Break Even Analysis In business planning, asking the proper questions and obtaining answers to those questions is arguably the most important thing. Questions such as; how much do we have to sell to reach our profit goal? How much do our sales need to increase in order to cover a planned increase in advertising costs? What price should we charge to cover our costs and allow for the planned profit goals? Is our business going to be profitable? Answers to such difficult questions become accessible with the utilization of the break even analysis.
Break even analysis can be conceived arguably as one of the simplest tools in accounting; however, its simplicity does not take away from its importance. Break even analysis is used in cost and managerial accounting along with capital budgeting to evaluate projects or product lines in terms of their volume and profitability relationship. Essentially it helps business owners to understand how much product they have to sell to cover all expenses. Total expenses consist of two cost components; fixed and variable costs.
Fixed costs are the expense items which generally do not change from month to month, regardless of how much you sell, use, or produce. On the flip side, variable costs are those expenses that change with the unit level of either production or sales. Such expenses normally increase with increased production because such expenses are directly involved in making the product or making the sale. The most basic formula for break even analysis is total fixed costs divided by the average price per unit minus variable costs per unit. In mathematical terms, it is simply the point where total expenses equal to net sales revenue.
A key component of break-even analysis is the contribution margin, which is the product or service’s price minus variable costs per unit sold part of the equation. The contribution margin concept is grounded in marginal analysis; its focus is the extra revenue and costs that will be incurred with the next additional unit. The first step in determining the level of sales needed for a business to break even is to compute the contribution margin, by subtracting the variable costs per unit from the selling price. For example, if Price is $30 and Variable Costs are $20, the contribution margin is $10.
The next step is to divide the total annual fixed costs by the contribution margin. For example, a company with Fixed Cost of $50,000 and a contribution margin of $10 would need to sell 5,000 units to break even. For the purposes of this assessment of the break even analysis, we will look into its use when it comes to small business as I am personally involved in running my family’s fence company. The goals of this assessment are to identify what benefits the implementation of the break even analysis would have in the business.
Generally, break-even analysis has numerous potential applications for small businesses. For example, it can help managers assess the effect of changing prices, sales volume, and costs on profits. It can also help small business owners make decisions regarding whether to expand their operations or hire new employees. In trying to realizing what possible impact the implementation of break even analysis would have in our small business, we would have to apply the tool in real life situations as they pertain to the business nature.
The first situation we can directly analyze break even is when we are skeptical about projected sales of when introducing a new product. More specifically, we as a company started manufacturing pre-assembled fence panels that customers can purchase from us and can install by themselves. It was projected that we would sell 1,500 fence panels in the first year. With this ailing economy some, my father was very skeptical. However, once we projected that we would sell 1,500, it would be important to assess what that projection really means before we would put the panels into production.
We want to know what minimum quantity of units must be sold to avoid losing money. For the purposes of this example, we will assume that the selling price will be $25, fixed costs of $10,000, and variable costs of $15. In using the break even formula and plugging in the above numbers, we would determine how many units we would have to sell to break even, which in this specific case it would be 1,000 fence panels. This tells us that selling fewer than 1,000 fence panels would yield losses.
Determining what the break even number is becomes very vital as we try to next project how long it will take to sell those 1,000 panels as the time it will take us to sell those panels would mean the amount of time we would have our money invested in and we would have to assess what impact having our money tied up in the production of those panels would have on the overall business and address whether we can even afford to have our money tied up into those fence panels for that specific amounts of time.
In looking at the next possibility where we can use the break even analysis, it would involve the question of how to manufacture a product, in terms of the nature of operations and how it will affect fixed costs. In this instance, we as a company may have a good idea on the quantity expect, the likely selling price, and the variable costs involved, but be uncertain about how to structure the new operation. For example, if the volume expected to be 15,000 units, at a selling price of $5 and variable costs of $3, the break even equation tells us that the fixed costs cannot be greater than $30,000.
This use of the break even would give us a good idea of how much the maximum fixed expense would have to be for us not to be at a loss when trying to introduce a new product. Ultimately, as we have looked into the detailed traits of the break even analysis along with the illustrations we have provided on how it would directly impact our company our company, it can be concluded that its implementation within our business structure is vital, as right now it is not used within our company.
According to Kevin Thompson, “the bottom line is that, especially for small business, the margins for error are much too narrow to make business decisions on gut instinct alone. ” For the past several years, a lot of decisions made within our company have been on gut instinct, which sometimes works but certainly most of the time does not. In taking break even analysis into consideration, it can provide a good idea of how much exactly do we need to sell in order to not lose money on a business decision.
As Kevin Thompson eloquently puts it, “every idea, whether it is the introduction of a new product line, the opening of branch offices, or the hiring of additional staff, must be tested through basic business analysis. ” The core of that business analysis is the break even analysis. ——————————————– [ 1 ]. Breakeven Analysis – Fixed Costs Variable Costs. ” Small Business Canada – Starting a Small Business – Small Business Articles. Web. 07 Dec. 2009. . [ 2 ]. Ibid [ 3 ]. Thompson, Kevin D. “Business Management: Planning for Profit. ” Black Enterprise. December 2009. [ 4 ]. Ibid