Break-even Analysis is a useful business management tool for determining the sales level of the product to earn profit for the firm. This management decision-making model provides a quick graphical representation of the costs and revenues of different scenarios and projects. It also allows business managers to visualize the impact of changes in price and costs on the profits of the business.
Break-even Analysis is especially useful to small business organizations that start producing and selling a single standardized product, do business in a single market, make products to order meaning that all output is sold and there is no inventory. However, multi-product firms can also use the costs and revenues data to figure out the break-even quantities for different products in the Product Portfolio.
Break-even Analysis helps to make somewhat realistic predictions about sales, costs and Target Profit rather than simply relying on manager’s intuition.
It is important to consider advantages of the Break-even technique first.
Advantages of Break-even Analysis
1. Easy to construct and interpret. Break-even Chart is relatively easy to construct. All the calculations required to draw the costs and revenues curves need only basic math skills. Break-even Analysis is also quite flexible as it can be drawn and redrawn in the Excel spreadsheet in order to visualize ever-changing business environment. Updating all the costs and revenues data is also fairly simple.
2. Precise Break-even Quantity can be calculated. The equation to determine Break-even Quantity (BEQ) and having the exact break-even point provide useful guidance to management about the output that must be produced and sold to cover all costs, Margin of Safety, loss or profit at different levels of output, etc.
3. Helps with making many important business decisions. Break-even Analysis can assist managers with decision-making regarding business location, whether to purchase new production equipment or not, pricing decisions, whether to make or buy products, whether to launch a new product or not, etc. The analysis can also show the effect of a decision to change costs or prices.
4. Comparisons can be made for various scenarios. By constructing new Break-even Charts to show changed circumstances, business managers can make easy comparisons between different options. For example, a new chart can show the possible impact on Break-even Quantity and profit of a change in the product’s selling price.
Business managers also need to recognize the limitations of the break-even model as theoretical assumptions and predictions are often missed when it comes to real life.
Disadvantages of Break-even Analysis
1. Calculating Break-even Quantity does not guarantee success. By calculating the Break-even Quantity, the business will know how many products it has to produce and sell to break-even. But, having this knowledge does not ensure that the business will actually sell all the products and cover all of its costs to make profit. While Break-even Analysis assumes that the business will sell all of its output, in reality, most businesses will have unsold stock which requires incurring costs such as storage and insurance costs. Furthermore, unsold inventory might need to be sold at a discount. So, assuming that all output produced is sold and there is no inventory seems unrealistic. While Break-even Analysis is a management tool to help decision-making, it does not guarantee that a profit will be made whatsoever. It is possible for Margin of Safety to be negative.
2. Assumes that all costs and revenues are represented by straight lines. Break-even Analysis assumes that all cost functions are linear represented by straight lines. This assumption is unrealistic too.
- The Sales Revenue curve. This line will not be straight when customers demand discounts for larger orders, managers reduce prices to sell more units produced, or when the business uses price discrimination charging different prices to different groups of customers.
- The Variable Cost (VC) curve. This line will not be straight, neither will change directly with output. It is because economies of scale which lower Average Variable Cost (AVC) of production when the business is operating on a larger scale. Also, not all raw materials will be purchased for the same price. And, not all of the production workers are paid the same wages per piece or per hour – labor costs may increase as output reaches maximum due to higher overtime rates.
- The Fixed Costs (FC) curve. This line will not be straight due to possible increases in rent, changes in interest rates charged on bank loans with non-fixed interest rates or the different number of managers the business hires and their compensation.
3. It is a static model. Break-even Analysis as a static model is valid and accurate only for a very limited time period such as one year. And, each set of break-even calculations will only be valid for one point in time. Therefore, the analysis might not be very useful in a dynamic business environment as it represents only a snapshot position of the business. Costs change, market conditions change and prices change all the time. For example, production costs can change at short notice when there are fluctuations in exchange rates which affect businesses using imported raw materials. So, the actual Break-Even Quantity and profit or loss are very likely to be different from those predicted in Break-even Analysis.
4. Ignores many internal and external factors. There are many factors from internal and external business environment that can influence costs and revenues of the business. These factors include:
- Profit in the short-term vs long-term. In order to maximize sales in the short-term, managers may decide to reduce prices. This will attract and retain more customers, but increase the break-even quantity needed to be sold to make profit.
- Demand changes constantly. Many things may influence demand for products such new fashion trends, health epidemics or simply bad weather forcing people to stay at home instead of going shopping.
- Profit depends on risk involved. Whilst low-risk projects generally lead to a quicker Break-even Quantity, the value of the profits is likely to be low. High-risk projects have the potential of huge amounts of profits but have a high Break-even Quantity.
- Innovation. Introduction of new technologies such as autonomous cars, drones or digital foldable newspapers may have insanely high demand far exceeding Break-even Quantity and original forecasts.
- Motivation. Break-even Analysis ignores any impact of workers demotivation which may lead to declining productivity.
- Others. Response from competitors after price modifications and the availability of spare capacity are also ignored. In addition, external economic and legal factors such as unemployment levels and changes in minimum wages that can have a direct impact on the profitability of businesses are omitted in the analysis as well.
5. Only suitable for single-product firms. Break-even Analysis is mainly suitable for businesses producing and selling only one product. It also assumes that all of the output will be sold. However, for firms with a large Product Portfolio, Indirect Costs (Overheads) must be divided between the various products. While Indirect Costs (Overheads) appropriation can be conducted, the process is rather subjective. Although there is lots of computer software to help managers to calculate multi-product break-even quantities, these may not truly represent the Break-even Quantity for each product.
6. Garbage In, Garbage Out (GIGO). The principle of Garbage In, Garbage Out (GIGO) means that if we use any incorrect or unrealistic data, we will receive unconvincing results. Hence, the overall accuracy of numerical predictions in Break-even Analysis will depend on the validity of the original data used to make the required calculations and on managerial acumen to interpret the estimated results.
7. Difficulties with classifying costs. It is not only not easy to separate costs into Fixed Costs (FC) and Variable Costs (VC), but some costs simply cannot be conveniently classified into fixed and variable. Also, the introduction of Semi-Variable Costs (SVC) makes the process of classifying costs much more complicated.
To sum it up, Break-even Analysis is a quantitative management-decisions making tool. It should be used in conjunction with other quantitative and qualitative business tools and techniques, as well as in the context of a business. Only then the assumptions of the break-even model can aid comprehensive business decision-making.
