What is break even point? What is break even analysis?
Break even point can be defined as the business volume that balances total costs with total gains. At break even volume, in other words, cash inflows equal cash outflows, exactly, and net cash flow equals zero.
Business people calculate break even in order to answer questions like these:
- How many product units must we sell to break even?
- How many rooms must we rent in order to cover costs?
- At what unit sales volume do we earn a profit?
The term break even is a verb, as in "When do we break even?" The form break-even is an adjective, as in "The break-even point." However, the adjectives break even and breakeven are equally correct.
Break even analysis
In the simple analysis, break even is the quantity (unit volume) that balances total costs with total gains for a net cash flow of 0. The break even quantity depends on at least three variables: Fixed cost, variable cost per unit, and revenues per unit.
Break even analysis attempts to find break even volume by analyzing relationships between fixed and variable costs on the one hand, and business volume, pricing, and net cash flow on the other. Understanding how these factors impact each other is crucial in budgeting, production planning, and profit forecasting, And, break even analysis, is central to this understanding.
The basic components of simple break even analysis include:
- Cash inflows (or revenues).
- Fixed costs.
- Variable costs.
- Semi-variable costs (sometimes).
The simple analysis assumes that each unit brings the same cash inflow. This usually means the unit selling price.
Fixed costs remain fixed, or constant, regardless of unit volume. For example, if the costs of floor space, manager's salaries, and janitorial services, do not change with volume, they are fixed costs.
These costs vary in direct proportion to quantity sold or unit volume. Variable costs for selling goods, for instance, might include the direct cost the seller pays to acquire each unit. As a result, the total variable cost can be simply cost per unit multiplied by the unit volume.
Semi-variable costs are constant across a range of business volumes, but change when volume goes out of range. Wages for a call center operator, for example, might be a fixed cost when daily call volume is between 0 and 100 calls per day. A second operator might be necessary when call volume is 101 to 200. And, a third might be necessary if daily call volume is 201 to 300.
- Within each call volume range (e.g., 201-300), operator cost is fixed.
- Across all ranges (0 - 300), operator cost is semi-variable.
Break even point as unit volume
In business, break even point usually means the unit volume that balances total costs with total gains. For the analyst, break even is the quantity Q for which cash outflows equal cash inflows, exactly. At the break even quantity, therefore, net cash flow equals zero.
Simple break even analysis finds Q by analyzing relationships between just three variables: fixed costs, variable costs, and cash inflows. The analysis must consider additional factors, however, when semi-variable costs or variable pricing are present.
Break even point as a time period
Note that business people also refer to a similar but different concept, the break even point in time, or payback period. Payback period is the time necessary for investment returns to cover investment costs. Payback analysis does not consider units, but instead the timing of cash inflows and outflows. For more on the break even point in time, see Payback period.
Break even points for business start up
Business people starting a new business need especially to understand both kinds of break even points (break even time and break even unit volume). This is because start ups typically lose money for a while before becoming profitable. There is a limit, however, to the time owners can tolerate losses. Before launching a new business, therefore, they have a keen interest in knowing the break even business volume. The new firm turns profitable only when it exceeds break even volume. A decision to launch the business may depend on the owners' view of the time and expense required to reach that volume.
Explaining break even in context
Sections below further define, explain, and illustrate break even analysis. Note especially that break even appears in context with related terms and concepts from the fields of business analysis, finance, and investment analysis.
- What is break even point analysis?
- What is simple break even?
- How do you find break even point with a graphical solution?
- Calculating break even with semi-variable costs.
- How does break evenanalysis change with variable pricing or other variable inflows?
Simple Break Even Analysis addresses questions of this kind: How many units must we sell in order to break even? That is, How many units must we sell to bring total cash inflows equal to total cash outflows?
Break Even Analysis Input Variables
The simplest form of break even analysis considers just three input variables:
- Firstly, Cash inflow per unit.
This usually means selling price per unit. As a result, analysts sometimes label this variable as revenues. The cash inflow total, therefore, is a function of unit volume.
- Secondly, Fixed costs.
These costs are constant across all possible unit volumes. Example fixed costs include such things as equipment costs, floor space leasing costs, and executive staff salaries.
- Thirdly, Variable costs.
The variable cost total varies by unit volume. Typical variable costs include per unit costs for such things as factory direct labor, materials, and sales commissions.
The Simple Break Even Formula.
The simple break even formula shows how these inputs produce the break even quantity Q. Suppose for instance, a firm produces and sells a product with these values:
F = Total Fixed costs = $1,200
v = Variable cost per unit = $15
P = Selling price per unit = $40
The formula finds the break even number of units—break even point—as follows:
Q = (1,200) / (40 – 15)
= 1,200 / 25
= 48 units
Knowing the break even quantity Q, the analyst verifies the result by comparing total inflows to total outflows.
= Q * P = (48) ( $40) = $1,920
= Fixed costs + Variable costs
= F + (Q * v) = $1,200 + (48)($15) = $1,920
Sometimes the break even result includes a fractional unit (for example, 50.34 units). No one sells or ships fractional units, however. In such cases, of course, the analyst rounds break even quantity Q up to the next whole unit (to 51 units).
Break even analysis focuses on net cash flow. In particular, the analysis tries to find a business volume that results in 0 net cash flow. Exhibit 1 shows the net cash flow result (solid black line) due to different values of the input variables (selling price, fixed costs, variable costs, and unit volume).
Exhibit 1. Simple break even point analysis. Here, three factors make this example "simple." Firstly, fixed costs are constant at $1,200 for all unit volumes. Secondly, unit selling price is constant at $40. And, thirdly, total variable costs are proportional to unit volume. Variable cost per unit v is $15 and total variable cost is simply the product of v and unit volume. As a result, break even volume is 48 units. On the graph, break even volume is the horizontal axis point where Net Cash Flow is 0.
The four lines on the graph show resulting vertical axis values as a function of horizontal axis units sold. Because the break even equation is a linear equation, all four "curves" graph as straight lines. The graph, in other words, plots unit volume (v) as an independent variable, along with results for three dependent variables:
- Variable costs
- Fixed costs
- Net cash flow
The "Net Cash Flow" curve is in fact the difference between net inflows and net outflows. For graphing purposes, net cash flow for any unit volume UVi calculates as:
Net cash flow at UVi
= (UVi * Cash inflow per unit)
– (Variable costs at UVi + Fixed costs)
As unit volume increases, net cash flow climbs from negative to positive. And, as a result, break even quantity Q is the unit volume were net cash flow crosses 0 on the horizontal axis.
For working spreadsheet examples of the break even equation and break even graphs, as they appear above, see the Excel-based ebook Financial Metrics Pro.
Break Even Point Does Not Exist When Selling at a Loss
Obviously, break even point Q does not exist for products selling at a loss. This occurs when a product has a negative gross margin, that is, when unit cost of goods sold is greater than unit selling price.
There are in fact a few strategic reasons for selling one or a few products at a loss. Sellers may use a "loss leader," for example, simply to "get customers into the store," or to leverage sales of other products. And, they may sell at a loss to pursue rapid market share gains. Such products, however, always contribute a net loss to profits, regardless of volume.
For working spreadsheet examples of the break even equation and break even graphs, as shown above, see Financial Metrics Pro.
In the simple example above, total variable cost is simply the product of unit volume and cost per unit. This is because cost per unit is constant across all unit volumes.
The analyst faces new complexities, however, when cost per unit itself also changes with unit volume. As a result, "Variable cost" in the break even analysis is not a simple linear function of unit volume. This situation occurs in business, where, for instance:
- The manufacturer's unit cost for raw materials depends on the size of the raw materials order.
- Direct labor costs per unit may depend somewhat on the size of the production run. Consequently, labor cost per unit differs for different volumes.
- Above a certain unit volume, a company may have to add more staff or production equipment. These additional costs may be fixed costs within a limited volume range, but across all ranges they are semi-variable costs.
- In order to achieve high unit volume, the company may have to lower selling price, or offer volume discounts, or use pricing tiers for different order sizes. As a result, not all units sell at the same price. This creates semi-variable inflows.
Under such conditions, the simple break even equation is not accurate, or else it is accurate only within a limited range of unit volumes.
Example Break Even With Semi Variable Costs
Consider a manufacturing setting with three cost and price factors:
B = Total Fixed costs = $1,200
v = Variable cost per unit = $15
P = Selling price per unit = $40
Now, however, there is an additional semi-variable cost factor (sv). When production volume is 0 - 30 units, an additional $100 labor cost is required, making sv1 = $100. For volumes in the range 31-60 units, additional labor costs are $200 meaning that sv2 = $200. In the range 61-90 units, additional labor costs are $300 meaning that sv2 = $300. The image below summarizes this semi-variable cost factor.
sv1 = $100 sv2 = $200 sv3 = $300
Finding Break Even With Semi-Variable Costs
The easiest approach to finding the break even volume is to use the simple equation separately for each range. Consequently, total fixed costs in each range i are the sum of the given overall fixed cost (F) and the semi-variable cost for the range (svi).
Step 1. Finding Fixed Costs For Each Range
Total fixed cost for range i = F+svi.
Step 2 Finding Ranges Containing Break Even
The next step is to find which ranges, if any, contain a break even point. Depending on the input figures, it is possible to have no ranges with a break even point, or a break even point in just one range, or a break even point in multiple ranges.
- When a unit volume range shows net cash flow negative at one point and positive at another, the range includes a break even point.
- If net cash flow is negative throughout the range or positive throughout, the range does not include a break even point.
To test these two criteria for this example, we need only calculate net cash flow at the lower limit and at the upper limit. This is because, here, net cash flow across each range is a linear function of unit volume. That is, net cash flow is a "straight line" function.
Example Calculations With Semi-Variable Costs
For this example, we can determine if has range has a break even point by calculating net cash flow at its upper and lower limits using this equation:
Net cash flow = Incoming cash flow – Range total fixed cost – Variable cost
= Units * P − (F+svi ) – Units * v
Break even for Range 1 (0 - 30 units)
Examine Range 1 for possible break even points with these calculations:
Net cash flow at 0 units
= (0)( $40 ) −( $1,200 + $100 ) − ( 0 ) ($15 ) = −$1,300
Net cash flow at 30 units
= (30)( $40 ) − ( $1,200 + $100 ) − ( 0 ) ($15 ) = −$550
Range 1 has no break even points because net cash flow is negative across the entire range.
Break even for Range 2 (31 - 60 units)
Examine Range 2 for possible break even points with these calculations:
Net cash flow at 31 units
= (31)( $40 ) −( $1,200 + $200 ) − ( 31 ) ($15 ) = −$625
Net cash flow at 60 units
= (60)( $40 ) − ( $1,200 + $200 ) − ( 60 ) ($15 ) = $100
Conclusion 2:Range 2 has a break even point because net cash flow is negative at the range lower limit (31 units) and positive at the upper limit (60 units). Within this range, therefore, semi-variable costs sv2 are constant and thus add into fixed costs, F. As a result, the analyst finds the Range 2 break even point with the break even formula Q = F / ( P - v ), applying it to this range only.
Break even ( Q ) in Range 2 = ( $1,200 + $200 ) / ($40 – $15) = 56 units
Break even for Range 3 (61-90 units)
Examine Range 3 for possible break even points with these calculations:
Net cash flow at 61 units
= (61)( $40 ) −( $1,200 + $300 ) − ( 61 ) ($15 ) = $25
Net cash flow at 90 units
= (90)( $40 ) − ( $1,200 + $300 ) − ( 90 ) ($15 ) = $750
Range 3 does not have a break even point because all unit volumes in the range show positive net cash flow. All unit volumes in the range are therefore above break even.
For more on semi-variable costs in break even analysis, and working spreadsheet example, see Financial Metrics Pro.
Variable Inflow Sources
Analysis in the examples above assumes constant cash inflow (or selling price, P) for each unit sold. However, in some situations, different customers pay different prices for the same goods or services.
- Seats on airline flights often sell at different prices. This is because ticket price may depend on such things as class of service, advance purchase, demand for the flight, or competitor's prices.
- Consultants, physicians, and other professional service providers sometimes charge clients according to their willingness or ability to pay.
- Businesses that sell to other businesses may negotiate prices individually with each customer.
- Companies launching new products or entering new markets may try out different pricing models from time to time.
Calculating Break Even With Variable Inflows
Break even questions still have relevance in such cases. However, cash inflows that can vary from unit to unit call for an analysis more complex than the examples shown above.
In such cases, the break even analyst can proceed as follows:
- Firstly, calculate break even quantity using an average (mean) inflow or average (mean) selling price per unit. This analysis shows the cash inflow total that balances costs, that is, to breaks even
- Secondly, set this cash inflow level as a target to reach for break even.
- Thirdly, propose different pricing models and their resulting unit volume needs for reaching the target inflow.