is the amount of money that the product commands in the market.
Volume: Volume is the total number of products produced.
Now that we know all the associated terms, let us go back to the meaning of break-even point. The break even point is where total costs and the total price is the same. So using this as the basis for the derivation, let us now derive the analysis formula.
Total Cost = Total Revenue.
Expanding this, we say that the total cost will be the sum of the fixed component and the variable component per unit produced. Total revenue on the other hand will be equal to the price of one unit multiplied by the number of units sold. Hence, we get the break even analysis formula.
(Variable Costs per unit * number of units) + Total Fixed Cost = Price per unit * number of units.
Another required calculation is how much volume you will need to sell in order to break even. Its volume is given by the below given formula.
Volume = Fixed Costs / (Price per unit - Variable Costs per unit)
The other consideration in the analysis is the amount of time it will take for you to break even. For that you will need to define a certain time-period. Say, you want to know how many months it will take you to break even, then the period will be defined in months.
Break even period = Break even volume / sales per period (per month)
But the thing to keep in mind while you do your break even analysis is that the point is one consideration. Many businesses, like the airline business, have long gestation periods and it may be years till they can cover the money they have invested. But that doesn't necessarily mean no one in America is starting airlines. In the long run, there are chances that you may make exponential profits in some businesses, if you are willing to suck up a few years of losses.
