Break even analysis refers to that volume of production where the total sales of the company will be equal to the total costs of production and hence at breakeven point company will be in such a position where there is no profit as well as no loss. So for example if the total fixed cost of the company is $45000 and variable cost per unit is $1 and company sales price is $10 then in order to break even company has to sell 5000 units because at 5000 units company variable cost is $5000 and fixed cost is $45000 so total cost is $50000 and at $10 company’s revenue will be $50000. Now, if a company sells above 5000 units then it will be making the profit and if a company sells below 5000 units then it will be making the loss. Break-even analysis is based on certain assumptions, let’s look at assumptions of breakeven analysis –
- The first and foremost assumption of breakeven analysis is that it is easy to segregate fixed cost and variable cost which in real life may not be practical because some cost has elements of both fixed as well variable cost which in turn can make it difficult to calculate the breakeven point.
- Another assumption is that fixed cost will remain same irrespective of the output which again may not hold true because as the output increases beyond a certain level it leads to increase in fixed cost also. Hence in above example, if the capacity of the machine is to produce 20000 units and production increases beyond 20000 units then it will lead to increase in fixed cost which in turn will make 5000 units of breakeven production irrelevant.
- Variable cost per unit will remain constant at all level of production is another assumption of breakeven analysis whereas variable costs tend to decrease as the level of production rises due to company reaching efficiency in production with rising level of output.
- Selling price will remain constant is another assumption on which breakeven analysis is based and we all know that selling price of any product does not remain same which again can lead to the wrong calculation of break-even point as with every change in selling price the breakeven point will also change as far as the company is concerned.
- Another assumption is that there is no change in technology, production methods, and workers efficiency and also there is no scope of a breakdown in production due to unforeseen circumstances like fire, earthquake, floods and so on.
As one can see from the above that break-even analysis is based on many assumptions but still it is used by many companies in order to arrive at that point where the company is making no profit and no loss. In short, it is still one of the widely used methods despite its assumptions and limitations.