Break-Even Point Analysis

We recognize that business generally has two types of costs. First, fixed cost. It is cost that inflexible and include such expense as interest, rent, property tax, and straight line depreciation expense that must be charged no matter the production quantity produced, either in bad or good season. The second, variable cost.It is related to the operating level of a company such as the number of labor and their working hours, raw material incurred, and  quantity based depreciation expense. Other variable costs, while they lend themselves to control, are not necessity directly affected by production levels. Thus, a company may as it sees fit reduce or enlarge expenditures for advertising and promotion, research or ground-keeping.

What financial executives are interested in knowing is the relationship between sales and costs, both of the fixed and variable kind. More precisely, they are interested in determining at what point sales will fully absorb the company's costs. This known as the break-even point. Once the minimum sales necessary to cover expenses is determined, the next step is to determine a company's profitablity, or loss, level at various sales levels.

The above chart image indicates a break-even point level at 2000, where both fixed and variable cost, or total cost, are fully covered by sales. The chart shows that once passed the break-even point, profit grow faster that the increase in total cost, or precisely the variable cost.

Break even point, or BEP, enables management to determine how much in the way of fixed cost can reasonably be absorbed. It also facilitates control over other expenses by enabling variable cost to be handled in a manner that will result in the greatest profit return.

Several things must be understood about BEP analysis. Fist, the lower the BEP, the better the situation is for the concern. Another is that cost do not move in straight line. In order to support a larger base of sales, a company may have to invest in new facilities and a larger work force, both of which can result in a substantial enlargement of both fixed cost and variable cost. Therefore, the BEP may move to a new level.

BEP also does not take into account changes in price levels and their effect on demand. Last, while use of BEP is relatively simple for a company with single line of products, its employment by concerns with a widely assorted product mix is a good deal more difficult because overhead cost are not easily related to various products. If a product line is discontinued, for example, the resulting effect on costs may not be discernible.