Saturday Brain Storming Thought (204) 06/01/2024
BREAK-EVEN ANALYSIS
Break-even analysis refers to the point at which total costs and total revenue are equal
A Break-even point analysis is used to determine the number of units needed to cover total cost
Key Takeaways of Break-even Analysis
1) Break-even analysis tells you how many units of a product must be sold to cover the fixed and variable costs of production
2) The Break-even point is considered a measure of the margin of safety
3) Break-even analysis is used broadly, from stock and options trading to corporate budgeting for various projects
Users of Break-even Analysis
1) Entrepreneurs
Helps them to determine the minimum level of sales needed to cover costs which is critical for early stage of business
2) Financial Analysts
To use to determine profitability and risk metric
3) Investors
To determine financial performance of conpanies to decide investment amountvand expected profit
4) Stock and Option Traders
To determine how much money is needed to cover their expenses for each transaction they make
5) Businesses
To determine a better picture of their cost structure, pricing as well as operational efficiencies
6) Government Agencies
To understand the financial viability of projects and programs
Importance of Break-even Analysis to businesses
1) Pricing
Businesses can set price of the products to cover fixed and variable costs with reasonable profit margin
2) Decision Making
Use this analysis to help them make informed decisions
3) Cost Reduction
Find areas where they can reduce costs to increase profitability
4) Performance Metric
It helps businesses ascertain where they are when it comes to achieving their short, medium and long term goals
Strengths of Break-even Analysis
1) Pricing
Solid basis to determine price of products
2) Setting Revenue Targets
It can be a great tool for setting concrete sales targets for team
3) Mitigate risk
It can help you mitigate risk by avoiding investments or product lines that aren’t likely to be profitable
4) Gaining funding
Manageable Break-even point is likely to make you more comfortable with the prospect of taking on extra financing or debt
Limitations of Break-even Analysis
1) Does not predict demand
Demand is not stable
2) Depends on reliable data
Accuracy of Break-even Analysis depends on accuracy of your data
3) Too Simple
Costs can be changed, so your Break-even point may need to be evaluated and adjusted at a letter time
4) Ignores Competition
Competitors aren’t factored into the equation
Standard Break-even time period
An acceptable Break-even time is 6 to 18 months
Events to consider Break-even Analysis
1) Expanding a business
To calculate minimum sales required to cover costs to entering in new market
2) Lowering Prices
When businesses need to lower their pricing strategy to beat competitors in a specific market segment or product
3) Narrowing down business scenarios
It help Business leaders reduce decision making to a series of yes or no questions
Break-even Analysis formula
Break-even Quantity = (Fixed Costs) / (Sales price per unit – variable cost per unit)
Break-even chart
It shows the relationship between cost and sales and indicates profit and loss on different quantity
Intersection of total cost and total revenue is Break-even point
Fixed Costs
These are costs that do not change with varying output ie salary, rent, building machinery etc
Variable costs per unit
It is the variable cost incurred to create a unit ie contribution margin per unit
Sales price per unit
It is the selling price per unit
Factors that increase Break-even point
1) Increase in customer sales
ie higher demand
2) Increase in production costs
ie increase in price of raw materials, salaries of employees, rent etc
3) Equipment repair
Equipment failures means higher operational costs
Factors to reduce Break-even point
1) Raise product prices
It may lose some customers
2) Outsourcing
Due to outsourcing, manufacturing cost reduces when production volume increases
Assumptions in Break-even Analysis
1) all elements of cost ie production, administration, selling distribution can be divided into fixed and variable components
2) Variable costs remains constant per unit of output
3) Fixed cost remain constant at all volume of output
4) Selling price per unit remains unchanged or constant at all levels of output
5) Volume of production is the only factor that influences cost
6) There will be no change in the general price level
7) There is one product and in case of multi product, the sale remains constant
Margin of Safety
Margin of safety represents the strength of the Businesses
Margin of Safety = (current output – Break-even output)
OR
Margin of safety = (actual sales – BEP sales)
COMPILED BY:-
Er. Avinash Kulkarni
9822011051
Chartered Engineer, Govt Regd Valuer, IBBI Regd Valuer
