Investors need to study what opportunities can give them the best return for their money. But how will this be possible? A simple tool like the break-even analysis is a good start.
Introduction
For the month of August, 2010, a bakery owner named Mr. Bear was able to sell 120 pieces of bread at $10 each. He paid his assistant baker, $500, $100 for supplies, and the remaining $600 was for his rent and loan amortization. He has zero profit but he was able to pay all his variable and fixed costs and expenses. Mr. Bear obtained break-even sales for his first month of operations.
The wages of his assistant and used supplies are variable expenses because such wages and supplies used will depend on production. By next month, if Mr. Bear wants a 10% targeted profit, he has to reduce variable costs and expenses by 10% or will have to get a 10% increase in price, assuming all other things are constant.
The rent and loan amortization have nothing to do with his changes in sales because whether or not he has to increase prices by 10% or reduce his variable expenses by the same rate, he has to pay the $600 for rent and BACO bank for his loan. The rent and loan amortization are fixed in nature and will never be changed within the relevant range or capacity.
What is a Break-Even Point?
In the above example, we can see that the break-even point for a product is the point where total revenue received equals the total costs associated with the sale of the product. A break-even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. A break-even analysis can also be used to analyze the potential profitability of an expenditure in a sales-based business.
Break-Even Point Formula and Example with Calculations
Using the example above with Mr. Bear, the given data will be:
Selling Price per Unit = $10
Unit Variable Cost/per unit = $5 ($600/120)
Fixed Cost = $600
x = units to be sold
Formula:
Unit Selling Price x Number of Units Sold = (Unit Cost x Number of Units Sold) + Fixed Costs + Profit
Substituting the data,
$10.00x = $5x + $600.00 + 0
5x = ($600.00 + 0)
x = ($600.00 + 0) / 5
x = 120 Units.
Once the number of units is available it is easy to calculate the amount of sales needed to break even by multiplying the sales price of the product by the break-even number of units. In this example this calculation is as follows:
Break Even Sales (Dollar Amount) = 120 Units x $10.00 per unit
Break-Even Sales (Dollar Amount) = $1,200.00
The formula to calculate the break-even point is: Break-Even Point = Fixed Costs / (selling price - variable costs).
To calculate the number of units of a product that the company must sell in order to breakeven, the formula is:
Unit Selling Price x Number of Units Sold = (Unit Cost x Number of Units Sold) + Fixed Costs + Profit, where x is the number of units that the corporation needs to sell to break even.
For $10.00x = 5x + $150.00 + 0
5x= ($150.00 + 0)
x = ($150.00 + 0) / 5
x = 30 Units.
Once the number of units is available it is easy to calculate the amount of sales to break even by multiplying the sales price of the product by the break-even number of units. In this example this calculation is as follows:
Break-Even Sales (Dollar Amount) = 30 Units x $5.00 per unit
Break-Even Sales (Dollar Amount) = $150.00
Lowering the Break-Even Point: Why and How?
Why Lower the Break-Even Point?
Management’s objective is always to increase profit. In the above definition and illustration of the break-even point, it tells management that this is the volume and the amount of dollar sales the company has to obtain for a given period in order to avoid loss. Lowering that number and dollar sales means the company is losing. Management, therefore, should work to lower the break-even units and dollar sales.
Ways to Lower the Break-Even Point:
1. Lower direct costs, which will raise the gross margin. Be more diligent about purchasing material, controlling inventory, or increasing the productivity of your labor by more cost-effective scheduling or adding more efficient technology.
2. Exercise cost controls on your fixed expenses, and lower the necessary total dollars. Be careful when cutting expenses that you do so with an overall plan in mind. You can cut too deeply as well as too little and cause distress among workers, or you may pull back marketing efforts at the wrong time, which will give out the wrong signal.
3. Raise prices! Most entrepreneurs are reluctant to raise prices because they think that overall business will fall off. More often than not that doesn’t happen unless you are in a very price-sensitive market, and if you are, you really have already become volume driven.
