Break-Even Analysis
What it is:
A break-even analysis is a calculation of the point at which revenues equal expenses. In securities trading, the break-even point is the point at which gains equal losses.
How it works/Example:
The basic idea behind doing a break-even analysis is to calculate the point at which revenues begin to exceed costs. To do this, one must first separate a company's costs into those that are variable and those that are fixed. Fixed costs are costs that do not change with the quantity of output and they are not zero when production is zero. Examples of fixed cost include rent, insurance premiums or loan payments. Variable costs are costs that change with the quantity of output. They are are zero when production is zero. Examples of common variable costs include labor directly involved in a company's manufacturing process and raw materials.
For example, at XYZ Restaurant, which sells only pepperoni pizza, the variable expenses per pizza might be:
- Flour: $0.50
- Yeast: $0.05
- Water: $0.01
- Cheese: $3.00
- Pepperoni: $2.00
- Total: $5.56
Its fixed expenses per month might be:
- Labor: $1,500
- Rent: $3,000
- Insurance: $200
- Advertising: $500
- Utilities: $450
- Total: $5,650
Based on the total variable expenses per pizza, we now know that XYZ Restaurant must price its pizzas at $5.56 or higher just to cover those costs. But if the price of a pizza is $10, then the contribution margin, or the revenue minus the variable cost for XYZ Restaurant, is ($10 - $5.56 = $4.44).
But how many pizzas does XYZ Restaurant need to sell at $10 each to cover all those fixed monthly expenses? Well, if $4.44 is left over from each pizza after accounting for variable costs, then we can determine that XYZ Restaurant must sell at least ($5,650 / $4.44 = 1,272.5) pizzas per month in order to cover monthly fixed costs.
It is important to note that some fixed costs increase "stepwise," meaning that after a certain level of revenue is reached, the fixed cost changes. For example, if XYZ Restaurant began selling 5,000 pizzas per month rather than 2,000, it might need to hire a second manager, thus increasing labor costs.
Why it matters:
Break-even analyses help business owners determine when they'll begin to turn a profit and helps them price their products with that in mind. It provides a dynamic overview of the relationships among revenues, costs and profits.
However, typical variable and fixed costs differ widely among industries. This is why comparison of break-even points is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" break-even point should be made within this context.