The break even analysis is also known as cost volume profit analysis. It is a vital financial metric that helps every business owner determine what needs to do to recover the original investment. So, this article explains break even analysis and its benefits.
Definition of break even analysis
The break even point (BEP) analysis in accounting simply means the point at which an organization’s total revenue is equal to its total costs. It involves the determination of the number of units or value of a product required for a company to recover its total costs. However, break even point analysis involves the use of the behavioral classification of cost. That is, separating costs into fixed and variable costs. BEP can be BEP in unit or BEP in value.
The break even point Formula
However, fixed costs are the costs that do not vary irrespective of changes in the units produced or level of activities. Contribution is the difference between the sales and variable costs, while variable costs are the costs that change when the level of activities changes. Therefore, contribution per unit simply refers to the sales price minus variable cost per unit. Variable cost per unit is the variable cost incurred per unit of a product. Additionally, the contribution margin ratio is the contribution divided by sales.
Example of break even point analysis
The management accountant of Adex Ltd is contemplating on what will be the break even point of the company if the fixed cost is $120,000 and the selling price is $20. The variable cost per unit is $12.
The determination of the break even point of Adex is done as thus:
Calculation of BEP(unit)
Contribution per unit = $20 – $12
Benefits of break even point analysis
Some benefits of Break even analysis include:
Break even point analysis helps business owners to determine the appropriate pricing policy for their products. When a company is contemplating changing the price of its product, BEP analysis helps to make the appropriate decisions.
It helps a company to determine the sales volume of its product required to meet a particular profit in a period. So, to calculate the target profit, it is calculated as thus:
However, it should be noted that the target profit in the above formula should be profit before tax. If profit after tax is given, you need to convert it to profit before tax by using the formula as thus:
Sourcing for funds
Break even analysis is a vital tool for business owners to source funds for their business. So, it is a key part to include when writing a business plan for funding purposes.
Margin of safety
Break even Point analysis also helps the managers of companies to determine the extent to which their level of sales can reduce before the company starts incurring losses.
Changes in costs
It also helps to determine the effect of changes in costs of the company such as variable cost and fixed cost on the company’s profit
It helps to mitigate the risk by helping the investors to avoid investment opportunities that may not be profitable. This can be done by knowing the number of units to be sold before recovering the initial cost of the investment.
Understanding the number of units or value of your product requires to be sold before your company can recover the total costs will help to make well-informed business decisions. However, break even point analysis has certain assumptions to follow as well as some limitations.
Subscribe to our newsletter!
Afeez is one of the founding partners of Marasas Consulting limited. He consults for both individuals and entities in the area of accounting, management, audit, tax, and investment. He has a wide range of experience both online and offline which allows him to provide relevant and timely professional advice and assistance to business owners with their accounting, tax, management, audit, and investment plans.
Afeez is a member of the Institute of Chartered Accountants of Nigeria (ICAN) and a member of the Nigerian Institute of Management (Chartered). He is a certified Google analyst and strategist. He earned his Bachelor degree in Management and Accounting from Obafemi Awolowo University, Ile-Ife, Nigeria, and earned an ordinary national diploma in Accountancy from The Polytechnic of Ibadan, Oyo State, Nigeria. He earned certification in “Excel Crash Course” and “Reading of Financial Statement” from Corporate Finance Institute, Canada.
Afeez is dedicated to helping clients achieve business success by helping them to establish solid and sound accounting, tax, and financial processes.