Break-Even Point Analysis
Read this text on break-even point analysis. It goes through the process of calculating the break-even point for cost analysis under different scenarios. Take notes on each of the following: define the break-even point, differentiate between fixed and variable costs, and write the formulas on how to calculate the break-even point, calculate the contribution margin, calculate the contribution margin ratio, and calculate the margin of safety.
Contribution Margin Ratio
The contribution margin ratio expresses the contribution margin as a percentage of sales. To calculate this ratio, divide the contribution margin per unit by the selling price per unit, or total contribution margin by total revenues. Video Production's contribution margin ratio is:
Supposing that Video Productions had a total contribution margin of USD 48,000 on revenues of USD 120,000, we compute the contribution margin ratio as follows:
That is, for each dollar of sales, there is a USD 0.40 contribution to covering fixed costs and generating net income.
Using this ratio, we calculate Video Production's break-even point in sales dollars as:
The break-even volume of sales is USD 100,000 (5,000 units at USD 20 per unit). At this level of sales, fixed costs plus variable costs equal sales revenue.
In a period of complete idleness (no units produced), Video Productions would lose USD 40,000 (the amount of fixed costs). However, when Video Productions has an output of 10,000 units, the company has net income of USD 40,000.
Although you are likely to use break-even analysis for a single product, you will more frequently use it in multi-product situations. The easiest way to use break-even analysis for a multi-product company is to use dollars of sales as the volume measure. For break-even analysis purposes, a multi-product company must assume a given product mix. Product mix refers to the proportion of the company's total sales attributable to each type of product sold.
To illustrate the computation of the break-even point for Wonderfood, a multi-product company that makes three types of cereal, assume the following historical data:
| Product 1: Raisin Flakes | Product 2: Sugar Wheat | Product 3: Rice Cereal | Total | |||||
|---|---|---|---|---|---|---|---|---|
| Amount | Percent | Amount | Percent | Amount | Percent | Amount | Percent | |
| Sales | $60,000 | 100% | $30,000 | 100% | $10,000 | 100% | $100,000 | 100% |
| Less: | ||||||||
| Variable costs | $40,000 | 67% | $16,000 | 53% | $4,000 | 40% | $60,000 | 60% |
| Contribution margin | $20,000 | 33% | $14,000 | 47% | $ 6,000 | 60% | $ 40,000 | 40% |
We use the data in the total columns to compute the break-even point. The contribution margin ratio is 40 percent or (USD 40,000/USD 100,000). Assuming the product mix remains constant and fixed costs for the company are USD 50,000, break-even sales are USD 125,000, computed as follows:
[To check our answer: (USD 125,000 X 0.40) – USD 50,000 = USD 0.]
To find the three product sales totals, we multiply total sales dollars by the percent of product mix for each of the three products. The product mix for products 1, 2, and 3 is 60:30:10, respectively. That is, out of the USD 100,000 total sales, there were sales of USD 60,000 for product 1, USD 30,000 for product 2, and USD 10,000 for product 3. Therefore, the company has to sell USD 75,000 of product 1 (0.6 X USD 125,000), USD 37,500 of product 2 (0.3 X USD 125,000), and USD 12,500 of product 3 (0.1 X USD 125,000) to break even.