Break-even Point Analysis

Explanation

The Break-even Point (BEP) is the level of sales or activity at which total revenue equals total cost, meaning the business makes neither a profit nor a loss. At this point net profit is zero (RM0). Break-even Point Analysis is a cost accounting tool that helps managers know how many units, or what value of sales, must be achieved before any profit begins to be earned. This analysis is important for decisions such as setting the selling price, fixing sales targets and assessing the risk of a product. Before calculating the BEP, you must first understand three cost and margin concepts that form the foundation of this analysis.

Fixed Cost is a cost whose total amount stays unchanged in the short term even when the quantity produced or sold rises or falls. Examples include factory rent, supervisors' fixed salaries, insurance and depreciation of plant. This cost must be paid whether the business produces many units or none at all. In contrast, Variable Cost is a cost that changes directly with the level of production or sales. The more units produced, the higher the total variable cost. Examples include direct raw materials, direct wages paid per unit and sales commission. Remember: total fixed cost stays constant but fixed cost per unit falls as production rises, whereas variable cost per unit stays constant but total variable cost rises as production rises.

Contribution Margin is the balance of sales revenue after variable cost has been deducted, and this balance is what contributes towards covering fixed cost and then generating profit. Contribution Margin per Unit is calculated using the formula: Contribution Margin per Unit = Selling Price per Unit - Variable Cost per Unit. For example, if the selling price per unit is RM50 and the variable cost per unit is RM30, then the contribution margin per unit is RM20. Every unit sold contributes RM20 towards covering fixed cost. Once fixed cost is fully covered, every ringgit of contribution margin after that becomes profit. The Contribution Margin Ratio is the Contribution Margin per Unit divided by the Selling Price per Unit, expressed as a percentage or decimal, and is used to compute the BEP in ringgit value.

There are two methods to calculate the Break-even Point. The first is the equation method: Sales = Variable Cost + Fixed Cost + Profit. Because profit is zero at the BEP, the equation becomes Sales = Variable Cost + Fixed Cost. If we replace Sales with (Price per Unit x Units) and Variable Cost with (Variable Cost per Unit x Units), we can solve for the number of units. The second is the contribution margin method: Break-even Point (units) = Total Fixed Cost / Contribution Margin per Unit, and Break-even Point (RM) = Total Fixed Cost / Contribution Margin Ratio. Both methods must give the same answer; the contribution margin method is faster and is used more often in short solutions.

The Break-even Chart is the visual display of this analysis. The horizontal axis (x-axis) represents the quantity of units or the level of activity, while the vertical axis (y-axis) represents ringgit values (cost and revenue). The Fixed Cost line is drawn horizontally because its total stays constant. The Total Cost line starts at the fixed cost level (not zero) and rises according to variable cost. The Total Revenue line starts from the origin (0,0) and rises more steeply. The point where the Total Revenue line and the Total Cost line intersect is the Break-even Point. The area to the left of the intersection shows the loss area (cost exceeds revenue), while the area to the right shows the profit area (revenue exceeds cost). The vertical gap between the revenue line and the total cost line at any sales level shows the profit or loss at that level.

Worked examples

Practice

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Key terms

Break-even Point

The sales level at which total revenue equals total cost, with no profit and no loss (net profit is zero).

Fixed Cost

A cost whose total stays unchanged even when the level of production or sales changes, such as rent and fixed salaries.

Variable Cost

A cost whose total changes directly with the level of production or sales, such as raw materials and direct wages.

Contribution Margin per Unit

Selling price per unit minus variable cost per unit; the amount each unit contributes towards covering fixed cost and generating profit.

Source: DSKP KSSM Prinsip Perakaunan Tingkatan 5

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