What is the breakeven point?
Estimating profitability involves working out the least level of sales required to cover all the costs. A business loses if it is not selling enough units for the revenue to cover the expenses. As revenue increases, it offsets more fixed costs. Making a profit depends on the ability of a business to make a revenue that is enough to cover both the fixed and variable costs. For every item sold, the revenue covers its variable cost, and the surplus of revenue is added to the carried-over account to offset any fixed costs. This carried-over account of revenue may not cover all the fixed costs; therefore, a company must sell a particular quantity of goods to make sufficient revenue to cover the fixed costs. This level of sales is called the break-even point, which is reached when the total revenue offsets the total costs, and the firm makes a zero-profit. If the firm can sell above this point, it will make a profit. For every item sold above the break-even point, a marginal surplus of revenue after covering the variable cost, e.g. raw materials, becomes a profit. Analysing its break-even point helps a firm to plan the level of sales it needs to become profitable and also shows the minimum level of production to be reached and the likelihood of any associated risks, such as the probability of not reaching the break-even point, thereby making a loss.
How to estimate the break-even point?
This can be calculated by drawing a graph showing the point where the total revenue intercepts with the total cost. To draw a chart for plotting a break-even point, take the following steps:
Case’s assumptions: –
Total fixed costs are £10,000.
Total variable costs are £2.00 per unit.
Selling price is £6.00 per unit.
Construct a chart: with output (units) on the horizontal (x) axis, and costs and revenue on the vertical (y) axis.
Fixed cost: Plot a horizontal fixed costs line at £10,000 when output is zero. It is a horizontal line because it is a fixed cost and does not change with production.
Variable cost: Plot a variable cost line from the points of (0,0) and (1,000, 2,000). At 1,000 output, the variable cost is (1,000 x £2= £2000).
Total cost: Plot a total cost line from point (0, 10,000) and point (1,000, 12,000). At zero output the total cost is equal to the total fixed cost of £10,000. At 1,000 output, the total cost is £10,000 plus (1,000x £2= £2,000) equal to £12,000.
Revenue: Plot the revenue line from the points (0,0) and (1000, 6000). At zero output, the revenue is zero. At 1,000 output, the revenue is £6,000 (1,000x £6= £6,000).
Estimate the breakeven point: Find the point of interception between the total cost and the total revenue lines. This point is the break-even point, and it will be at 2,500 output, where revenue is £15,000. With revenue of £15,000, the fixed cost is £10,000, and the variable cost is £5,000. Making the total revenue equal to the total cost of £15,000. The break-even point can also be calculated as the output quantity by the total fixed cost divided by the contribution margin. Break-even point as a value can be calculated by multiplying the break-even point as output quantity by the price per item.
Be aware of the breakeven limitation
Break-even is a useful tool for working out the minimum sales needed to make a profit, although it has many limitations. It makes fixed assumptions about various factors which may differ from actual conditions. For example, it assumes that the revenue and cost regression is linear, which is not the case in real life. It also assumes that all produced units are sold, forecasts are reliable, and marketing forces remain unchanged. If new businesses enter the market or an economic recession starts, then it could take longer to reach the break-even point than anticipated. Besides, many organizations add a margin of safety to the break-even point when deciding on their minimum sales target. The break-even point is a static tool and relies on fixed assumptions to calculate it.
This article is extracted from my new book- Mastering Enterprise Skills for Potential Entrepreneurs, which can be found on www.amazon.co.uk. If you want to receive more information about the book and our activities, you can register in our newsletter by using this link.
Prepared by: Munther Al Dawood
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