Break-Even Analysis Uses, Advantages & Its Disadvantages Reviewed.
Break-Even Analysis: Break-even analysis is the relationship between cost volume and profits at various levels of activity, with an emphasis placed on the break-even point. This point is where the business receives neither a profit nor a loss, when total money received from sales is equal to total money spent to produce the items for sale.
Break-even analysis implies that at some point in the operations, total revenue equals total cost — the break-even point. This analysis can be handled algebraically or graphically; however, in all cases, the first step is to classify costs into at least two types — fixed and variable. The cost-volume-profit relationship can best be visualized by charting the variables.
Need for Break-Even Analysis
You must be wondering why there is a need for performing break-even analysis? When is it done? To answer the above queries, let us now understand the three major business decisions which are taken with the help of break even analysis:
Setting Up of New Business: To start a new business, the initial step is finding out the feasibility of the project. It helps to determine whether the business idea is profitable and also provides an actual estimation of cost to frame the pricing strategy in a better way.
Replacing the Business Model: It plays a vital role when the management plans to change the business model. For instance, the organization decides to convert from an assembling unit to a manufacturing unit. It needs to clearly understand and interpret the cost involved, output, and prospective revenue and profit, before implementing such decisions.
Creating New Product: If the organization is planning to launch a new product that involves huge cost and capital expenditure; it must find out the potential of the product in the market through break-even analysis.
Benefits of Break-Even Analysis
Break-even analysis has been widely used by companies to determine the profitability of the business.
Following are some of the advantages it has for business organizations:
Smart Pricing: Break-even analysis is widely used by the companies for determining the appropriate price of the products or services such that the profit increases and the cost incurred are recovered.
Better Decision Making: It provides a solid base for decision-making on the viability of a project leaving aside emotional thinking.
Figure Out Missing Expenses: While implementing the break-even analysis, the organizations can easily find out and include those expenses also which are otherwise left out or ignored.
Plan Business Funding: If the business lacks sufficient capital for the project, it can approach to the external sources of funds, only after analyzing its break-even position which should be strong enough to pay off the debts.
Set Revenue and Sales Targets: Break-even analysis gives a clear picture of the number of units to be sold or the amount of revenue to be generated for covering up the cost and achieving profitability. These figures set a target for the lower levels to perform accordingly.
Meeting Fixed Costs: It even helps the company to cover up the fixed cost of the project.
Limitations of Break-Even Analysis
As we know that break-even analysis is a cost-revenue-output relationship, it has a limited arena to determine the viability of any project.
Let us now understand the various other drawbacks of a break-even analysis:
Break-even analysis always relates cost to the output, which may not be the case every time.
It is a mere interpretation of the future by past business functions.
It is not suitable for determining long-term profits due to the assumption of the linear relationship between cost, revenue, and output since many other factors affect the business operations in the long run.
There exist no tax provisions in the break-even chart.
It may result in a poor analysis if the company lacks an efficient accounting system.
It is assumed that the selling price is constant, and the cost function is linear, which is not the case in reality.
The analysis considers that the price of output as per the assumed horizontal demand curve, which is only possible under perfect competitions.
Break even Analysis considers only cost and output for profit determination when management skills, market conditions, technological factors, etc. also affect the business.