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What is Break-Even Analysis? Importance, Limitations & How to Calculate Break Even Point?

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# What is Break-Even Analysis?

Break-even analysis is a business tool widely used in all industries to evaluate business performance in terms of cost, as it is a supply-side analysis. This determines at what point your company, or new product or service, will be more profitable. Break-even analysis results in neither gain nor loss. Instead, it determines the number of sales required to cover all variables and fixed costs. It calculates all minimum units to sell and find out the number of sales required to pay all expenses before making a profit. Its main objective is that it allows any company to know when it, or any of its products, will begin to benefit. If the revenue of any business goes below the break-even point, the company is sure to go into a loss. If revenue is up, it is the business’s recognition to be profitable.

# Why should you do a Break-Even Analysis?

There are many reasons for doing a break-even analysis-

  • Price Smart:- Finding a break-even point will help you price the products better. A lot of time goes into pricing, but it is equally important to know how to affect your profitability. You can use this tool to provide the best value for the product that can achieve maximum profit without increasing the current price.

  • Cover fixed costs:- Most people think about pricing, so they think about how much their product costs, which we also call variable cost. Performing a break-even analysis helps you to easily cover all fixed costs.

  • Catch lost expenses:- When you are thinking about starting a new business or a small business, it is very likely that you forget about some expenses. Therefore, break-even analysis can help you review all financial commitments to locate your break-even point. This will limit the number of surprises or at least have a company ready for them.

  • Set revenue target:- Once the break-even analysis is complete, you get to know how many sales you have to make to be profitable. This completely helps you and your sales team set more tangible sales goals.

  • Decide wisely:- Most entrepreneurs often make decisions regarding their business based on emotions. Emotion is important in how you feel, although it is not enough for a business. To be a successful entrepreneur, decisions must be based on facts, not feelings.

  • Limit financial constraints:- Performing a break-even analysis also helps your business reduce its risk. This helps you avoid failures and limit financial tolls which can lead to poor decisions on your business. Also, you can easily be realistic about possible outcomes.

  • Fund your business:- This analysis is an important component in any business plan. This is usually a special requirement if you want to fund outsiders for your business. To fund your business, you have to prove that your plan is very viable. Also, if the analysis sounds good, then you will be comfortable enough to bear the burden of various methods of financing.

# Components of Break-Even Analysis

There are two main components of break-even analysis.

  • Fixed cost- Fixed cost is also called overhead cost. These costs increase when a business starts its financial activity. Fixed costs include interest, taxes, salaries, rent, depreciation costs, labor costs, energy costs, etc. These are the fixed limits of the cost of production. If there is no production, then in that case the cost should also be incurred.
  • Variable costs- Variable costs are those costs that decrease or increase according to the volume of production. These costs include raw material costs, packaging costs, fuel, and other costs that are directly related to production. It is natural to have activity-like fluctuations in this interval.

# When is Break-even analysis used?

There are three common scenarios when it helps to perform a break-even analysis.

  • New Business – Break-even analysis is a very necessary tool for a new venture. It also directs management with pricing strategies and is practical about all the costs of your business. This analysis also tells you whether the new business is productive or not.
  • Create a new product – If an existing company launches a new product, they have to focus on the break-even analysis before starting this task and see if the product is the required expense collection for the company.
  • Change in Business Model – If you want to change the business model, break-even analysis can help you in a situation like you want to shift from retail business to wholesale business. This analysis will help the company determine whether you need a change in the selling price of a product.

# Importance of Break-Even Analysis

  • A break-even analysis tells a company or its owner how many units need to be sold to cover costs.
  • A company or owner knows at which point a company can break even, so it becomes very easy for them to set goals in advance and accordingly create a budget for the firm. This analysis can also easily establish a realistic budget for any company.

  • The company’s sales deteriorate as the financial situation worsens or breaks down. Break-even analysis helps a company decide the number of sales to earn the least profit. With a margin of safety report, management can execute a high business decision.

  • Any change in the price of a product can affect the break-even point.

  • Profit margins of companies can be greatly influenced by fixed and variable costs; Therefore, with a pause-analysis, management can find out if any impact is changing the cost.

  • The goal is to determine the selling price or desired sales mix to make a profit.

# Limitation of Break-Even Analysis

There are some limitations of Break-Even Analysis:

    • You can still ignore the existence of semi-variable costs at once, but most costs are either not fully fixed or not fully variable.
    • If production increases or decreases, fixed costs can change greatly.
    • For various reasons such as bullet purchase discounts, overtime, etc., variable costs per unit can be ignored.
    • Technology, production methods can change in practice.
    • Various external factors such as the past, the economic condition can also affect sales volume.

# Formula for Break-Even Analysis

The formula for Break-Even Analysis is as follows:

  • Break-Even Point (Units) = Fixed costs / (Revenue per unit – variable cost per unit)

# How to Calculate Break Even Point?

Suppose your company Bottles and has the following production figures:

Selling price per unit (Revenue per unit) = Rs. 40

Variable cost per unit =Rs. 20

Total fixed cost (for total units of particular product) = Rs. 20,000

Break-Even Point (Units) = Fixed costs / (Revenue per unit – Variable cost per unit)

                                           = 20,000 / (40-20)

                                           = 1,000 (units)

# Conclusion

If you want to determine the price of your product correctly, break analysis is also a perfect tool to determine it. A break-even analysis helps you calculate how much you have to sell before you start to make a profit. You can also see how fixed cost, price, quantity, and other factors affect your net profit.

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