MODULE 6
BREAK-EVEN ANALYSIS
Week 16-17 (May 10-21, 2021)
Sorsogon State University
Pricing and Costing Cristy Docdocos
2nd Semester SY 2020-2021 Instructor
Introduction
Break-even analysis is useful in determining the level of production or a targeted desired
sales mix. The study is for a company's management’s use only, as the metric and calculations
are not used by external parties, such as investors, regulators, or financial institutions. This type
of analysis involves a calculation of the break-even point (BEP). The break-even point is calculated
by dividing the total fixed costs of production by the price per individual unit less the variable
costs of production. Fixed costs are costs that remain the same regardless of how many units are
sold.
Break-even analysis looks at the level of fixed costs relative to the profit earned by each
additional unit produced and sold. In general, a company with lower fixed costs will have a lower
break-even point of sale. For example, a company with $0 of fixed costs will automatically have
broken even upon the sale of the first product assuming variable costs do not exceed sales
revenue.
Although investors are not particularly interested in an individual company's break-even
analysis on their production, they may use the calculation to determine at what price they will
break even on a trade or investment. The calculation is useful when trading in or creating a
strategy to buy options or a fixed-income security product.
Learning Objectives
After studying this topic, the students should be able to:
1. Understand what is Break-Even Analysis.
2. Identify the components of Break-Even Analysis.
3. Recognize the uses of Break-Even Point.
4. Illustrate how to determine break-even point and sales.
Pre-test
1. What Is a Break-Even Analysis?
2. What is assumption
3. Importance of margin of Safety; in your opinion.
4. Enumerate the uses of break-even point
Key Concepts
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WHAT IS A BREAK-EVEN ANALYSIS?
A break-even point is that position where a business entity can recover its cost through
the revenue it generates from the sales. Here, we can say that the company is now able to
meet its expenses through its sales revenue.
Break-even analysis is the means to identify the effect of variation in sales volume on
the cost, revenue and profitability of a project or a product. It consists of several calculations,
based on which the business organizations determine the feasibility and viability of starting a
new project or producing a new product.
It is just an estimation of sales and does not determine the actual revenue generated by
the products or projects.
COMPONENTS OF BREAK-EVEN ANALYSIS
Break-even analysis is done by establishing a relationship between three significant
elements of a project, i.e., costs, revenue and contribution margin.
1. Costs: The total expenses incurred on a project or product is its cost. It can be
categorized as follows:
-Fixed Costs: Those costs which remain the same throughout irrespective of the sales or
revenue are known as the fixed costs, e.g., rent, interest, depreciation, etc.
-Variable Costs: The expenses which are progressive with the increasing sales and production
volume are called variable costs, e.g., raw material, fuel, electricity, etc.
2. Revenue: The return generated from the sales of a product during a particular period
is termed as revenue. In simple terms, it is the total sales value or amount.
3. Contribution Margin: Contribution margin is the ratio of the revenue available for
meeting fixed costs per unit to the sales price of each unit.
ASSUMPTIONS OF BREAK-EVEN ANALYSIS
To simplify the process of computing the break-even analysis, the following assumptions are
taken into consideration:
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• Total fixed costs remain constant at all the output levels.
• All the costs can be considered as either fixed or variable costs.
• Straight-line cost and revenue behavior.
• Throughout the output level, sales price per unit is constant.
• The business has a constant product mix and produces only one kind of product.
• The inventory remains constant at the start and the end of the accounting period.
• Costs and sales revenue is affected only by the sales volume.
• The unit variable cost remains constant since the change in total variable cost is
considered to be proportionate to the output level.
• The other factors such as efficiency, production and technology do not change.
WHAT IS MARGIN OF SAFETY?
The margin of safety is the difference between the amount of expected profitability and the
break-even point. The margin of safety formula is equal to current sales minus the breakeven
point, divided by current sales.
There are two applications to define the margin of safety:
1.Budgeting
In budgeting and break-even analysis, the margin of safety is the gap between the
estimated sales output and the level by which a company’s sales could decrease before the
company will become unprofitable. It signals to the management the risk of loss that may happen
as the business is subjected to changes in sales, especially when a significant number of sales are
at risk of decline or unprofitability. A low percentage of margin of safety might cause a business
to cut expenses while a high spread of margin assures a company that it is protected from sales
variability.
2. Investing
In the principle of investing, the margin of safety is the difference between the intrinsic
value of a stock against its prevailing market price. Intrinsic value is the actual worth of a
company’s asset, or the present value of an asset when adding up the total discounted future
income generated.
When applied to investing, the margin of safety is calculated by assumptions, meaning an
investor would only buy securities when the market price is materially below its estimated
intrinsic value. Determining the intrinsic value or true worth of a security is highly subjective
because each investor has a different way of calculating intrinsic value, which may or may not be
accurate. The fair market price of the security must be known in order to then use the discounted
cash flow analysis method to give an objective fair value of a business.
What is the Margin of Safety Formula?
In accounting, the margin of safety is calculated by subtracting the break-even point amount from
the actual or budgeted sales and then dividing by sales; the result is expressed as a percentage.
Margin of Safety = (Current Sales Level – Breakeven Point) / Current Sales Level x 100
USES OF BREAK-EVEN ANALYSIS
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Break-even analysis is not only used for taking strategical decisions but has also proved
to be applicable in day-to-day business activities.
Let us now go through its following uses in business functions:
• Goals: Through the break-even analysis, the company can determine the number of units
to be sold or sales revenue to be generated for reaching the break-even point.
• Planning: The further plans of expansion or growth can be set easily if the management
knows what exactly is to be aimed.
• Material: Material management becomes easy with break-even analysis since the
company decides to advance the cost and quality of material to be used as input.
• New Product: Break-even analysis is also used by the management for monitoring the
performance of a new product.
• Prices: It is an essential tool for balancing the cost of a product and setting up a
competitive price. For instance, if the price is low, it becomes difficult for the company to
attain a break-even position on time.
COMPUTATION OF BREAK-EVEN POINT
Break-even analysis is an essential tool in the hands of the business experts,
management, financial experts and professional for determining the success possibilities of a
project on various parameters.
These parameters can be better understood in the following discussion:
Break-Even Point
Is that point of sale where the company can meet the project’s cost from the revenue
generated by that particular project.
The formula for determining the break-even point is as follows:
Break Even Points = Fixed Cost / (Sales Price - Variable Cost)
Or
Break-Even Point = Fixed Cost / Contribution Margin Per Unit
Or
Break-Even Point = Fixed Cost / Profit Volume Ratio.
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References
https://theinvestorsbook.com/how-to-calculate-break-even-analysis.html
https://corporatefinanceinstitute.com/resources/knowledge/finance/margin-of-
safetyformula/#:~:text=In%20budgeting%20and%20break%2Deven,the%20com
pany%20will%20become%20unprofitable.
https://theinvestorsbook.com/break-even-analysis.html#Uses
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