In break-even analysis, total cost must be separated into fixed costs and variable costs. Therefore, at the break-even point, total revenue is the sum of fixed costs plus variable costs. Sometimes for break-even analysis, revenue and costs must be expressed in unit prices, unit costs, and volume. Revenue is equal to the selling price per unit multiplied by the number of units produced and sold. Variable cost is equal to the variable cost per unit multiplied by the number of units produced and sold. This makes the break-even equation selling price per unit times number of units produced and sold equals fixed cost plus variable cost per unit times number of units produced and sold.
So, the basic break-even formula will tell us how many units need to be produced and sold in order to cover all of the related costs of those units. If profit is added into the formula, we can determine the amount of profit that will be earned when a specific number of units are sold. We can also solve for the number of units that would need to be sold in order to generate a desired profit level. This formula would be selling price per unit multiplied by the number of units produced and sold equals fixed cost plus variable cost per unit times number of units plus profit.
Break-even analysis can also be used to assist management in setting prices for their products. It is also a useful tool when examining the financial implications of different strategies being proposed for the company. Still another use for break-even analysis is for determining optimum fixed and variable cost combinations. Many different scenarios can be tested using the break-even formula, in order to arrive at a sound financial plan.
There are a number of assumptions that are used with break-even analysis. It is assumed that fixed costs are constant. It is also assumed that average variable costs per unit are constant. Break-even analysis also assumes that the quantity of goods sold is equal to the quantity of goods produced. Another limitation of break-even analysis is that it only considers costs, or supply. It does not consider demand, such as what the actual sales volume will be for the product. Only anticipated sales volume can be used for break-even analysis.
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