In order to find out how many products a business needs to produce and sell to stop making a loss and start making a profit, the business tool called Break-even Analysis is constructed and used.
Managers of all businesses around the world are always concerned with the difference between Sales Revenue and Total Costs (TC). This difference is profit. It is because a business organization can only survive in the long-term, if it is making a profit.
Profit, or breaking-even, or loss
Let’s say that Burger King sells one hamburger for USD$5 on average and it sells 10,000 burgers in one month. Then, its Sales Revenue will be USD$50,000 in that month. In financial terms, the company can find itself in one of the three following situations at any point in time:
- Making a profit. When Sales Revenue of the business exceeds Total Costs (TC) of production.If Burger King’s Total Costs (TC) are lower than USD$50,000, the company will make the profit.
- Breaking-even. When Sales Revenue of the business equals to Total Costs (TC) of production, the business is not making any profit nor any loss. If Burger King’s Total Costs (TC) equal to USD$50,000, the company will neither make the loss nor the profit.
- Making a loss. When Sales Revenue of the business is lower than Total Costs (TC) of production. If Burger King’s Total Costs (TC) are higher than USD$50,000, the company will make the loss.
What does Break-even Analysis show managers?
Break-even Analysis can be used for this purpose to answer the following question as it shows the relationship between sales revenue, various costs and output:
‘How many products do we need to produce and sell to break-even?’
In fact, break-even is the level of output where Sales Revenue equals Total Costs (TC). The business is not making a profit nor a loss from the production and sales of its product. It just breaks-even.
So, how many products do we need to produce and sell for our total Sales Revenue to cover our Total Costs (TC)? In other words, the total Sales Revenue that the business earns from producing and selling its output exactly equals the Total Costs (TC) of producing and selling that output.
What else can Break-even Analysis show decision makers?
Carrying out Break-even Analysis can inform business managers of a few more things about launching, producing and selling products:
- ‘Should we start selling this product?’ Whether it is financially worthwhile for the business to produce and launch a particular good or service. In case, the demand for the product is lower than the break-even quantity.
- ‘How many products do we need to sell to stop making a loss and start making profit?’ Break-even quantity shows the number of units the business needs to produce and sell before it starts to make a profit.
- ‘How much maximum profit can we make selling this product?’ Expected level of profit that the business will earn, if all goes according to plan – the business can sell all the products it is able to produce. This number will be higher than the break-even quantity.
- ‘How many products do we need to sell to achieve the target profit?’ The level of sales of the product needed to earn a certain specific amount of the target profit.
- ‘If we increase the price, how many less products do we need to sell now to break-even?’ The effect on profit of changes in sales either by increasing or decreasing the price of a product. Decreasing the price for elastic products will increase sales while increasing the price for inelastic products will increase sales.
- ‘If we manage to decrease costs, how many less products do we need to sell now to break-even?’ The effect on profit of changes in business costs. Here, the business can either lower Fixed Costs (FC) or Variable Costs (VC) as these are used for the purpose of constructing Break-even Analysis.
- ‘Do we have any margin of safety, if our customers do not show up?’ The margin of safety in Break-even Analysis will show the amount by which sales can fall from the actual level of demand before losses are made. In other words, how many products do not need to be sold and the business still makes the profit. The higher the margin of safety, the lower the risk of a loss being made.
Indeed, the break-even output shows the managers how many products their businesses need to produce and sell to finally start making a profit – the break-even quantity plus one more unit. As mentioned, if the Sales Revenue a business earns from selling its output is greater than the Total Costs (TC) of producing it, then the business earns profit. However, if the revenue earned is less than the Total Costs (TC) then the business will surely make a loss. If the Sales Revenue covers all Total Costs (TC), the firm will merely break-even.
This form of analysis is widely used in the business world as it provides useful information for decision-making. Especially when new firms are concerned about their profits because they need to determine the level of sales of the product that must be made in order to start earning their first profits. Without earning any profit, these firms will not only not grow, but will surely not survive for too long.
