A Breakeven Analysis is one of the most common ways to assess a business decision. In its most simplistic form, a breakeven analysis looks at how many units of a product or service must be sold in order for total revenues to equal the cost of production.
A breakeven analysis is commonly used in financial analysis and corporate budgeting to help make project and investment decisions. However, breakeven analysis can also be used for home economics purposes to help consumers make smart decisions regarding purchases.
The breakeven level of sales can be solved for by taking into account the contribution margin each unit of sales contributes towards covering fixed costs. This article will teach readers how to conduct a breakeven analysis with an example both from a business and consumer perspective.
Formula for Breakeven Analysis?
A breakeven analysis can be calculated formulaically by dividing the total fixed costs by the contribution margin per unit sold. The breakeven point is represented by the quantity of units needed to be sold. The contribution margin is equal to the sales price less all the variable costs. For each unit sold, the net contribution margin will go towards covering fixed costs. The formula to calculate the breakeven level can be seen below.
# Quantity x (Sales Price – Variable Costs)
Any expected level of production above the breakeven point represents profits to be had. If in the analysis you want to meet a certain amount of profit, you can add this amount to the fixed costs that need to be covered. For value investors, they can think of anything above this breakeven level as a margin of safety as they contemplate taking on the project or making an important life decision.
Breakeven Analysis for the Consumer
Understanding the concept of breakeven can help consumers make smart financial decisions in their day-to-day life. The breakeven analysis can be used when assessing decisions such as whether to join a gym on a monthly basis or buy workout equipment at home, how much spending one needs to do at a club store (ex. Costco, Sam’s Club) for the annual membership fee to make sense, or also big decisions such as how many years it will take the incremental salary you might earn from taking your MBA to cover the cost of tuition, housing, and lost wage opportunity cost.
Let’s walk through an example below for a consumer faced with joining a gym or buying equipment at home. With the gym membership, there is no money upfront but there is an ongoing $50 per month membership fee. The cost to purchase equipment at home would be a harder to stomach upfront $1,000 cost. To figure out how many months it would take to breakeven with the upfront investment, we can simply divide the two into each other as seen below.
= Fixed Costs / Variable Unit Price
= $1,000 / $50 per month
= 20 months
In this example, the breakeven analysis tells us that at the 20 month point, the consumer will be have spent $1,000 either way; if they purchased the equipment upfront, or it they purchased the monthly gym membership. This means that if they only plan on going to the gym for 20 months, they would be indifferent as to purchasing equipment or a monthly membership. If the person plans on being active and wanting a gym membership for longer than 20 months, the option of purchasing at home equipment would be the most economical choice, or vice versa.
Breakeven Analysis for a Business
In a business context, breakeven analysis can get much more complicated with many moving variables, but the concept remains the same. Let’s look at a simplified example of an ice cream store owner thinking of opening a second location.
The rent of the new store is $5,000/month and to staff it with one worker during operating hours is $2,500/month. The sales price of ice cream is $5 for the average customer and the cost of the ice cream to the store is $1 per scoop. To figure out how many scoops of ice cream the store needs to sell before it will be earning any profits, we can put it through the breakeven formula.
= Fixed Costs / Variable Contribution Margin
= ($5,000 + $2,500) / ($5 – $1)
= $7,500 / $4
= 1,875 scoops per month
or , 62.5 scoops per day.
In this example, the breakeven level of sales is 1,875 scoops of ice cream each month, which reflects 62.5 scoops per day in a 30-day month. At this level of sales, the total of $7,500 monthly fixed costs are covered. In our business example, the basic sales price has been substituted for the “contribution margin” of $4, which reflects the variable profit at the gross margin level that each unit of sales “contributes” to covering fixed costs.
Limitations of a Breakeven Analysis
A breakeven analysis is often the first step in analyzing a project before more time and resources are committed to the analysis. The main drawback of a breakeven analysis is that it does not tell you how profitable a decision will be, but only at what point the decision will break even.
Some of the main disadvantages of a breakeven analysis are that it ignores critical items in the profitability of a project such as the cost of capital, assumes a single product or product-mix is being sold, and ignores changes in sales prices and costs at different levels of quantity. A full discounted cash flow can take into account the time value of money and the cost of capital while also being more dynamic adjusting for different price levels at various quantities and points in time.
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Takeaway
A breakeven analysis is an insightful way to explore the risks and opportunities of any financial decision. It is often the first step in determining the feasibility of a project before more comprehensive discounted cash flows of a project are calculated. A breakeven analysis is not only valuable for business managers but can help consumers make informed choices in their everyday decisions to save money and retire earlier!
