Definition of Break-Even Point
The break-even point is the amount of sales required to cover a company’s costs and expenses that are reported on its income statement. In other words, the break-even point will result in a net income of $0 on an income statement prepared using the accrual method of accounting.
The break-even point expressed in dollars of revenues is calculated by dividing the company’s total fixed expenses for the accounting period by its contribution margin ratio.
The break-even point in units of products is calculated by dividing the company’s total fixed expenses for the accounting period by the contribution margin per unit.
The break-even calculation assumes that the selling prices, contribution margins, and fixed expenses will not change.
Definition of Payback Period
The payback period is the expected number of years it will take for a company to receive net cash inflows that add up to the amount of its initial cash investment. Note that the payback period focuses on future cash flows over many years and not the net income reported on a single income statement.
The payback period is often computed when evaluating potential capital expenditures. However, the payback period is considered to be flawed because it ignores the following:
- Cash flows occurring after the payback period
- Time value of money.
