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Eliminating Guesswork With the Break-Even Point
Pricing
and marketing decisions involve a lot of guesswork, but some of the
uncertainty can be eliminated by careful analysis of costs and margins to
determine the break-even point.
The break-even point, the level of sales necessary to cover all fixed and
variable costs, is useful in deciding whether to raise or lower prices, to
buy or lease equipment or facilities, to enter new markets, or to build a new
plant. Without the basic information provided by break-even analysis, the
difference between revenue and profit remains blurry.
Variable Costs
Variable costs such as labor and sales commissions are especially significant
in evaluating possible benefits from a price change. Fixed costs associated
with basic expenses like rent and interest on loans continue at about the
same rate when sales rise or fall, but variable costs go up and down with
changes in volume of production or service, fluctuating in direct
relationship with sales volume.
Once you cross the break-even line, your profit margin is equal to the
difference between the variable cost per unit of production or hour of
service and the price per unit. To determine variable costs per unit, divide
total variable costs by the number of units produced or hours of service
provided.
Tricky Decisions
It all sounds pretty straightforward, but it can become tricky when you’re
deciding which costs are fixed and which are variable. Some expenditures
combine elements of both. Separating such charges into their fixed and
variable parts is one approach to judging their impact on the break-even
point.
Also, even fixed costs can vary with time. Rent is a fixed expense only for
the length of a lease, and, if you need more space because of increased
sales, rent can become a variable expense.
Break-even analysis can help you assess the logic of sales targets and
determine growth strategies. If results show that the targets will push the
business to capacity or require near-total market control to produce a
profit, you may need to reevaluate your pricing strategy or look for new cost
savings.
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