Introduction to Break-even Point
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A person starting a new business often asks, "At what level of sales will my company make a profit?" Established companies that have suffered through some rough years might have a similar question. Others ask, "At what point will I be able to draw a fair salary from my company?" Our discussion of break-even point and break-even analysis will provide a thought process that may help to answer those questions and to provide some insight as to how profits change as sales increase or decrease.
Frankly, predicting a precise amount of sales or profits is nearly impossible due to a company's many products (with varying degrees of profitability), the company's many customers (with varying demands for service), and the interaction between price, promotion and the number of units sold. These and other factors will complicate the break-even analysis.
In spite of these real-world complexities, we will present a simple model or technique referred to by various names, including:
- break-even point
- break-even analysis
- break-even formula
- break-even model
- cost-volume-profit (CVP) analysis
- expense-volume-profit (EVP) analysis
The latter two names are appealing because the break-even technique can be adapted to determine the sales needed to attain a specified amount of profits. However, we will use the terms break-even point and break-even analysis.
To assist with our explanations, we will use a fictional company Oil Change Co. (a company that provides oil changes for automobiles). The amounts and assumptions used in Oil Change Co. are also fictional.
At the heart of break-even point or break-even analysis is the relationship between expenses and revenues. It is critical to know how expenses will change as sales increase or decrease. Some expenses will increase as sales increase, whereas some expenses will not change as sales increase or decrease.
Variable expenses increase when sales increase. They also decrease when sales decrease.
At Oil Change Co. the following items have been identified as variable expenses. Next to each item is the variable expense per car or per oil change:
The other expenses at Oil Change Co. (rent, heat, etc.) will not increase when an additional car is serviced.
For the reasons shown in the above list, Oil Change Co.'s variable expenses are $9 if it services one car, $18 if it services two cars, $90 if it services 10 cars, $900 if it services 100 cars, etc.
Fixed expenses do not increase in total when sales increase. Fixed expenses do not decrease when sales decrease. In other words, fixed expenses such as the monthly rent will not change when sales increase or decrease.
At Oil Change Co. the following items have been identified as fixed expenses. The amount shown is the fixed expense per week:
Some expenses are part variable and part fixed. These are often referred to as mixed expenses or semi-variable expenses. An example would be a salesperson's compensation that is composed of a salary portion (fixed expense) and a commission portion (variable expense). Mixed expenses could be split into two parts. The variable portion can be listed with other variable expenses and the fixed portion can be included with the other fixed expenses.
Revenues or Sales
Revenues (or sales) at Oil Change Co. are the amounts earned from servicing cars. Oil Change Co. charges one flat fee of $24 for performing the oil change service. For $24 the company changes the oil and filter, adds needed fluids, adds air to the tires, and inspects engine belts.
At the present time no other service is provided and the $24 fee is the same for all automobiles regardless of engine size.
As the result of its pricing, if Oil Change Co. services 10 cars its revenues (or sales) are $240. If it services 100 cars, its revenues will be $2,400.