What is Break-Even Point Analysis?
Managers must know how different costs behave as the volume of sales expands or contracts. Cost-volume-profit analysis is the study of the interrelationships of sales, costs and net income. It is a key factor in many planning decisions. The essence of cost-volume profit analysis is attaining an understanding of how costs and profits change in response to changes in volume.
This study is often called break-even-point analysis. This is the point of zero net income which is often the starting point of cost-volume-profit analysis that provides perceptions of possible dangers of certain courses of action.
Let us assume that any cost may be classified as either fixed or variable. Fixed costs are costs which remain constant in total regardless of changes in the level or volume of activity within the current period. Variable costs are those which are expected to fluctuate in total in proportion to sales, production or other measures of activity.
The Fun Beach Towel Company operates a retail stand at the XYZ Mall selling inexpensive beach towels during summer. The company is now in the process of negotiating for a lease of a retail stand in ABC Mall. The company has determined that the following costs will probably characterize the proposed stand:
Selling price per beach towel.. 20.. 100%; variable expense.. 10.. 50%; contribution margin..10..50%; Fixed Expenses.. $700.
Should the company enter into a lease agreement with ABC Mall? Fun Beach Towel Company will have to answer certain questions before a decision can be made.
Break-Even Point Computation
Question: What would be the break-even-point of the company in terms of numbers of units (beach towels) sold and dollar of sales?
At break-even point, revenue is precisely equal to costs, no profits are realized, and no losses are incurred.
For the purpose of this illustration, the unit contribution approach is used. The approach is based on the fact that every unit sold generates or provides a certain amount of contribution margin that goes toward the covering of the fixed costs.
The contribution margin is the excess of sales price over the variable expenses pertaining to the unit in question: Unit sales price is $20; unit variable expenses – $10; unit contribution margin to fixed cost and net profit – $10.
To find the number of units that must be sold to break-even, total fixed cost must be divided by unit contribution margin. Thus, $700 divided by $10 is 70 beach towels.
If only the percentage relationship between variable expenses and sales is known, the formula can still be used to compute the break-even point in dollar sales: Sales price -100%; variable expense -50%; contribution margin – 50%.
Total Fixed Cost divided by contribution margin ratio equals break-even point in dollar sales. Thus, $700 divided by 50% is $1,400. The company must sell more than 70 beach towels in order to have a profit.
