Break-even point and Margin of Safety
Break Even Point and Margin of Safety
For any business, Break-even point is very important. Particularly, for start up businesses, it is very important to know how much they need to produce and sell to break even.
There are two types of costs in any business - Fixed costs and Variable costs. Clearly, Total Costs is a sum of Fixed Costs and Variable Costs.
Total Costs = Fixed Costs + Variable Costs
Break-even point is a point of sale where the Total Costs become equal to Total Sales Value.
Break-even Sales Value = Fixed Costs + Variable Costs
Any sales made in excess of Break-even sales, is called Margin of safety.
Margin of safety = Actual sales – Break-even point sales
In this article, we will find out how to calculate Break-even point and Margin of Safety.
Break-even point (units) = Fixed Costs/Per unit contribution
Contribution is excess of Selling Price over Variable Cost. It can be calculated on per unit basis or on total unit basis.
Contribution per unit = Selling Price per unit – Variable Cost per unit
Contribution (total units) = Total sales Value – Total Variable Cost
Let us understand this by an example.
A business produces 2,500 units. Selling price per unit is £50. Fixed Cost is £20,000 and Variable cost per unit is £40.
Total Variable costs = 2,500*40 = 100,000
Total cost = Fixed Costs + Variable Costs = 20,000 + 100,000 = 120,000
Contribution per unit = £50 – £40 = £10 per unit
Break-even point = Fixed Costs/Contribution per unit = £20,000/£10 = 2,000
At this level, sales value equals 2,000*50 i.e. 100,000.
Total Costs is 20,000+ 2,000*40 = 100,000. So, at this point both Sales Value and Total Costs are same.
So, the business is breaking even at 2,000 units. Any sales beyond this point will be margin of safety. So, the margin of safety in this case would be 2,500-2,000 i.e. 500 units or 500*£50 i.e. £25,000 sales value.
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