Break-even analysis is a technique widely used by production management and management accountants. It is based on the categorization of production costs into those that are “variable” (costs that change when production changes) and those that are “fixed” (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue to determine the level of sales volume, sales value, or production at which the company makes neither a profit nor a loss (the “break-even point”).
The balance chart
In its simplest form, the break-even chart is a graphical representation of the costs at various levels of activity shown on the same chart as the change in revenue (or sales, income) with the same change in activity. The point at which there is no profit or loss is known as the “breakeven point” and is represented in the graph below by the intersection of the two lines:
Break-even Analysis Chart:
break-even analysis chartIn the diagram above, line OA represents the variation in income at various levels of productive activity (“production”). OB represents the total fixed costs of the business. As production increases, variable costs are incurred, which means that total costs (fixed + variable) also increase. At low levels of production, costs are greater than revenues. At the point of intersection, P, costs are exactly equal to revenue and therefore there is no profit or loss.
Fixed costs
Fixed costs are those business costs that are not directly related to the level of production or production. In other words, even if the company has zero production or high production, the level of fixed costs will remain practically the same. Over the long term, fixed costs may change – perhaps as a result of investment in production capacity (e.g. adding a new manufacturing facility) or through growth in overhead costs required to support a larger, more complex business.
Examples of fixed costs:
– Rent and fees
– Depreciation
- Research and Development
– Marketing costs (not related to revenue)
– Administration costs
Variable costs
Variable costs are those costs that vary directly with the level of production. They represent payment-related factors of production such as raw materials, direct labor, fuel and revenue-related costs such as commissions.
A distinction is often made between “direct” variable costs and “indirect” variable costs.
Direct variable costs are those that can be directly attributable to the production of a particular product or service and allocated to a particular cost center. Raw materials and the salaries of those who work on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but vary with production. These include depreciation (when it is calculated in relation to production – e.g. machine hours), maintenance and certain labor costs.
Semi-variable Costs
Although the distinction between fixed and variable costs is a convenient way to categorize business costs, in reality there are some costs that are fixed in nature but which increase when production reaches certain levels. These are largely related to the “scale” and/or overall complexity of the business. For example, when a company has relatively low levels of production or sales, it may not require costs associated with functions such as human resource management or a fully resourced finance department. However, as the scale of the business grows (e.g. production, number of people employed, number and complexity of transactions), more resources are required. If production increases suddenly, some short-term increase in storage and/or transportation may be necessary. In these circumstances, we say that part of the cost is variable and part is fixed.
Formula
The break-even formula is calculated by dividing the total fixed costs of production by the price per unit minus the variable costs of producing the product.
Break-even point in units = Fixed Costs / (Sales price per unit – Variable Cost per Unit)
The break-even point is the point at which No profit No loss
