Break even point analysis can be a very useful and relatively simple tool for management to use to make decisions. It can be an approach for dealing intelligently with uncertainty and there will always be difficulties in estimating uncertain variables such as demand. By specifying the levels of other variables like costs or profit that affect the income of a firm, a required or minimum level can be found for the unknown quantity. Any problem requiring income estimation can be set up so that the most difficult variable to estimate is isolated for solution.

break even analysis is not a panacea. It's only one of the many tools available to the business decision maker. But it's a good tool with which to approach decision problems.

Some Shortcomings of Break Even Analysis

The major problem with break even analysis is that no project really exists in isolation. There are alternative uses for the firm's funds in every case. For example, in a manufacturer's case, a vacant plant could be leased to another company for some return. It could also be used for another product. We, must, therefore, always consider not only the value of an individual project, but how it compares to other uses of the funds and facilities.

Nor does break even analysis permit proper examination of cash flows. Click HERE for more on Cash Flows. It is generally accepted in basic financial theory that the appropriate way to make investment or capital decisions is to consider the value of a proposed project's anticipated cash flows. If the discounted value of the cash flows exceeds the required investment outlay in cash, then the project is acceptable.

There are other limitations. Break even makes many restrictive assumptions about cost-revenue relationships; in normal use, it's basically a negative technique, defining constraints rather than looking at benefits; and it's essentially a static tool for analysing a single period. What all this theory boils down to is that break even analysis is too simplistic a technique to be used to make final investment decisions on its own.

Some Basic Uses for Break Even

It's a cheap screening device. Discounted cash flow techniques require large amounts of expensive-to-get data. Break even analysis can tell you whether or not it's worthwhile to do more intensive (costly) analysis.

It provides a handle for designing product specifications. Each design has implications for cost. Costs obviously affect price and marketing feasibility. break even permits comparison of possible designs before the specifications are frozen.

It serves as a substitute for estimating an unknown factor in making project decisions. In deciding whether to go ahead or to skip it, there are always variables to be considered: demand, costs, price, and miscellaneous factors. When most expenses can be determined, only two missing variables remain profit (or cash flow) and demand. Demand is usually tougher to estimate. By deciding that profit must at least be zero, (the break even point), you can then fairly simply find the demand you must have to make the project a reasonable undertaking.

You still have to compare the demand figure at break even with the market share you think you can capture to judge the worthiness of the project, and you'll have to use your business sense here. But break even gives you a way to attack uncertainty, to get onto the target if not the bull's-eye.

Break Even Applied to Uncertainty

A break even analysis is a management control tool that approximates how much you must sell in order to cover your costs with NO profit and NO loss. Profit comes after the break even point.

The following formula will help in the calculation of your break even sales volume level:

Break Even in Sales Dollars

=

Fixed Costs * / Contribution Margin % **

=

$250,000 / 15%

=

$1,666,667

* Fixed Costs are those costs that are not variable as a result of the sales activity. For example, rent of the building or insurance costs may be fairly constant no matter how sales vary, while, expenses such as advertising and usage of shop or store supplies will vary with sales.

** Contribution Margin = Revenue - Variable Costs. In a retail business, the gross margin % is generally recognized as the Contribution Margin %. Gross Margin equals the difference between the Sales and the Cost of the Sales.

In this example, $1,667,667 are the sales that are required to cover fixed costs of $250,000 and a contribution margin of 15 percent, with nothing left over for profit.

If you now wanted to calculate the sales that are required to now build in a profit factor, add the profit factor you want to allow for to the fixed costs. For example, if in this example, the fixed costs are $250,000 and you want a $150,000 profit, add the two together and then apply the break even formula to this.

Break Even in Sales Dollars

=

(Fixed Costs + Profit Margin) / Contribution Margin %

=

($250,000 + $150,000) / 15%

=

$400,000 / 15%

=

$2,666,667

Use Break Even To Calculate Break Even Point In Units Sold

The above formula was illustrating the break even point in dollar sales. With some modification, you can calculate the break even point in Units Sold.

If this was a small manufacturing company and you wanted to calculate how many unit sales you need to break even, you could divide the break even sales volume by the unit selling price. For example, if the unit sells for $10, the break even unit sales before a profit is allowed for is 166,667 units and after a profit is allowed for 266,667 units.

A Chartered Accountant can help you with calculating the Break Even Point. Contact Keith Anderson CA at (780) 447-5830 if you need advice. 

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