BackToBasics
Break-even analysis
Fundamental to any business plan is understanding where your break-even point is, and the volume of sales needed to turn a profit
Words Nick Craggs, First Intuition
Accountants can be faced with a number of decisions that affect a business in the short term. These can include decisions about what to charge for a product, whether to make a product at all, if it is worth making in-house or buying it in, and how many to make. The list of decisions that an accountant can face, as I am sure you are all aware, is almost limitless!
Break-even analysis is one tool accountants can use when making decisions in the short term. In short, this allows an accountant to estimate what level of sales the company needs to achieve to at least cover its costs and ensure it isn’t making a loss. Before we can look at break-even analysis, we need to revise the concept of marginal costing and contribution.
Key point
Break-even analysis allows accounting professionals to understand the level of income required for a business to cover its costs and remain operational.
Break-even analysis allows us to calculate the point where we are selling enough units to generate enough contribution to just cover our fixed costs.
Marginal costs and contribution
A marginal cost is a cost that goes up with production. If you make one more unit of production, the costs that go up are your marginal costs. The second concept we need to understand is contribution. Contribution is the amount of money you have left after you have taken the marginal costs from the selling price. We tend to work on a per unit basis for this, so if you sell a product for £20 per unit and it costs £8 in material and £4 in labour per unit, then you will have a contribution of £8 per unit. This is the sales price of £20 less the £12 marginal cost. This contribution isn’t profit though – remember that you have only paid your marginal costs, you haven’t paid any fixed costs yet. This is where break-even analysis comes in.
Break-even analysis allows us to calculate the point where we are selling enough units to generate enough contribution to just cover our fixed costs. This level of production is known as the break-even point. Obviously, you would hope to be selling more than this and making enough contribution to leave a profit, but knowing this figure allows the accountant to make decisions. One way it helps is in the measure of risk. If you need to sell lots and lots of units before you cover your costs, then this is a riskier product than one where you only need to sell a few units before you have covered all your costs and start making a profit.
Let’s take our product we discussed above that generates £8 of contribution per unit. If we have overheads of £50,000, we need to know how many units we need to sell to generate £50,000 of contribution. To calculate the break-even point, we divide the £50,000 overheads by the £8 of contribution, giving us 6,250 units.
If we sell at a minimum of 6,250 units, we can be sure that we are covering our costs. Then the accountant can decide if selling 6,250 units is likely or not. This can be expressed in either units, as we have seen here, or revenue. If we calculate a break-even point that isn’t a whole number, we always round up no matter what we calculate the break-even point to be. Even if the break-even point works out to be 450.1 units, we will round this up to 451 units.
Safety and risk
We would hope that we would be selling more than 6,250 units to have some leeway, so if our sales fell a bit we would still be covering our fixed costs. This difference between our current sales figures and the break-even point is called the margin of safety, which is another measure of risk.
If a product has a low margin of safety, then sales only need to fall by a small amount before it becomes loss-making. Whereas, if a product has a high margin of safety, you can absorb a fall in sales and still be able to make a profit. A margin of safety of 500 units is a lot if the break-even point is 100 units, but not so much if the break-even point is 40,000 units. We normally express margin of safety as a percentage because an absolute figure doesn’t show the actual risk.
Looking back at our example where our break-even point is 6,250 units, if we expect to sell 10,000 units then we have a margin of safety of 3,750 units. However, as I mentioned before, we need to express this as a percentage to show the actual risk. The margin of safety as a percentage is not calculated as the margin of safety divided by the break-even point, which is a common mistake. It is calculated as the margin of safety in units divided by the sales volume. In our scenario this would be 3,750/10,000 x 100%, giving us a margin of safety of 38% (rounded to the nearest whole per cent). This means that our sales volume can fall by 38% before we are only just covering our fixed costs. More than that and we would be making a loss.
Break-even analysis and margin of safety are only some of the tools an accountant may use to make decisions. There will be other financial considerations to look at as well as other non-financial considerations.
