Break-even analysis is used to determine the point at which revenue received equals the costs associated with receiving the revenue. Break-even analysis calculates what is known as a margin of safety, the amount that revenues exceed the break-even point. This is the amount that revenues can fall while still staying above the break-even point. Break-even analysis is a supply-side analysis; it only analyzes the costs of the sales. It does not analyze how demand may be affected at different price levels.
Break-even analysis of projects
The organization should critically evaluate all new projects. Critical evaluation is necessary to emphasize internal controls and justify the costs. One of the important dimensions of this evaluation is to find the operating level which justifies the costs implicit in the activity. There will always be a scale of activity below which the costs do not justify starting the proposed activity. The knowledge of this level of activity is necessary for decision making. Break-even analysis is an approach which helps management to identify the critical level of activity, namely the break-even level, which is that level of activity at which funds allocated to the project are just sufficient to cover costs of operation. If the activity is operated below this level, the project will incur losses. In order to find this break-even level, management requires information on:
(i) Funding sources sanctioned for the project, which usually are
- Fixed grants, such as grants received from government.
- Variable receipts, such as participation fees charged.
(ii) costs associated with the project, which again will be
- Fixed costs, and
- Variable costs.
The break-even level of activity would be identified by equating the two revenue and two cost components. This is an important tool in project analysis. One can also find break-even levels under different revenue levels.