What Is a Break-Even Analysis?
Break-even analysis entails the calculation and examination of the margin of safety for an entity based on the revenues collected and associated costs. Analyzing different price levels relating to various levels of demand a business uses break-even analysis to determine what level of sales are necessary to cover the company's total fixed costs. A demand-side analysis would give a seller significant insight regarding selling capabilities.
- Break-even analysis tells you at what level an investment must reach to recover your initial outlay.
- It is considered a margin of safety measure.
- Break-even analysis is used broadly, from stock and options trading to corporate budgeting for various projects.
The Basics Of Break-Even Analysis
Break-even analysis is useful in the determination of the level of production or a targeted desired sales mix. The study is for management’s use only, as the metric and calculations are not necessary for external sources such as investors, regulators or financial institutions.
Break-even analysis looks at the level of fixed costs relative to the profit earned by each additional unit produced and sold. In general, a company with lower fixed costs will have a lower break-even point of sale. For example, a company with $0 of fixed costs will automatically have broken even upon the sale of the first product assuming variable costs do not exceed sales revenue. However, the accumulation of variable costs will limit the leverage of the company as these expenses come from each item sold.
Break-even analysis is also used by investors to determine at what price they will break even on a trade or investment. The calculation is useful when trading in or creating a strategy to buy options or a fixed-income security product.
The concept of break-even analysis deals with the contribution margin of a product. The contribution margin is the excess between the selling price of the product and total variable costs. For example, if an item sells for $100, the total fixed costs are $25 per unit, and the total variable costs are $60 per unit, the contribution margin of the product is $40 ($100 - $60). This $40 reflects the amount of revenue collected to cover the remaining fixed costs, excluded when figuring the contribution margin.
Calculations For Break-Even Analysis
The calculation of break-even analysis may use two equations. In the first calculation, divide the total fixed costs by the unit contribution margin. In the example above, assume the value of the entire fixed costs is $20,000. With a contribution margin of $40, the break-even point is 500 units ($20,000 divided by $40). Upon the sale of 500 units, the payment of all fixed costs are complete, and the company will report a net profit or loss of $0.
Alternatively, the calculation for break-even point in sales dollars happens by dividing the total fixed costs by the contribution margin ratio. The contribution margin ratio is the contribution margin per unit divided by the sale price. Returning to the example above the contribution margin ratio is 40% ($40 contribution margin per item divided by $100 sale price per item). Therefore, the break-even point in sales dollars is $50,000 ($20,000 total fixed costs divided by 40%). Confirm this figured by multiplying the break-even in units (500) by the sale price ($100) which equals $50,000.
Real World Example
Break-even analysis is not only used by businesses. Suppose an options trader buys a 50-strike call for $1.00 premium when the underlying is trading at $46. A break-even analysis will show that the price of the underlying must reach $51 before they break-even on the trade. While the call will be in-the-money (ITM) at any price trading above $50, the trader will still need to recoup the option premium of $1 which they originally paid to buy the option.