Break-even analysis is a part of cost-volume-profit (CVP) analysis. These techniques focus on how selling prices, sales volume, variable costs, fixed costs and the mix of product sold affects profit. It provides understanding the relationships between cost, sales volume and profit which ultimately help you to make better business decisions.
There are four key components of CVP Analysis;
Contribution Margin Ratio Analysis (CM)
Break-Even Point Analysis (BEP)
Target Profit Analysis (TP)
Margin of Safety Analysis (MoS)
Cost-volume-profit (CVP) analysis is used to determine how changes in costs and volume affect a company's operating income and net income. This is the level of sales where the company will not incur a loss, yet not make a profit. In performing this analysis, there are several assumptions made, including:
Sales price per unit is constant.
Variable costs per unit are constant.
Fixed costs are constant e.g. rent, insurance and wages
Everything produced is sold.
Costs are only affected because of activity changes.
If a company sells more than one product, they are sold in the same mix.
CVP analysis requires that all the company's costs, including manufacturing, selling, and administrative costs, be identified as variable or fixed.
To be able to explain appropriately, I will break each element into small pieces and explain how to calculate them to effectively establish this analysis. I will use a fiction company and some random numbers throughout the article to be able to explain how we calculate and analyse them accordingly.
Sample details: Company A sold 500,000 of their products with variable cost per unit of £2.1, fixed cost is £1,700,000 and Sales price per unit of £5.5.
Note: You can download related excel spreadsheet here.
Revenue, Costs (Fixed and Variable) and Operating Profit
First, let’s calculate total revenue, costs and operating profit numbers;
1. Contribution Margin Analysis (CM)
Key calculations when using CVP analysis are the contribution margin and the contribution margin ratio. The contribution margin represents the amount of income or profits the company made before deducting its fixed costs or in another way, CM is the amount remaining from sales revenue after variable costs have been deducted.
In summary, it is the amount of sales revenue available to cover (or contribute to) fixed costs up until the break-even point is reached. When calculated as a ratio, it is the percent of sales revenue available to cover fixed costs. Once fixed costs are covered, any revenue left contributes to the company’s operations profit.
Contribution Margin = Price per unit – Variable cost per unit
Contribution Margin Ratio = Contribution Margin / Sales Revenue
2. Break-Even Point Analysis (BEP)
The break‐even point represents the level of sales where net income equals zero. In other words, the point where sales revenue equals total variable costs plus total fixed costs, and contribution margin equals fixed costs or in a simple term, this is the level of sales where the company will not incur a loss, yet not make a profit.
Break-even is where Total Revenue equals Total Costs (Revenue = Costs)
Break-even Volume (units) = Fixed Costs / Unit Contribution Margin
Break-even Volume (Sales £) = Fixed Costs / Contribution Margin Ratio
3. Target Profit Analysis (TP)
We all know that the break-even point is important for the business and aim to do better than break-even and therefore, most of the companies set itself a target to achieve a certain level of profits. CVP analysis allows us to calculate the level of sales requires to achieve this goal.
Target Volume (units) = (Fixed Costs + Target Profit) / Unit Contribution Margin
Target Volume (Sales £) = (Fixed Costs + Target Profit) / Unit Contribution Margin Ratio
4. Margin of Safety Analysis (MoS)
The margin of safety is volume of sales that the company is selling above the break-even point. Like the break-even point, the margin of safety can be expressed either in units or revenue figures. However, the margin of safety is most often expressed as a percentage of sales.
In other words, the margin of safety indicates the risk of losing money that a company faces. How much can sales decrease in either volume or revenue before the company experiences a net loss? Let's look at it together.
Margin of safety in units = Budgeted sales − Break-even sales
Margin of Safety % = (Budgeted Sales – Break-even Sales) / Budgeted Sales
All of the above can be summarized in the following chart. The horizontal axis denotes Sales volume, the vertical axis counts sales and costs in revenue terms. The green line is Total Revenues for every unit sold, the orange line is Total Cost for every unit sold. The point where these two lines intersect is the Break-Even Point. You can also easily identify Total Costs (Fixed Costs + Variable Costs) as well as Margin of Safety areas for both Revenue and Volume terms.
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