Break-even analysis is a managerial (<\/span>cost) accounting tool used to examine the relationship\u00a0<\/span>of price to cost of a product. It also considers various sales volumes and the effect on profit given the different relationships of price to cost. The break-even analysis is an essential tool in maximizing profit with the least amount of resources. It <\/span>goes much further by defining the minimum production necessary to cover (pay) fixed costs at various sale prices. Naturally the higher the sales price the sooner fixed <\/span>costs are covered with production.\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0<\/span>\u00a0<\/em><\/strong><\/span><\/span><\/p>\n This article explains the sales price to cost relationship. The impact of sales <\/span>volume and how it affects total profit is expounded upon in Break-Even Analysis – Sales\u00a0<\/strong><\/span><\/span>Volume and Profit<\/strong><\/span> on\u00a0this website.<\/strong> To grasp the fundamentals of break-even analysis the reader must first understand some basic terms used in cost accounting including:<\/span><\/span><\/p>\n 1) Fixed Costs Secondly, a break-even point is explained and evaluated at different sale prices <\/span>(price points) and the corresponding contribution margin is determined. Finally a comprehensive example along with an outcome table is derived with insights in <\/span>assessing the results. Once the fundamentals are understood the reader can now evaluate simple and basic single item break-even analysis.<\/span><\/span><\/p>\n There are hundreds of terms used in cost accounting but a few terms are synonymous\u00a0<\/span>with cost accounting and they include fixed and variable costs along with contribution margin. These three terms plus two others are often used with break-even analysis and are explained below.<\/span><\/span><\/p>\n Fixed Costs<\/strong>\u00a0 – Those cash out costs per accounting period that must be paid no matter\u00a0<\/span>what level of production exists. Examples include rent, property taxes, insurance, legal compliance and so forth. Other fixed costs can include:<\/span><\/span><\/p>\n * Management salaries<\/strong> especially those contractually negotiated Variable Costs<\/strong> – Those costs that have a 1:1 correlation or very high dependency on <\/span>sales are referred to as variable costs. Traditionally, variable costs include materials <\/span>and labor for products and services rendered. Other variable costs include\u00a0<\/span>utilities and manufacturing equipment costs. V<\/span>ariable costs are referred to as prime costs in the food service sector of the economy.<\/span>\u00a0\u00a0<\/span><\/span><\/p>\n Sunk Costs<\/strong> \u00a0– Some costs are expended and can not be recouped no matter what the\u00a0<\/span>company does. A profit can be earned to pay back the investor’s fronted capital <\/span>used to pay for initial costs; but they can not be directly recovered. As an example, organizational costs to get the company set up cannot be retrieved whereas cash outlays for raw materials for production can be sold as raw materials thus recovering that cash outlay. Typical sunk costs include building construction (some aspects),\u00a0 specialized equipment purchases and engineering. The difference between sunk and fixed costs is the cash outlay involved. Sunk is where cash has already been expended, fixed are <\/span>required and ongoing. Usually fixed costs are contractually created like a lease a<\/span>greement. \u00a0 \u00a0 \u00a0\u00a0<\/span><\/span><\/p>\n
\n<\/span>2) Variable Costs
\n<\/span>3) Sunk Costs
\n<\/span>4) Markup
\n<\/span>5) Contribution Margin<\/span><\/span><\/p>\nBreak-Even Terminology<\/span><\/strong><\/h2>\n
\n<\/span>* Labor Force<\/strong> – Minimum staff in place without serving the first customer; think of a <\/span>hotel crew, restaurant staff and hospital personnel.
\n<\/span>* Operational Costs<\/strong> – Utilities, sanitation and maintenance are required no matter how <\/span>many customers use the facilities. Great examples include swimming pools, resorts, <\/span>theme parks and government complexes.
\n<\/span>* Capital costs<\/strong> of debt service
\n<\/span>* Communications<\/strong> – Landlines, internet and cell phones<\/span><\/span><\/p>\n
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