Break-even Point analysis
The Break-even Point is, in general, the point at which the gains equal the losses. A break-even point defines when an investment will generate a positive return. The point where sales or revenues equal expenses. or also the point where total costs equal total revenues. There is no profit made or loss incurred at the break-even point. This is important for anyone that manages a business, since the break-even point is the lower limit of profit when prices are set and margins are determined.
Achieving Break-even today does not return the losses occurred in the past. Also it does not build up a reserve for future losses. And finally it does not provide a return on your investment (the reward for exposure to risk).
The Break-even method can be applied to a product, an investment, or the entire company's operations and is also used in the options world. In options, the Break-even Point is the market price that a stock must reach for option buyers to avoid a loss if they exercise. For a Call, it is the strike price plus the premium paid. For a Put, it is the strike price minus the premium paid.
Break-even Point analysis
The above graph explains what is breakeven point and how the producers reach or arrive at breakeven point which is also otherwise called as no profit and no loss situation.
X-axis of the graph represents the output and the Y axis of the graph represents cost / revenue and price. The TR (total revenue) curve started at zero as there won't be any income when there is zero production. However the total revenue increases with the increase in the production or out, as such the TR curve is drawn up from left to right. The FC (fixed cost) curve is drawn parallelly about the x-axis, as fixed cost will be constant and it will be incurred even when there is no production, but fixed cost won't be raised with the increase in production. The TC (total cost) curve started at the point of FC curve as total cost includes fixed cost plus variable cost.
With the increase in the production or output, the total cost is raised and the total revenue is also gained at the same time. But at one point the total cost and the total revenue meet together, the point is called breakeven point which means the point where there is no profit no loss to the organisation. The area below the BEP is construed as loss to the organisation as the total cost is higher than the total revenue and the area above the BEP point is construed as profit to the organisation, as total revenue curve is higher than the total cost curve.
Break-even Point calculation
Calculation of the BEP can be done using the following formula:
where: BEP = TFC / SPU - VCPU
BEP = break-even point (units of production)
TFC = total fixed costs,
VCPU = variable costs per unit of production,
SPU = selling price per unit of production.
The relationship between fixed costs, variable costs and returns
Break-even analysis is a useful tool to study the relationship between fixed costs, variable costs and returns. The Break-even Point defines when an investment will generate a positive return. It can be viewed graphically or with simple mathematics. Break-even analysis calculates the volume of production at a given price necessary to cover all costs. Break-even price analysis calculates the price necessary at a given level of production to cover all costs. To explain how break-even analysis works, it is necessary to define the cost items.
Fixed costs, which are incurred after the decision to enter into a business activity is made, are not directly related to the level of production. Fixed costs include, but are not limited to, depreciation on equipment, interest costs, taxes and general overhead expenses. Total fixed costs are the sum of the fixed costs.
Variable costs change in direct relation to volume of output. They may include cost of goods sold or production expenses, such as labor and electricity costs, feed, fuel, veterinary, irrigation and other expenses directly related to the production of a commodity or investment in a capital asset. Total variable costs (TVC) are the sum of the variable costs for the specified level of production or output. Average variable costs are the variable costs per unit of output or of TVC divided by units of output.
The Break-even Point analysis must not be mistaken for the Payback Period, the time it takes to recover an investment.
In Value Based Management terms, a break-even point should be defined as the Operating Profit margin level at which the business / investment is earning exactly the minimum acceptable Rate of Return, that is, its total cost of capital.
Benefits of Break-even Analysis
The main advantage of break-even analysis is that it explains the relationship between cost, production volume and returns. It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques. The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.
Margin of Safety = Expected or Actual Sales Level - Break-even Sales Level