What are the advantages of break-even analysis?
Break-even analysis means calculating and investigating the safety margin. For an entity on the basis of collected revenues and related costs. Put another way, the analysis points out the number of sales it takes to pay for doing business costs. Studying various price levels related to different demand levels, the break-even analysis decides what sales levels are essential to covering the firm’s fixed costs. A demand-side analysis makes for a seller to get significant insights into selling abilities.
How does break-even analysis work?
Break-even analysis helps determine the production level or a targeted desired sales mix. The metric and calculations are not for external parties, like regulators, investors, or financial institutions. This analysis type is concerned with a break-even point calculation. The break-even point is arrived at by dividing the total fixed costs by the price per individual unit, minus variable production costs. Regardless of the number of units sold, fixed costs stay the same as the moniker implies.
Break-even analysis targets fixed costs levels compared to the profits made by each additional unit produced and sold. Typically, a company with lower fixed costs will have a lower break-even point of sale. For Example, a company with $0 fixed costs will automatically have broken even upon the sale of the first product with variable costs that do not exceed sales revenue.
Special considerations: Break-even analysis
Notwithstanding investors not being particularly interested in an individual firm’s production break-even analysis, the calculation can be used to decide to determine at what price they will break even on a trade/investment. The calculation comes in handy when trading in or coming up with a strategy to purchase options or a fixed income security product.
Contribution margin: Break-even analysis
The Break-even analysis concept is involved with a product’s contribution margin. The contribution margin is the excess between the product’s selling price and total variable costs. For instance, in case an item sells for $100, the total fixed costs are $25 per unit. The total variable costs are $60 per unit, and $40 is the product contribution margin. The $40 implies the revenue amount collected to cover remaining fixed costs, which are left out when reckoning the contribution margin.
Break-even analysis calculations
Break-even analysis calculation may have two equations. Divide the total fixed costs by the unit contribution margin per the first calculation. In the instance above, take the value of the whole fixed costs is $20,000. With a $40 contribution margin, the break-even point is 500 units. That’s arrived by $20,000 divided by $40. Upon the sale of 500 units, all fixed cost payments are complete, the company reporting a net profit of $0 loss.
Conversely, break-even point calculation takes place by dividing the total costs by the contribution margin ratio. The contribution margin ratio is the contribution margin per unit divided by the sale price.
Coming back to the instance above, the contribution margin ratio is 40%. That’s arrived at by the $40 contribution margin per item divided by $100 same price per item. Hence, the sales dollars break-even point is $50,000, reckoned by $20,000 total fixed costs divided by 40%. You can check this result by multiplying the break-even in units by the sale price, which equals $50,000.
Contribution Margin against gross margin
It is important not to confuse contribution margin with gross margin — also called the gross profit margin. Gross margin is the profit a company makes on total sales, post accounting for the direct sales, both variable and fixed, associated with producing the services and goods sold.
The gross margin takes a high-level view of profitability. The contribution margin decides financial viability at a single unit level. Another important difference between the two is that the gross margin considers fixed costs for its calculations. Conversely, contribution margin has its basis only in variable costs.
Break-even analysis: it's meaning for investors
Break-even analysis, for investors, shows the minimum amount of sales essential for a company to forestall losses. When studying two or more companies making a similar product or offering a similar service, Break-even analysis may help decode if one company has a major advantage as regards lower production costs, pricing power — thanks to strong branding, or factors permitting it to sell fewer units to break even.
Per a wide interpretation, a form of break-even analysis could be applicable in the context of options and stock trading. Investors can calculate the point if they neither lose nor gain.
Calculating trading break-even percentage may be useful in deciding an investment strategy employing targets with stop loss.
In options trading the Break-even point for a call option where the investor neither makes nor loses money equals the sum of the strike price and the premium paid for the call.
For instance, in case an investor purchases XYZ September ’50 call $1.50’, the implication is that they have bought an options contract for XYZ stock expiring in September with a $50 strike price, paying $1.50 per share in premium. Here, the investor will break even when the XYZ stock price is $51.50 ($50+$1.50).
On the same lines, the Break-even point for a put option is the strike price minus the premium. Therefore, if the investor had bought a put option for XYZ at $50 strike price in the above instance, paying a $1.50 premium. Subsequently, the XYZ share price would need to decline to $50 — $1.50, or $48.50, facilitating the breaking even of the put.
Conclusion
Break-even analysis is a manner in which you may determine the sales volume needed to recover the costs of offering goods/services. Businesses may determine their pricing strategy on the basis of Break-even analysis. In addition, companies may use Break-even analysis to assess the feasibility of new/existing product lines or service offerings. Some Break-even analysis principles may be applied to stock and options trading.
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