Importance of Break-even analysis
Importance of Break-even analysis
It is an undisputable fact that every business’ objective is to survive and make profit as compensation of being in existence. Frankly, predicting a precise amount of sales or profits is nearly impossible. No business aims at making losses whatsoever. Given this, a person starting a new business often asks, ‘’ At what level of sales will my company make a profit? ’’ This question clearly predicts the uncertainty of businesses on the level of sales at which profits will be realized.
Certainly, break-even analysis is the first resort. Therefore, it becomes absolutely necessary for a business to prioritize break-even analysis when making profit oriented decisions. This leads us to the reasons why businesses should pay attention to break-even analysis. Break-even point can be defined as a point where total costs (expenses) and total sales (revenue) are equal. Specifically, break-even analysis if the use of break-even point to make cost, volume, and profit analysis.
Break-even analysis offers businesses lots of benefits that are worth considering. There are a number of benefits that hitherto a business would not enjoy. The break-even analysis gives an insight about the sales level a business needs in order to make profit. It gives the business a forecast on its cost, volume, and profit behavior. Managers can determine the effect of changes in cost and volume of sales on the profit. By so doing, it guides the decision making process of a business.
The break-even analysis is also helpful to managers as the provided information such as margin of safety in units and sales (MOS), and degree of leverage (DOL) can be used in making important decisions in business, for example projecting the sales level needed to obtain certain targeted profit. With the help the break-even analysis, businesses can ascertain the number of units of a product to sell to generate a targeted profit. Similarly, break-even analysis is a tool used to determine the lowest quantity of sales at which neither profit nor loss will be obtained.
In a situation where the demand of a company’s product begins to fall, it would be able to determine the number of employees to maintain so as reduce production cost as well as prevent surplus. Obviously, companies incur addition storage cost to store unsold goods; hence, the break-even analysis will help managers not incur such cost. Companies can use the break-even analysis to study the relationship between selling price, fixed costs, variable costs, and sales volume and its effect on the contribution margin. Therefore, business can tell which of the element to alter in order to make a certain profit.
Moreover, such analysis facilitates the managers with a quantity which can be used to evaluate the future demand. If, in case, the break-even point lies above the estimated demand, reflecting a loss on the product, the manager can use this information for taking various decisions. He might choose to discontinue the product, or improve the advertising strategies, or even re-price the product to increase demand. Furthermore, managers can use break-even analysis to determine whether an investment will generate profit or not.
As a result, managers will not venture into investments that will lead to losses. Another important usage of the break-even point is that it is helpful in recognizing the relevance of fixed and variable cost. The fixed cost is less with a more flexible personnel and equipment thereby resulting in a lower break-even point. The importance of break-even point, therefore, cannot be overstated for a sound business and decision making. Additionally, the break-even analysis gives managers the understanding of how profitable different product or services might be.
Managers can determine how much each product contributes to the overall profit and how relevant the product is to the firm. The most important aspect of the break even-analysis gives managers the knowledge about how much product must be sold to cover costs. Therefore, it helps managers to work hard towards selling a level of product that will cover its costs so as to make profit. In conclusion, businesses that pay attention to break-even analysis tend to understand their costs, hence are very likely to take effective decisions regarding pricing, investment, and expenditure among other things.