# Introduction Break-even analysis is a technique widely used by production management and management accountants.

It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production). Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "breakeven point"). Break–Even Point A company's break-even point is the amount of sales or revenues that it must generate in order to equal its expenses. In other words, it is the point at which the company neither makes a profit nor suffers a loss. Calculating the break-even point (through break-even analysis) can provide a simple, yet powerful quantitative tool for managers. In its simplest form, break-even analysis provides insight into whether revenue from a product or service has the ability to cover the relevant costs of production of that product or service. Managers can use this information in making a wide range of business decisions, including setting prices, preparing competitive bids, and applying for loans. Background The break-even point has its origins in the economic concept of the point of indifference. From an economic perspective, this point indicates the quantity of some good at which the decision maker would be indifferent (i.e., would be satisfied without reason to celebrate or to opine). At this quantity, the costs and benefits are precisely balanced. Similarly, the managerial concept of break-even analysis seeks to find the quantity of output that just covers all costs so that no loss is generated. Managers can determine the minimum quantity of sales at which the company would avoid a loss in the production of a given good. If a product cannot cover its own costs, it inherently reduces the profitability of the firm. The Break-Even Chart In its simplest form, the break-even chart is a graphical representation of costs at various levels of activity shown on the same chart as the variation of income (or sales, revenue) with the same variation in activity. The point at which neither profit nor loss is made is known as the "break-even point" and is represented on the chart below by the intersection of the two lines:

variable costs are incurred. In the long term fixed costs can alter . and hence neither profit nor loss is made. At the point of intersection. As output increases.Depreciation . the level of fixed costs will remain broadly the same. OB represents the total fixed costs in the business.revenue related) . adding a new factory unit) or through the growth in overheads required to support a larger. more complex business. Fixed Costs Fixed costs are those business costs that are not directly related to the level of production or output. At low levels of output. direct labor. A distinction is often made between "Direct" variable costs and "Indirect" variable costs.Research and development .Rent and rates . even if the business has a zero output or high output. Costs are greater than Income. . costs are exactly equal to income. meaning that total costs (fixed + variable) also increase. In other words. They represent payment output-related inputs such as raw materials.g. P.Administration costs Variable Costs Variable costs are those costs which vary directly with the level of output. fuel and revenue-related costs such as commission.In the diagram above. the line OA represents the variation of income at varying levels of production activity ("output").perhaps as a result of investment in production capacity (e.Marketing costs (non. Examples of fixed costs: .

In a company that produces a single good or service.g. Revenue is assumed to be equal for each unit sold. Raw materials and the wages those working on the production line are good examples. It is only one of the many tools available to the business decision maker. These are largely related to the overall "scale" and/or complexity of the business. such as administrative costs. depreciation of equipment. Predetermining the profit to be \$0. when a business has relatively low levels of output or sales. for example. are those that will be incurred by the company even if no units are produced. in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. Breakeven analysis is not a panacea. number and complexity of transactions) then more resources are required. without the complication of quantity discounts. fixed costs are usually allocations of such costs to a particular product. These include depreciation (where it is calculated related to output . there is no total revenue (\$0). more materials will be required as more units are produced. where profit is the difference between total revenues and total costs. In these circumstances. as the scale of the business grows (e. machine hours). For example. as follows: Let TR = Total revenues TC = Total costs P = Selling price F = Fixed costs V = Variable costs Q = Quantity of output . In a multi-product company. output. But it is a good tool with which to approach decision problems. Managerial Analysis Typically the break-even scenario is developed and graphed in linear terms. although some fixed costs (such as a specific supervisor's salary) may be totally attributable to the product. however.Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Semi-Variable Costs Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs. If no units are sold. total costs are considered from two perspectives. the manager uses the standard profit equation. maintenance and certain labor costs. number people employed. this would include all costs necessary to provide the production environment. and regulatory fees. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. However. Fixed costs. To find this break-even quantity. he or she then solves for the quantity that makes this equation true. Variable costs are those that increase with the quantity produced. it may not require costs associated with functions such as human resource management or a fully-resourced finance department.e. However. we say that part of the cost is variable and part fixed. Indirect variable costs cannot be directly attributable to production but they do vary with output.g.

sales goals and market demand are not necessarily equivalent. (Let D = desired level of profit. the desired profit is regarded as an increase in the fixed costs to be covered by sales of the product. It is tempting to set the contribution margin (and thus the price) by using the sales goal (or certain demand) as the quantity. Q = F(P − V). then the break-even quantity is 25 (\$100 ÷ [\$10 − \$6] = \$100 ÷ \$4) When 25 units are produced and sold. If demand is estimated to be at least 25 units. As an example. it may be even more useful to know the quantity necessary to generate a desired level of profit. Beyond these 25 units. an inelastic-demand item due to its inherently essential nature. or selling price minus variable costs. then the company will not experience a loss. but will also have contributed enough in total to have covered all associated fixed costs. if fixed costs are \$100. and then P ×Q − (F + V − Q ) = 0. Therefore. A small change in price may affect the sale of skis more than the sale of insulin. internal rate of return. and is particularly applicable to nonessential products. Finally. the higher the break-even point. price per unit is \$10. or net present value analysis.) TR − TC = D P × Q −(F + V × Q) = D Then Q = (F + D) ÷ (P −V) Here.TR = P × Q TC = F + V × Q TR . Thus. the analysis may lead to erroneous conclusions. As the decision-making process often requires profits for payback period. Price-elasticity exists when customers will respond positively to lower prices and negatively to higher prices. all fixed costs have been paid and each unit contributes to profits by the excess of price over variable costs. If these assumptions are violated. However.TC = profit Because there is no profit (\$0) at the break-even point. While it is useful to know the quantity of sales at which a product will cease to generate losses. as it defines the break-even quantity (Q ) {note: Q is previously defined as “quantity of output”} as the number of times the company must generate the unit contribution margin (P − V ). or the contribution margin. using this method to set a prospective price for a product may be more appropriate for . Profits will grow with each unit demanded above this 25-unit break-even level. each of these units will not only have covered its own marginal (variable) costs. It is particularly interesting to note that the higher the fixed costs. TR − TC = 0. this form may be more useful than the basic break-even model. This is typically known as the contribution margin model. to cover the fixed costs. and variable costs per unit are \$6. Basic Assumptions Several assumptions affect the applicability of break-even analysis. companies with large investments in equipment and/or high administrative-line ratios may require greater sales to break even. especially if the customer is price-sensitive.

total revenues and total costs are modeled as linear values. Modeling the added complexity of nonlinear or step-function costs requires more sophistication. A primary key to detecting the applicability of linearity is determining the relevant range of output. but the linear model appears to ignore these options. as prices and costs tend to change over time. then linearity is appropriate in the anticipated range of demand (100 units plus or minus some forecast error). the linear model may perform adequately. the break-even quantity is 50 (200 ÷ [18 − 14]). full costing reduces the denominator in the break-even model. or to the step-function nature of fixed costs. implying that each unit of output incurs the same per-unit revenue and per-unit variable costs. If the forecast of demand suggests that 100 units will be demanded. The second-shift supervisor's salary is a fixed-cost addition. the price may shift downward to \$18 to bolster price-elastic demand. as noted. quantity discounts begin at 50 units of materials. but may be avoided if the manager is willing to accept average costs to use the simpler linear model. if all prices and costs double. then the break-even point Q = 200 ÷ (20 − 12) = 200 ÷ 8 = 25 units. it is wiser to estimate demand based on an established. acceptable market price. as determined with current costs. While both of these methods increase the break-even point. Thus. labor should be included in the fixed costs in the model. but only at a sufficient level of output. even as materials costs are rising. Using the earlier example. whereas the variable costing alternative increases the denominator. rather than 25. Managers should project break-even quantities based on reasonably predictable prices and costs. For example. historical records of the proportionate quantity-discount sales may be useful in determining average revenues. Typically. In this case. Linearity may not be appropriate due to quantity sales/purchases. then the average cost of materials may be used in the model. variable costs have been defined primarily as “labor and materials. by contrast. a second shift may be added. if demand surpasses the capacity of a one-shift production line. instead. Recognizing the appropriate time horizon may also affect the usefulness of break-even analysis. One obviously important measure in the break-even model is that of fixed costs. A more difficult issue is that of volume sales. For a prospective outlook incorporating generalized inflation. treats these fixed production overhead charges as period charges. However. fixed costs may be determined by full costing or by variable costing. Variable costing. . If. treating these as a variable cost.products with inelastic demand. they may not lend themselves to the same conclusion. For products with elastic demand. Typically. In the traditional costaccounting world. In this case. weakened market demand for the product may occur. It may defy traditional thinking to determine which costs are variable and which are fixed. In this case. Volume sales or bulk purchasing may incorporate quantity discounts.” However. while materials costs may rise to \$14. but quantity discounts on materials are applicable for purchases over 500 units from a single supplier. a portion of these costs may be included in the fixed costs allocated to the product. In this case. labor may be effectively salaried by contract or by managerial policy that supports a full workweek for employees. Full costing assigns a portion of fixed production overhead charges to each unit of production. when such sales are frequently dependent on the ordering patterns of numerous customers.

Managers should project break-even quantities based on the choice of capital-labor mix to be used in the relevant time horizon. so that fixed costs and the time horizon are interdependent. Traditionally. then the project is acceptable. Some Shortcomings of Breakeven Analysis The major problem with breakeven analysis is that no project really exists in isolation. There are other objections. in a manufacturer's case. but how it compares to other uses of the funds and facilities. 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. for example. defining constraints rather than looking at benefits. It could also be used for another product. We. This ABC system tends to allocate. . Breakeven analysis can tell you whether or not it's worthwhile to do more intensive (costly) analysis. There are alternative uses for the firm's funds in every case. in which case much of the variable labor cost is eliminated. If the discounted value of the cash flows exceeds the required investment outlay in cash. in this case. For example. the CEO's salary to a product based on his or her specific time and attention required by this product. Breakeven makes many restrictive assumptions about cost revenue relationships. Some Basic Uses for Breakeven It's a cheap screening device. rather than on its proportion of direct labor hours to total direct labor hours. therefore. Alternatively. managers may decide to change from in-house production to subcontracting production. the bulk of the costs then involve the (fixed) depreciation of the new equipment. salaried staff to support company-wide computer systems. must.Complicating the analysis further is the concept that all costs are variable in the long run. a vacant plant could be leased to another company for some return. What all this theory boils down to is that breakeven analysis is too simplistic a technique to be used to make final investment decisions on its own. and it's essentially a static tool for analyzing a single period. in normal use. fixed costs have been allocated to products based on estimates of production for the fiscal year and on direct labor hours required for production. fixed costs are minimal and almost 100 percent of the costs are variable. they may choose to purchase cutting-edge technology. Another shortcoming of breakeven analysis is that it does not permit proper examination of cash flows. always consider not only the value of an individual project. Technological advances have significantly reduced the proportion of direct labor costs and have increased the indirect costs through computerization and the requisite skilled. Activity-based costing (ABC) is an allocation system in which managers attempt to identify “cost drivers” which accurately reflect the appropriate usage of fixed costs attributable to production of specific products in a multi-product firm. Using a make-or-buy analysis. Discounted cash flow techniques require large amounts of expensive-toget data. it's basically a negative technique.