Break Even Analysis

Break even analysis depends on the following variables:

1. The fixed production costs for a product.

2. The variable production costs for a product.

3. The product's unit price.

4. The product's expected unit sales [sometimes called projected sales.]

On the surface, break-even analysis is a tool to calculate at which sales volume the variable and fixed costs of producing your product will be recovered. Another way to look at it is that the break-even point is the point at which your product stops costing you money to produce and sell, and starts to generate a profit for your company.

You can also use break even analysis to solve managerial problems:

•  setting price levels
•  targeting optimal variable/ fixed cost combinations
•  determining the financial attractiveness of different strategic options for your company

Using Break Even Analysis

Imagine that you are an entrepreneur at a location in the United States. You are planning to enter the gourmet soy-based burger market.

Using break-even analysis, here is what you want to know...

At what volume of burger sales will you start to make money?

One of your MBA partners developed an expected unit sales forecast. You want to compare this 18-month forecast of 150,000 units to the volume of burgers you will have to sell in order to break even.

Projected Sales Forcasted Break Even

You are forecasting 18-month sales because that is your banker's deadline for showing a profit. If you are not making money in 18-months, your banker may call your loan, and you would be facing bankruptcy.

Here is what you know now:

The variable unit cost for making one burger is $.97.

The fixed cost of making burgers for 18 months will be a total of: $140,000. Remember, fixed costs cover things like your rent, your phone bill, and insurance coverage - these items tend not to vary in amount per month over the term of one year.

Your MBA partner has forecast expected unit sales of 150,000 burgers in 18 months.

The unit price you are projecting for the burger is: $1.99.This is your best estimate of what the average consumer will pay for your soy-burger.

If you charge $1.99 for your burger, how many burgers will you have to sell before you make back your total cost: $140,000 + (150,000 burgers x 97 cents)?

.

What is the break even point when the unit price is raised to $2.79?

Here is what you know now:

The variable unit cost for making one burger is $.97

The unit price you think you might sell the burger for is: $2.79.

The fixed cost of making burgers for 18 months will be a total of: $140,000.

If you charge $2.79 for your burger, how many burgers will you have to sell before you make back your total cost?

At a unit price of $2.79, our break-even volume on burgers sold
drops to 76,900 units. You should be able to sell this many burgers in
nine to eleven months if your forecasts are accurate to +/- 20%.
This is going to make your banker happier!

If you have the time, try some other alternatives.

•  Lower your variable cost - try $.80 as a variable unit cost to produce one unit and see what happens.

·  Or adjust your fixed costs - try $100,000 as your fixed cost over 18 months. What could you do to lower your fixed costs, if you select this strategy?

Each time you change a parameter in Break-Even Analysis, the break-even volume changes, and so does your risk/profit profile. By now you know what we are driving at - all these factors can be controlled by managers! Therefore, each can be the focal variable in a break-even analysis.