Define: Break-even Analysis

UK Accounting Glossary

Definition: Break-even Analysis



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Full Definition of Break-even Analysis


Break-even analysis is a managerial tool used in business to estimate a fair, competitive and profitable price for products and services. Break-even analysis categorizes costs as a variable (changing with the volume of production) and fixed (unrelated to volume). In break-even analysis, first, break-even point – where total revenue equals total cost – is calculated. Break-even analysis finds this by dividing total fixed costs by per unit contribution to fixed costs (unit price – unit variable cost). Dollar value is calculated by multiplying break-even point by price per unit. Any per unit contribution to fixed costs beyond break-even point goes to profit. Thus break-even analysis measures the volume of activity required by businesses to remain profitable after covering all fixed expenses. Mangers use break-even analysis to assess multiple price levels and variable-fixed price combinations. Break-even analysis also helps in determining optimal costs, prices and product mix. In macroeconomics, break-even analysis yields the point where income exceeds consumption resulting in savings.

The break-even point for a product, brand, or company is the point where total revenue received equals total costs (TR=TC). At a price or quantity greater than this point, the firm is making a profit; below this point, a loss. Break-even quantity is calculated by:

Total fixed costs / (price – average variable costs)

An example:

  • Assume we are selling a product for $2 each.
  • Assume that the variable cost associated with producing and selling the product is 60 cents.
  • Assume that the fixed cost of operations (the basic cost of operating the business even if no product is produced) is $1000.
  • In this example, the firm would have to sell (1000/(2 – 0.6) = 714) 714 units to break even.

This analysis is particularly useful in comparing the profit consequences of alternative prices. By inserting different prices into the formula, you will obtain a number of break-even points, one for each possible price charged. If the firm was able to increase the selling price for its product, from $2 to $2.30, then it would have to sell only (1000/(2.3 – 0.6) = 589) 589 units to break even.

Break-Even Analysis with Multiple Prices
To make the results clearer, they can be graphed. To do this, you draw the total cost curve (TC in the diagram) which shows the total cost associated with each possible level of output, the fixed cost curve (FC) which shows the costs that do not vary with output level, and finally, the various total revenue lines (R1, R2, and R3) which show the total amount of revenue received at each output level, given the price you will be charging.

The break-even points (A, B, C) are the points of intersection between the total cost curve (TC) and a total revenue curve (R1, R2, or R3). The break-even quantity at each selling price can be read off the horizontal, axis and the break-even price at each selling price can be read off the vertical axis. The total cost, total revenue, and fixed cost curves can each be constructed with simple formulae. For example, the total revenue curve is simply the product of selling price times quantity for each output quantity. The data used in these formulae come either from accounting records or from various estimation techniques such as regression analysis.

Limitations

  • This is only a supply-side (ie.: costs only) analysis.
  • It tells you nothing about whether you can actually sell the product at these prices.
  • It assumes that fixed costs (FC) are constant
  • It assumes variable costs are constant per unit of output

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Definition Sources


Definitions for Break-even Analysis are sourced/syndicated and enhanced from:

  • A Dictionary of Economics (Oxford Quick Reference)
  • BusinessDictionary.com
  • Oxford Dictionary Of Accounting
  • Oxford Dictionary Of Business & Management

This glossary post was last updated: 4th February 2020.