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Do you want to know at what point of sales you will cover all your losses?
Every businessman wants to know what is the minimum sales level where he does not incur losses. The level where business does not make either profit or loss is called 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 to management to decide their minimum sales level so that they can survive in market. The break-even analysis is used to answer many questions of the management in day-to-day business.
Let's understand this in details. There are two types of cost incurred in any business namely Variable cost and Fixed Cost.
Variable Cost: Variable cost means cost which varies directly with levels of output. These are direct costs that means costs which change as per 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: Fixed cost which are fixed in nature which means they are going be incurred irrespective of level of output. These costs do not change with 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 loan, property taxes etc.
Every business needs to recover both of these costs since both costs are expenses of business. Whether it is variable cost or fixed cost, it is expense of 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 picture. Break even point is the level where your fixed costs are recovered. Here is the calculation of How break-even point is calculated.
1. Limit Financial Strain.
Reduces risk by indicating when a business idea should be avoided. Through realistic consideration of alternative outcomes, it assists potential enterprises in avoiding failure and limiting the financial toll of a faulty idea.
2. MAKE QUALITY DECISIONS:
The break-even analysis will help you start your business based on facts and not on the basis of emotions.
3. BUSINESS FUNDING:
In order to take on investors or debt to fund your firm, a break-even analysis is frequently required. It demonstrates the viability of your plan, which will make you feel more comfortable with taking on debt.
4. SETTING REVENUE TARGETS:
After you've completed the analysis, you'll know exactly how much you need to sell to break even. This establishes your company's sales targets. It will be easier to follow through if you have a number in mind.
Break even point = Fixed Cost / Contribution per Unit
Now what is 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 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 company is Rs 15,000 per month. What is 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 minimum to recover all costs of business. If less that 5,000 units are sold, business will make loss. If more that 5,000 units are sold, business will make profit. The concept of Break-even point plays very crucial role in taking decision related to expenses, sales level, production level and other financial matters.
A break-even analysis allows you to determine your break-even point. But this isn't the end of your calculations. Once you crunch the numbers, you might find that you have to sell a lot more products than you realized to break even. Ideally, you should conduct this financial analysis before you start a business so you have a good idea of the risk involved. The advantages of Break-even analysis are as follows:
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There are lots of complexities involved in calculation of Break even point like Semi-variable costs, changing contribution margin at different level of sales, non-availability of Information, changing sales prices, product mix which means some products are sold in bundle, different contribution 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.
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