Break-even analysis

Break-even analysis, also called cost-volume-profit analysis, studies the relationships between selling price, sales and production volumes, costs, expenses, and profits.

It is used to examine the effects of changes in selling prices, cost and profit volumes, price setting, and marketing strategies and helps to inform decision-making. Break-even analysis depends on the calculation of a break-even point. First we’ll define a break-even point.

Break-even point (BEP)

Because of the Covid-19 pandemic economic slowdown, Russia recently showed an unwillingness to agree to output reductions being added to oil prices. This resulted in a price war between Russia and Saudi Arabia where the price of oil per barrel has gone below $50 (the estimated break-even point for most oil-producing countries). For more information, read the following Washington Post article.

Additional reading: Oil price war threatens widespread collateral damage [1]

A business reaches break-even point when total cost and total revenue are equal. This is the point where the business is incurring neither profit nor loss. Below break-even point, fixed costs will consume all excess sales revenue over variable costs. Above the break-even point, which is the excess of sales revenue, variable costs are greater than fixed costs. This is known as contribution and leads to profits.

Next we’ll look at some calculations that will give you a better understanding of how marginal costs can be used to derive the contribution margin businesses earn on a sale.

Understanding the importance of contribution helps with calculating break-even points. Here are two key methods for determining a break-even point.

Method 1: BEP volume $

[text{BEP} = frac{text{Fixed costs}}{text{Gross profit margin}}]

If the fixed costs are $60,00 and the gross profit margin is 90%, the BEP is $66,666. This means a company must generate at least $66,666 to cover its fixed and variable costs.

If the company generates sales above $66,666 then it will start making a profit. If it makes less than $66,666 in sales revenue, it will start making a loss.

Method 2: BEP in units

[text{BEP} = frac{text{Fixed costs}}{text{Contribution margin}}]

Where (text{Contribution margin} = text{Sales price} – text{Variable costs})

If the sales price is $40 and variable costs are $15 per unit, then the contribution is $25. With a fixed cost of $38,500 and a contribution per unit of $25, the BE point is 1,540 units.

If a company sells more than 1,540 units, it will make a profit. If it sells less, it will incur a loss.

You can develop a cost-volume-profit (CVP) or BE analysis chart to visually present the impact of BEP. The total cost curve includes both fixed costs and variable costs, while fixed cost remains unchanged, and variable costs increase with the volume.

CVP analysis can be represented on a graph to easily understand different operating profit or loss levels.

Below BEP, total costs exceed total sales leading to a loss. Above BEP, total sales exceed total costs leading to profit.

The following news article discusses the urgent need for hotels to identify their break-even points during the Covid19 pandemic to avoid heavy losses.

Read: Hotels must find a break-even point during pandemic [2]

In the comments below, share your thoughts on how hotels can find their break-even points during the ongoing pandemic.

References

1. Oil price war threatens widespread collateral damage [Internet]. Washington Post. 2020 Mar 9. Available from: https://www.washingtonpost.com/climate-environment/oil-price-war-threatens-widespread-collateral-damage/2020/03/09/3e42c9e2-6207-11ea-acca-80c22bbee96f_story.html
2. Brock E. Hotstats: hotels must find a break-even point during pandemic [Internet]. Asian Hospitality; 2020 May 19. Available from: https://www.asianhospitality.com/hotstats-hotels-must-find-a-break-even-point-during-pandemic/