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Break Even Analysis
Companies Served Since 1981

Break Even Analysis


By Gregg Schoenberg Monday, February 11, 2013

When it’s time for a large corporation to evaluate the merits of bringing a new product or service to market they have a host of options available to test its financial viability. From marketing surveys to focus group studies to detailed analysis by the finance department, it can seem that the only limit to their tool kit is the size of their budget.

Of course entrepreneurs can’t usually afford these luxuries, so many of us fail to conduct any analysis at all, relying instead on our gut and intuition. But this creates unnecessary risk, and we can mitigate this risk by utilizing a basic tool of corporate finance: the break-even analysis.

The premise of the break-even analysis is quite simple, it tells us what level of sales we need to reach in order to avoid losses, and thus helps stop us from entering markets where we have no chance of making a profit. The sample analysis in the table below for the fictional ABC Company shows that their break-even point for a new product that would sell for $2 a unit is 1,000 units; if they cannot realistically expect to sell more than that, they should not bring the product to market.

 

Break-even Analysis for ABC Company's Potential New Product

Price Quantity Total Revenue Fixed Cost Per Unit Variable Cost Total Cost Profit (Loss)
(P) (Q)  (TR) (FC) Variable Cost (V) (VC) (TC) (P/L)

 $2

0

 $-

 $1,000

 $1

 $-

 $1,000

 $(1,000)

 $2

200

 $400

 $1,000

 $1

 $200

 $1,200

 $(800)

 $2

400

 $800

 $1,000

 $1

 $400

 $1,400

 $(600)

 $2

600

 $1,200

 $1,000

 $1

 $600

 $1,600

 $(400)

 $2

800

 $1,600

 $1,000

 $1

 $800

 $1,800

 $(200)

 $2

1000

 $2,000

 $1,000

 $1

 $1,000

 $2,000

 $-

 $2

1200

 $2,400

 $1,000

 $1

 $1,200

 $2,200

 $200

 $2

1400

 $2,800

 $1,000

 $1

 $1,400

 $2,400

 $400

 $2

1600

 $3,200

 $1,000

 $1

 $1,600

 $2,600

 $600

 $2

1800

 $3,600

 $1,000

 $1

 $1,800

 $2,800

 $800

 $2

2000

 $4,000

 $1,000

 $1

 $2,000

 $3,000

 $1,000

 

It’s quite easy to construct a break-even analysis like this in Excel, and it’s even easier to distill the break-even relationship into this simple equation: B=FC/P-V where B is equal to the break-even level of sales, FC equals the fixed cost associated with the product, P equals the sales price, and V equals the per unit variable cost (the amount required to produce one additional unit). In ABC’s case we see once again that FC of $1000 divided by P of $2 minus V of $1 results in B equaling 1,000 units (B=1,000/2-1 so B=1,000). For a review of the treatment of fixed and variable costs, see our piece on cost structure.

Break-even analysis can be used for more than just evaluating whether or not a new idea is likely to be a financially lucrative one. Once you have gone to market with a product, it can help you to see how changes in sales and fluctuations in costs affect your profitability.

For example, say ABC has gone live with its product and is now considering an advertising campaign to try and ramp up sales. If this ad campaign will add $0.25 per unit to variable costs, how many additional units of sales must the campaign generate in order to be worthwhile? Going back to our simple break-even equation B=FC/P-V we just have to plug in the additional $0.25 of V to see that B now equals $1000/$2 - $1.25 which means a new break-even point of 1,333 units. So if the ad campaign generates more than 333 additional sales it will pay for itself. Sales below this will result in a loss on the advertising dollars.

A final use for break-even analysis is to evaluate swapping variable costs and fixed costs, say by replacing labor with new equipment. Even if new equipment allows your firm to run more efficiently and decrease some of your variable costs, it will add to your fixed costs and thus may push up your break-even point, so be sure to analyze the impact carefully before making any large purchases.

Hopefully, you now have a good idea of what break-even analysis is and how it can help you to analyze several different scenarios that you are likely to face throughout the lifecycle of your company. For further reading and more detailed analysis, an introductory-level corporate finance textbook can be a great resource.

 

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