Definition / Examples of Break-even Analysis
How does Break-even Analysis work?
Contribution Margin vs. Gross Profit Margin
How to Use Break-even Analysis
What Does Break-even Analysis Mean for Investors?
Definition / Examples of Break-even Analysis
Break-even analysis is a method used to determine the sales volume of a product or service at which a company can recover the cost of providing that product or service. Calculating the break-even point requires estimating both fixed and variable costs, as well as the pricing for that product or service.
As an example of break-even analysis, we can consider that the goal of most companies is to make a profit, and understanding the sales level needed to break even – the number of units or the sales amount – will help reduce risks. The break-even point (BEP) can be expressed on a monthly, quarterly, or annual basis.
How does Break-even Analysis work?
There is a cost to produce any product or provide a service. Part of that cost is fixed and another part varies based on the number of units produced. Estimating the break-even point requires accurate information about fixed and variable costs.
Fixed costs do not change with the sales volume and may include rent, utilities, salaries, and insurance. Variable costs change with the sales volume and include materials and labor.
How to Use Break-even Analysis
Once the break-even point is determined, the entrepreneur should have a better understanding of whether the business plan will succeed. For example, the potter wants to sell more than 89 salad bowls per month so that his goal is not limited to just breaking even. If he feels confident that he can achieve this, his business plan may be on the right track.
However, if selling 89 salad bowls per month is not realistic, the business can still work if the potter can reduce fixed or variable costs or increase the price per bowl. For example, if he can lower fixed costs to $2500 by finding a cheaper studio and reducing marketing costs, he only needs to sell 74 salad bowls per month to break even ($2500 / $34 = 73.53, rounded to 74).
What Does Break-even Analysis Mean for Investors?
For investors, break-even analysis presents the minimum sales volume required to keep the company from incurring losses. When analyzing two or more companies that offer a similar product or service, break-even analysis can help determine whether one company has a significant advantage in terms of lower production costs or pricing power (due to a strong brand) or other factors that allow it to sell fewer units to break even.
Break-even analysis can also find application even in the context of stock and options trading. Investors may be able to calculate the point at which they neither make a profit nor incur a loss. Calculating the break-even point in trading can be a useful tool in determining an investment strategy using stop-loss and target points.
In options trading, the point at which an investor neither makes nor loses money is the sum of the strike price and the premium paid to purchase the option.
Source: https://www.thebalancemoney.com/break-even-analysis-5115542
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