Understanding Profitability - Break-even Analysis

Understanding Profitability Break Even Analysis By: Lovell M. Abello, BSA, CPA, MBA

Introduction The break-even analysis is an easy but controlling method for understanding the profitability of your business. The Break-even Point for a business is the sales volume or sales value where the business neither makes a profit or a loss but is said to break even. Cost Volume Profit Analysis An understanding of break-even analysis is based on the cost - volume - profit relationship within a business. Cost volume profit relationship as shown on the graph below:

$

Calculating The Break Even Point To calculate the break-even point for a business the following elements are essential:  Amount of fixed costs;  The contribution margin either as per unit or as a percentage of sales (contribution margin ratio).

The basic formulae are: Break-even point (for output) = fixed cost divided by contribution margin per unit

Contribution margin per unit = selling price per unit - variable cost per unit Break-even point (for sales) = fixed cost divided by contribution margin ratio Limitations  Break-even analysis is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.  It assumes that fixed costs are constant.  It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales (i.e. linearity).  It assumes that the quantity of goods produced is equal to the quantity of goods sold (i.e., there is no change in the quantity of goods held in inventory at the beginning of the period and the quantity of goods held in inventory at the end of the period).  In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant). References Book(s) D Dayananda – R Irons – S Harrison - J Herbohn - P Rowland, 2002, Capital Budgeting: Financial appraisal of investment projects – Cambridge University Press. pp. 150 Horngren, C.,Sundem, G & Stratton, W. "Introduction to Management Accounting" (2002) Prentice Hall The Margin of Safety in MAAW, Chapter 11 Website(s) http://businesscoaching.typepad.com/the_business_coaching_blo/2008/06/break-evenanalysis---cost-volume-profit-analysis.html. Accessed on November 5, 2009. http://en.wikipedia.org/wiki/Break_even_analysis. Accessed on November 5, 2009.