Every businessman wants to know what is the minimum sales level where he does not incur losses. The level where a business does not make either profit or loss is called the break-even level. The break-even point is the volume of production or sales where total costs are equal to revenue. This figure is very much useful for management to decide their minimum sales level so that they can survive in the market. The break-even analysis is used to answer many questions of the management in day-to-day business.
Let’s understand this in detail. There are two types of cost incurred in any business namely Variable cost and Fixed Cost.
Variable cost means cost which varies directly with levels of output. These are direct costs that mean costs that change as per the level of production. Examples of variable costs are material cost, wages, packing expense, transportation cost, etc. If you will produce 1 unit, then raw material for only 1 unit shall be consumed but if you produce 1000 units then raw material of 1000 units shall be consumed. In simple terms, no output no variable cost.
Fixed cost which is fixed in nature which means they are going to be incurred irrespective of the level of output. These costs do not change with the level of output. For example, rent expense of factory. The rent expense is going to be incurred whether you produce 1 unit of output or you produce 1000 units of output. Other examples of fixed costs are watchman salary, depreciation, interest on the loan, property taxes, etc.
Every business needs to recover both of these costs since both costs are expenses of a business. Whether it is the variable cost or fixed cost, it is the expense of the company and it reduces profit. Now one point is understood that variable costs are incurred only when output is produced but fixed costs are permanent in nature. So, if a product is sold, its variable cost shall be recovered. But what is the level where fixed costs are recovered since they are not directly linked to output? Here the concept of “Break-even point” comes into the picture. The Break-even point is the level where your fixed costs are recovered. Here is the calculation of How the break-even point is calculated.
Break even point = Fixed Cost / Contribution per Unit
Now, what is the contribution per unit? Contribution means Sales price per unit less Variable cost per unit. Contribution in simple meaning denotes margin per unit. The word contribution implies here the participation by each unit in recovering fixed costs of business. Suppose a product is sold for Rs 10 per unit and its variable cost (raw material, wages, etc) amounts to Rs 7 per unit. Here the contribution margin is 10-7=3 Rs per unit which means every unit sold will contribute Rs 3 towards recovering the fixed cost of business. Now let’s suppose the sum total of rent, depreciation, interest expenses come to Rs 15,000 per month. So, the fixed cost of the company is Rs 15,000 per month. What is the break-even point of this company per month?
Break even point = Fixed Cost / Contribution per unit
So, it will be 15,000 / 3 = 5,000 Units per month. This figure shows that 5,000 units need to be sold at a minimum to recover all costs of business. If less than 5,000 units are sold, the business will make a loss. If more than 5,000 units are sold, the business will make a profit. The concept of the Break-even point plays a very crucial role in taking decision-related to expenses, sales level, production level, and other financial matters.
|Description||Cost (Amount)||Units||Cost (Amount) per unit|
|Revenue / Sales (A)||–||–||–|
|Variable Cost (B)||–||–||–|
|Direct labour/ wages||–||–|
|Direct expenses (packing material etc.)||–||–|
|Contribution# (A-B)= (C)||–||–||–|
|Fixed cost (D)||–||–||–|
|Rent & electricity||–||–|
|Insurance & Taxes||–||–|
|Repairs & maintenance||–||–|
|Break even units (D)/(C per unit)= (E)||–|
# Total contribution varies with no of units.
There are lots of complexities involved in the calculation of Break-even point like Semi-variable costs, changing contribution margin at different levels of sales, non-availability of Information, changing sales prices, product mix which means some products are sold in a bundle, the different contributions of different products, calculation of depreciation, calculation of interest, apportionment of fixed overheads, apportionment of common costs like rent of head office, account department salary, etc. We at Finance help you in taking the right decision for your business by making accurate calculations, compiling data, performing data analysis, giving growth navigation solutions, shaping new strategies, and resolving problems.
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