There are essentially two methods to performing the break-even analysis. One method includes identifying the company’s fixed costs and variable costs, and then combining both into one total cost line. The break-even point occurs when this total cost line intersects the company’s revenues. The other method focuses on the company’s profit contribution, which is simply a per-unit measure of profit on each sale of a given product.
So, which of these two methods is best? Well, I’ve often focused on the profit contribution approach simply because I think it’s an easier method. It’s easier to determine, easier to depict on a graph and easier to track. However, there is another, far more important reason why I prefer this method: Ultimately, I think a company, its management and its employees should always be thinking about profit.
As such, we’ll start off by reviewing the profit contribution method first. Afterwards we'll look at the approach that focuses on the total cost line and its intersection with the company’s revenues.
Fixed Costs are much like indirect expenses. In this case, they are costs that can’t be billed to any particular customer or applied to the production of a given product. However, they are costs your company must cover nonetheless. They are essentially the company’s fixed monthly expenses and include support costs such as administration, salaries, electricity, rent etc.
Variable costs are more like direct expenses and are costs that are directly linked to the production of a product. They vary with usage and the volume ordered or manufactured.
1. Profit Contribution or Unit Contribution Margin Approach
The following video, graph and breakdown is from: Sample Break-Even Excel Sheet for Small Businesses. The post includes a sample excel sheet allows you to determine your break-even point by playing around with price on one graph, and variable costs on another.
This approach is often referred to as the unit contribution approach. It includes one single line that accounts for the individual profit accrued on the sale of each unit. The ($P-V) portion of the equation is the profit contribution. It is simply the product’s price minus its variable costs. The point where the unit contribution line intersects the fixed cost line is where the company reaches break-even. Below the line is a loss, while anywhere above the line is considered profit.
The other method is to graph both fixed costs and variable costs and then use both to define the company’s total costs. The intersection point of the total cost line with the company’s revenues is considered the break-even point.
The graph below shows the fixed, variable and total cost lines. Once again, the break-even is at 11 units as we are using the same variables as we did in the first method. In this case, the fixed cost line is maintained at $2,500.00, while the variable cost line increases by $300.00 with each additional unit sold. Fixed and variable are combined to form a total cost line, while the revenue is increased on each sale of $525.00 per-unit. Again, where these two lines intersect is where the company has reached break-even and covered its expenditures.
You can download the graph above right here: Download Fixed costs variable costs total cost break even
Ultimately, achieving break-even isn’t merely a question of playing around with pricing. After all, there are far too many variables to consider when it comes to pricing. Instead, the best approach is to focus on reducing variable and fixed costs. Lowering these costs will help you achieve profit faster.
Comments