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What is break-even analysis?
Break-even analysis is used to find the break-even point (BEP); the point a business needs to reach before it starts to make a profit from what it does.
Breaking even is the tipping point between a business making or losing money, which makes break-even analysis ultra-important for any investor.
Breaking even is the tipping point between a business making or losing money, which makes break-even analysis ultra-important for any investor.
FORMULA
BEP = (Fixed Costs/Price Per Unit) - Variable Cost Per Unit
Big ideas
- The five major components of break-even analysis are contribution margin, fixed costs, variable costs, revenue, and break-even point.
- The BEP is considered a margin of safety and indicates a point between profit and loss.
- Break-even analysis can be used across a variety of asset classes such as stocks and bonds, though it most commonly refers to business activity.
What are the components of break-even analysis?
There are five major components to the break-even analysis.
- Fixed costs - The cost of production. These costs are fixed and can include rent, wages, insurance, taxes, etc. Such costs do not change throughout a given year and are known in advance, more or less.
- Variable costs - Variable costs also relate to the cost of production, and include things like utilities, packaging, raw materials, etc. These costs vary depending on the number of units produced, which is why they are said to be variable.
- Break-even point - The point at which total revenue is the same as the total cost of production, indicating neither profit nor loss.
- Revenue - Revenue and sales are the same thing; the total amount raised from business activity. But it does not include secondary income like lawsuit proceeds etc.
- Contribution margin - This is the difference between the cost of producing a good and what it sells for, without taking variable costs into account. It’s an alternative way to look at analyzing profitability.
Why break-even analysis matters
Break-even analysis is important as it gives businesses an idea of what it will take to break even on production. It offers a tangible sales target of how many goods need to be sold to reach a break-even point.
The difference between actual sales and break-even sales is known as the margin of safety before the “red zone” of unprofitability is reached. The break-even analysis is used by entrepreneurs, investors, business owners, governments, financial analysts, options traders, and stock owners. It is useful for a number of reasons:
The difference between actual sales and break-even sales is known as the margin of safety before the “red zone” of unprofitability is reached. The break-even analysis is used by entrepreneurs, investors, business owners, governments, financial analysts, options traders, and stock owners. It is useful for a number of reasons:
- Price perspective - Businesses can get an idea of how they need to price their product to meet specific sales targets.
- Cost efficiency - Businesses can identify areas where costs can be reduced to meet targets.
- Market performance - A break-even analysis can indicate how well a company is performing in a general sense.
Break-even analysis is most commonly applied to business owners. But the analysis can be used in other assets including index funds, mutual funds, ETFs, stocks, options, and more, to identify a neutral point between profit and loss.
How to calculate break-even point: step-by-step guide
Calculating the BEP is easy when you understand it’s all about finding a margin of safety, as in at what point does your business pay for itself? It is used to indicate the amount of goods a company needs to sell before it breaks even on its production costs.
Break-even Analysis Chart
EXAMPLE
Imagine a company producing custom shirts.
The fixed costs, including rent and salaries, are $10,000 per month. The variable cost per shirt, covering materials and labor, is $5.
If the shirts sell for $20 each, the break-even point can be calculated by dividing the fixed costs by the difference between the selling price and the variable cost per unit.
Applying the formula:
Break-even point = Fixed costs / (Selling price - Variable cost per unit)
Break-even point = $10,000 / ($20 - $5) = 667 units
So, the company needs to sell 667 shirts per month to cover both fixed and variable costs.
The fixed costs, including rent and salaries, are $10,000 per month. The variable cost per shirt, covering materials and labor, is $5.
If the shirts sell for $20 each, the break-even point can be calculated by dividing the fixed costs by the difference between the selling price and the variable cost per unit.
Applying the formula:
Break-even point = Fixed costs / (Selling price - Variable cost per unit)
Break-even point = $10,000 / ($20 - $5) = 667 units
So, the company needs to sell 667 shirts per month to cover both fixed and variable costs.
Break-even analysis is also used outside of businesses that produce goods, having applicability to retirement planning, stocks, bonds, mutual funds, index funds, ETFs, and more.
Break-even analysis: retirement planning
Break-even analysis is useful in retirement planning to determine the point at which your retirement savings will start to generate positive returns. It helps you understand how much you need to save and invest to cover your living expenses after retirement.
By calculating your total expenses and income sources, you can see when your investment income will equal your expenses.
For example, if your yearly expenses are $50,000 and your investments yield a 4% return, you need $1,250,000 in savings to break even. This figure shows you how much you need to have saved to retire without depleting your principal.
Additionally, break-even analysis can help compare different retirement investment options. By comparing the break-even points of various portfolios, you can choose the one that best meets your retirement goals.
By calculating your total expenses and income sources, you can see when your investment income will equal your expenses.
For example, if your yearly expenses are $50,000 and your investments yield a 4% return, you need $1,250,000 in savings to break even. This figure shows you how much you need to have saved to retire without depleting your principal.
Additionally, break-even analysis can help compare different retirement investment options. By comparing the break-even points of various portfolios, you can choose the one that best meets your retirement goals.
Break-even analysis: stocks and bonds
Break-even analysis in stocks and bonds helps investors determine the point where their investment costs are covered by the returns. For stocks, the break-even point is where the stock price rises enough to cover the purchase price plus any associated costs, like brokerage fees, FX fees or spreads. For example, if you buy a stock at $100 and pay $5 in fees, your break-even price is $105.
Stock / Bond Portfolio Allocation (1926 - 2022)
Source: The historical data for U.S. stocks was sourced as follows: from the Standard & Poor’s 90 between 1926 and 1957, the S&P 500 Index from 1957 to 1974, the Wilshire 5000 Index from 1975 to 2005, the MSCI US Broad Market Index from 2005 to 2013, and the CRSP US Total Market Index from 2013 to 2022. For U.S. bonds, the data was derived from the Standard & Poor’s High Grade Corporate Index between 1926 and 1968, the Citigroup High Grade Index from 1969 to 1972, the Lehman Brothers U.S. Long Credit AA Index from 1973 to 1975, the Bloomberg US Aggregate Bond Index from 1976 to 2009, and the Bloomberg US Aggregate Float Adjusted Bond Index from 2010 onwards.For bonds, break-even analysis involves comparing the bond's purchase price to the income it generates. To perform a breakeven analysis on a bond investment, calculate the total interest received over the bond's term, subtract any investment fees, and consider the impact of inflation. Ensure this net interest, plus the principal repayment at maturity, equals or exceeds the initial investment to cover all costs and maintain purchasing power.
Break-even analysis: ETFs and mutual funds
Break-even analysis in mutual funds and ETFs helps investors understand when their investments will start generating positive returns after covering all costs. For mutual funds, the break-even point includes the fund's expense ratio and any transaction fees. If you invest $10,000 in a mutual fund with a 1% expense ratio, you need the fund to grow by at least $100 to cover costs in the first year.
For ETFs, break-even analysis considers the purchase price, expense ratio, and any brokerage fees. If you buy an ETF for $100 and pay $1 in fees, plus an annual expense ratio of 0.5%, the ETF needs to increase by $1.50 to break even in the first year.
Understanding the break-even point in mutual funds and ETFs helps in setting performance expectations and comparing different investment options. It ensures that you know when your investment starts to be profitable, guiding better decision-making and portfolio management. This straightforward approach helps you evaluate the efficiency of your investments effectively.
For ETFs, break-even analysis considers the purchase price, expense ratio, and any brokerage fees. If you buy an ETF for $100 and pay $1 in fees, plus an annual expense ratio of 0.5%, the ETF needs to increase by $1.50 to break even in the first year.
Understanding the break-even point in mutual funds and ETFs helps in setting performance expectations and comparing different investment options. It ensures that you know when your investment starts to be profitable, guiding better decision-making and portfolio management. This straightforward approach helps you evaluate the efficiency of your investments effectively.
Break-even analysis: index funds
Break-even analysis in index funds helps investors understand when their investment will cover all associated costs and start generating positive returns. For index funds, the break-even point includes the expense ratio and any initial transaction fees.
For example, if you invest $10,000 in an index fund with a 0.2% expense ratio, you need the fund to grow by at least $20 to cover the expense in the first year. This analysis helps you see how much the fund needs to earn to offset these costs.
This approach is useful for comparing different index funds. By understanding the break-even point, you can evaluate which fund will reach profitability sooner based on its costs and expected returns. It also helps in setting realistic expectations for your investment’s performance over time.
For example, if you invest $10,000 in an index fund with a 0.2% expense ratio, you need the fund to grow by at least $20 to cover the expense in the first year. This analysis helps you see how much the fund needs to earn to offset these costs.
This approach is useful for comparing different index funds. By understanding the break-even point, you can evaluate which fund will reach profitability sooner based on its costs and expected returns. It also helps in setting realistic expectations for your investment’s performance over time.
Break-even analysis: commodities and futures
Break-even analysis in commodities and futures helps investors determine the point where their investments start to become profitable. For commodities, this involves calculating the total costs, including purchase price, storage, and transaction fees. If you buy gold at $1,500 per ounce and pay $5 in fees to your broker and incur $45 in storage costs, your break-even price is $1,550.
In futures trading, the break-even point includes the contract price and any associated fees. For example, if you enter a futures contract for oil at $70 per barrel and pay $2 in fees, the oil price needs to rise to $72 per barrel for you to break even.
Break-even analysis also considers factors like margin requirements and potential leverage. If you use leverage in a futures contract, understanding the break-even point becomes even more critical due to the amplified gains and losses.
In futures trading, the break-even point includes the contract price and any associated fees. For example, if you enter a futures contract for oil at $70 per barrel and pay $2 in fees, the oil price needs to rise to $72 per barrel for you to break even.
Break-even analysis also considers factors like margin requirements and potential leverage. If you use leverage in a futures contract, understanding the break-even point becomes even more critical due to the amplified gains and losses.
Break-even analysis: pros and cons
Like all financial metrics, break-even analysis cannot be considered independently of a whole host of other performance indicators. Despite its common usage, it has both strengths and weaknesses if you don’t understand a metric in depth, it's easy to be drawn to false conclusions.
Pros
✅ Clear financial goal - Provides a specific sales target to cover costs, aiding in goal setting.
✅ Informed decisions - Helps businesses evaluate the viability of new projects or products.
✅ Cost control - Highlights fixed and variable costs, encouraging better cost management.
✅ Pricing strategy - Assists in determining optimal pricing to ensure profitability.
✅ Risk assessment - Identifies the minimum performance needed to avoid losses, aiding in risk management.
✅ Informed decisions - Helps businesses evaluate the viability of new projects or products.
✅ Cost control - Highlights fixed and variable costs, encouraging better cost management.
✅ Pricing strategy - Assists in determining optimal pricing to ensure profitability.
✅ Risk assessment - Identifies the minimum performance needed to avoid losses, aiding in risk management.
Cons
❌ Simplistic assumptions - Assumes all units are sold at a single price and that costs are constant, which may not reflect reality.
❌ Ignores market conditions - Does not consider market demand, competition, or changes in consumer behavior.
❌ No profit margin consideration - Focuses only on covering costs, not on achieving desired profit margins.
❌ Static analysis - A single break-even point may not account for changes over time, such as fluctuating costs or sales volumes.
❌ Overlooks cash flow - Does not address cash flow issues, which can affect business operations despite hitting break-even.
❌ Ignores market conditions - Does not consider market demand, competition, or changes in consumer behavior.
❌ No profit margin consideration - Focuses only on covering costs, not on achieving desired profit margins.
❌ Static analysis - A single break-even point may not account for changes over time, such as fluctuating costs or sales volumes.
❌ Overlooks cash flow - Does not address cash flow issues, which can affect business operations despite hitting break-even.
What is the sensitivity analysis with regard to the break-even point?
Break-even analysis is often used as a part of sensitivity analysis, a system frequently deployed in corporate financial modeling.
Sensitivity analysis in relation to break-even analysis examines how changes in key variables impact the break-even point. It involves adjusting factors like sales price, cost of goods sold, and fixed costs to see how sensitive the break-even point is to these changes.
Sensitivity analysis in relation to break-even analysis examines how changes in key variables impact the break-even point. It involves adjusting factors like sales price, cost of goods sold, and fixed costs to see how sensitive the break-even point is to these changes.
QUOTE
Courage taught me no matter how bad a crisis gets, any sound investment will eventually pay off.
For instance, if a company sells a product for $100 with a variable cost of $60 and fixed costs of $20,000, the break-even point is 500 units. Sensitivity analysis might look at what happens if the sales price drops to $90 or if variable costs rise to $70. This helps investors and business-owners understand the robustness of their break-even point under different scenarios.
Sensitivity analysis can be extended to include changes in sales volume, market conditions, and economic factors. It allows businesses to simulate different environments and assess their impact on profitability. For example, if a competitor lowers prices, a sensitivity analysis can show how much sales volume needs to increase to maintain profitability.
Sensitivity analysis can be extended to include changes in sales volume, market conditions, and economic factors. It allows businesses to simulate different environments and assess their impact on profitability. For example, if a competitor lowers prices, a sensitivity analysis can show how much sales volume needs to increase to maintain profitability.
What factors affect a company’s break-even point?
Several factors affect a company's break-even point, which is the level of sales needed to cover all costs.
- Fixed costs - These are expenses that do not change with the level of production or sales, such as rent, salaries, and insurance. Higher fixed costs increase the break-even point since more sales are needed to cover these costs.
- Variable costs - These costs vary directly with production volume, such as raw materials and direct labor. If variable costs per unit rise, the break-even point increases because each unit sold contributes less to covering fixed costs.
- Selling price - The price at which a product is sold affects the break-even point significantly. A higher selling price lowers the break-even point because each unit sold contributes more to covering fixed costs. Conversely, a lower selling price raises the break-even point.
- Sales volume - While not directly a factor, the level of sales achieved can impact the ability to reach and surpass the break-even point. Higher sales volumes can help a business cover its fixed and variable costs more quickly.
- Product mix - If a company sells multiple products, the mix of products sold affects the break-even point. Products with higher profit margins will lower the overall break-even point.
- Cost structure - The ratio of fixed to variable costs in a company’s overall cost structure can influence the break-even point. Companies with higher fixed costs need higher sales to break even, while those with higher variable costs can break even at lower sales levels.
- Operational efficiency - Improvements in operational processes can reduce both fixed and variable costs, thereby lowering the break-even point. Efficient operations mean lower costs and a quicker path to profitability.
- Market conditions - External factors like competition, economic conditions, and changes in consumer preferences can impact pricing, costs, and sales volumes, thereby affecting the break-even point.
Recap of break-even analysis
Break-even analysis is very useful in determining how many units have to be produced to break even, putting fixed and variable costs into a definitive context.
It also has application to a variety of asset classes, where investors can use the formula to determine what results need to happen to justify a particular investment; such as an ETF or bond return.
It also has application to a variety of asset classes, where investors can use the formula to determine what results need to happen to justify a particular investment; such as an ETF or bond return.
FAQ on break-even analysis
Q: Why is the contribution margin important in break-even analysis?
The contribution margin is crucial in break-even analysis because it represents the amount each unit contributes to covering fixed costs after variable costs are deducted. It helps determine how many units need to be sold to cover fixed costs and start generating profit. A higher contribution margin lowers the break-even point, making it easier for a company to achieve profitability.
Q: What are some limitations of break-even analysis?
Break-even analysis has several limitations. It assumes that costs are linear and constant, which might not reflect reality. It doesn't consider changes in market conditions, such as competition or demand fluctuations. The analysis also ignores the impact of multiple products with different margins. Additionally, it focuses solely on covering costs, without addressing desired profit levels or cash flow needs.
Q: How can a company reduce the break-even point?
A company can reduce its break-even point by lowering fixed costs, such as rent or salaries, and reducing variable costs per unit, like materials and labor. Increasing the selling price also helps, as it raises the contribution margin per unit. Additionally, improving operational efficiency can reduce overall costs, further lowering the break-even point.
Q: How do you conduct a sensitivity analysis?
To conduct a sensitivity analysis, begin by identifying key variables that impact your financial model, such as costs, sales price, and sales volume. Adjust each variable one at a time while keeping the others constant to see how changes affect the outcome, like profit or break-even point.
For example, increase the sales price by 10% and observe the effects, then do the same for costs and volume. Document the results to understand the impact of each variable on the overall outcome. This process helps in evaluating risks and making more informed business decisions.
For example, increase the sales price by 10% and observe the effects, then do the same for costs and volume. Document the results to understand the impact of each variable on the overall outcome. This process helps in evaluating risks and making more informed business decisions.
- Index Funds: A type of investment fund that follows the performance of a specific market index, offering a simple and low-cost way to invest.
- Mutual Funds: A professionally managed investment fund that pools money from multiple investors to buy a mix of stocks, bonds, or other assets.
- Options: A financial contract that gives someone the right, but not the obligation, to buy or sell an asset at a fixed price before a certain date.
- Bonds: A form of investment where you lend money to a company or government in exchange for regular interest payments and the return of your money at the end of a set period.
- Spreads: The difference between the buying price and the selling price of an asset, which affects trading costs.
- Expense Ratio: The percentage of an investment fund’s value that goes towards management fees and other running costs each year.
- Commodities: Physical goods like gold, oil, and wheat that are bought and sold in financial markets.
- Futures: Agreements to buy or sell something at a set price on a future date, often used for commodities or financial assets.
- Leverage: The use of borrowed capital to increase potential returns on an investment. While leverage can amplify gains, it also magnifies losses.
