Question

View "Pricing and Breakeven Analysis." A break-even analysis can be used to determine the amount of sales volume a business needs to start making a profit. List the formula used to conduct a break-even analysis and explain each component. Provide a real-world example of how the break-even analysis and formula could be applied.

Answer 1

Break-even analysis, also known as Cost-volume-profit analysis, is a process of calculating the point at which total revenues=total costs( break even point or no-profit no-loss point).
Under break even analysis, costs are bifurcated into fixed costs and variable costs. Fixed costs are period costs which remain fixed in total irrespective of the number of units produced, such as factory rent and insurance, So, higher the production, lower the per unit fixed cost since it is fixed in total. Variable cost, on the other hand, varies with production and is fixed per unit, such as direct materials or direct labour per unit of production. So, at higher production levels variable cost will be higher and vice-versa.

Selling price per unit minus variable cost per unit gives 'Contribution margin' per unit, which is basically the amount contributed by each unit sold which can be used to cover the fixed costs. So, with a given contribution margin, higher volume of sales will enable fixed costs to be covered easily leaving behind higher net income.
Break even point is the level of sales where fixed cost is just covered by the total contribution margin of units sold, such that there is no profit no loss.

The formulae for Break even point (in units,i.e. the number of units required to be sold such that there is no profit no loss) and Break even point(in sales dollars,i.e. the sales revenue required to be earned such that there is no profit no loss) are presented as below:

Break even point (in units) = Fixed costs/Contribution margin per unit

Break even point (in sales dollars) = Fixed costs/ Contribution margin ratio

Contribution margin ratio = (Contribution margin/Sales revenue) * 100

An example of application of break even analysis is presented below:

A shoe-manufacturing Company is exploring venturing into a new variety of men's shoes, which it feels will be in trend in 2021 and raise its existing profits by 20%.The Company expects that it can sell each pair for $120. The costs of direct materials in each pair will be approximately $30, cost of direct labour per pair is expected to be $10, and other direct expenses per pair is expected to be $20.
In order to manufacture the shoes, the Company will need to rent a machine costing $5,000 rent annually. Salary of the inspection staff is $1,000 annually.

Here, we can calculate the break even number of units (pairs of shoes to be sold) and required sales revenue as per workings below:

Selling price per unit = $120

Variable price per unit = Direct materials per unit+Direct labour per unit+Direct expenses per unit

= $30+$10+$20

= $60

Contribution margin per unit = $120 - $60 = $60

Also, contribution margin ratio = $60/$120 * 100

= 50%

Fixed cost = $5,000 + $1,000 = $6,000

Break even point (in units) = $6,000/$60 = 100 units

Break even point (in sales dollars) = Fixed cost/Contribution margin ratio

= $6,000/50%
= $12,000

So, we see above that the Company must sell at least 100 pairs and sales revenue of $12,000 in order to break even.

The break even analysis can also be used to calculate number of units required to be sold to earn target profit. (Target profit + Fixed costs) divided by contribution margin per unit, will give the number of units required to earn that target profit.