Common Uses for Break Even Analysis
Break even analysis is generally used to evaluate a go or no go decision on a project or a particular investment. It helps businesses understand the drivers of a project or an investment decision and forecast what will happen to overall success if certain key assumptions/drivers change. In the simplest terms, break even for a new project or investment can be calculated by determining the point at which revenue equals costs (initial fixed expenditure + ongoing variable costs) which means once all costs have been recovered. Beyond this point, every additional unit sold will bring in profit for the business.
Determining the Point of Profitability
The main use of break even analysis is identifying the point at which profitability will occur for a new project or investment decision. Break even analysis usually requires many inputs such as the initial investment requirement, variable costs per period (or per unit sold) and revenue per period (or per unit sold). By using these inputs you can identify the amount of time it would take for the initial investment decision to turn profitable. However, as noted many factors can influence the point of profitability. It can be effective for a company to identify a series of different break even points based on differing assumptions to determine the optimal scenario under which the project becomes profitable.
Determining Unit Pricing
This process can also be used to determine the pricing for the sale of every unit. This can be calculated by solving for the sales price and hence margin in the break even equation. Internal targets and estimates can be used for initial investment, cost per unit and ideal payback period (or future margin) and a necessary sales price per unit from this could be determined. Ideally, the best unit sales price will provide profitability for the business within a reasonable time frame while taking into account what the market can bear.
Determining Financial Plans
Another important use for break even analysis is to use the forecasts generated as part of the break even analysis process to help establish a wider financial strategy for the business. Thinking of each capital expenditure as a mini-break even analysis and then summing up the overall expenditure outlays, ongoing variable cost outlays, revenue and potential profits can help the firm create a budget for future operating purposes. Hence the efforts in running the break even exercise for various projects can be used for the wider budgeting or financial planning for the firm overall.
In short, establishing the break even point for a project or investment decision helps businesses make a go or no go decision on the project but can also help in setting the sales price and coming up with wider financial plans that can be helpful to the overall business.