Article DetailsUnderstanding Breakeven Analysis Formula |
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| Date Added: February 13, 2008 04:52:33 AM | |
| Author: Ahead Team | |
| Category: Business: Accounting | |
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Breakeven point is the "no loss - no profit" level of operations. At this level, your gross profit, i.e., Sales minus Cost of Sales, is just equal to your fixed overheads. What Are Overheads? Overheads are the establishment expenses that tend to be fixed irrespective of the level of sales. Items like rent, depreciation on premises & equipment and interest on term-loans are clearly fixed. These will continue to be incurred even if your business is temporarily shut down. There are other expenses that are partly fixed and partly variable. For example, staff salaries of office and managerial staff tend to be fixed. However, if a long shutdown is planned, several of the staff can be laid off on a temporary basis and the recurring expenditure can be reduced. Unit Selling Price Unit selling price is not the list price. Instead, it is the average price realized per unit, and is computed by dividing the total sales revenue (minus sales commissions) by the number of units sold. This averages out the differential rates charged to different customers or in different markets. Unit Variable Cost Variable costs are the average direct costs incurred for producing one unit of the product. Costs of raw materials and pay of production machine operators are prime examples. All expenses that vary with production levels can be considered variable expenses. Identifying the variable proportion of semi-variable expenses, such as electricity, might require some computations. Major Problem in Applying Break Even Analysis Formula The problem has already been hinted at. Many costs are semi-fixed or semi-variable. It is difficult in practice to arrive at accurate estimates of Fixed Overheads and Unit Variable Costs. Even if it is possible to segregate the fixed and variable elements, it will typically require elaborate calculations. The costs of doing such calculations might not be justified. In most cases, we can get reasonable estimates of overhead expenses and unit variable costs. And these reasonable estimates can give a good idea of break even levels needed for managing operations. Benefits of Using Breakeven Analysis Formula You are looking at the key elements of business profitability when you use the break even analysis formula to analyze your operations. * Overheads: When you look at each item of overhead, you might find possibilities to achieve cost savings. You will also become aware of the behavior of these cost items, and the need to achieve sufficient sales volumes to recover these establishment costs. * Selling Prices: Again, you might become aware of possibilities for increasing your revenues. For example, you might note that you are getting higher margins for certain products, or in certain markets, and decide to focus more on these products or markets. * Variable Costs: Close scrutiny of each item of variable cost might highlight wastages in such areas as materials usage or manpower utilization. These in turn can lead to identifying ways that reduce the wastage. Thus break even analysis can not only identify the sales volumes to aim for but also make you take a closer look at possibilities of profit control. Limitations of Break Even Analysis Break even studies focus on a static view of the business, assuming that existing conditions are applicable in all situations. This is far from reality. For example, if you scale up operations, your fixed overheads will be very different from what it is now. And variable unit costs can also change significantly if your scaling up involves modernization. You will have to do a new breakeven study to identify the break even volumes. Another example is concerned with opportunity costs. Opportunity analysis considers alternative uses of the same resources. For example, an opportunity analysis might reveal that leasing out your facilities might bring better returns than using for producing the existing line of products. Break even analysis does not consider such scenarios. Finally, breakeven analysis does not consider the time value of money. Money received after one year is lesser in value than money received now. Breakeven analysis does not take this aspect into consideration. Break even analysis formula can be used to get an overview of business profitability. A breakeven analysis will tell you how much you should sell at what prices, considering your fixed overheads and gross profit margin over production costs. Despite its limitations and practical difficulties, it has proven a valuable tool that provides the above kind of overview. It can also help management take a closer look at the key profit factors such as level of overheads, selling prices and costs of production. |
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