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# Computation of Break Even Point (BEP), margin of safety

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**Break Even Point**

Break–even point analysis is a measurement system that calculates the margin of safety by comparing the amount of revenues or units that must be sold to cover fixed and variable costs associated with making the sales. In other words, it’s a way to calculate when a project will be profitable by equating its total revenues with its total expenses. There are several different uses for the equation, but all of them deal with managerial accounting and cost management.

The main thing to understand in managerial accounting is the difference between revenues and profits. Not all revenues result in profits for the company. Many products cost more to make than the revenues they generate. Since the expenses are greater than the revenues, these products great a loss—not a profit.

The purpose of the break-even analysis formula is to calculate the amount of sales that equates revenues to expenses and the amount of excess revenues, also known as profits, after the fixed and variable costs are met. There are many ways to use this concept. Let’s take a look at a few of them as well as an example of how to calculate break-even point.

## Formula

The break-even point formula is calculated by dividing the total fixed costs of production by the price per unit less the variable costs to produce the product.

Since the price per unit minus the variable costs of product is the definition of the contribution margin per unit, you can simply rephrase the equation by dividing the fixed costs by the contribution margin.

This computes the total number of units that must be sold for the company to generate enough revenues to cover all of its expenses. Now we can take that concept and translate it into sales dollars.

The break-even formula in sales dollars is calculated by multiplying the price of each unit by the answer from our first equation.

This will give us the total dollar amount in sales that will we need to achieve to have zero loss and zero profit. Now we can take this concept a step further and compute the total number of units that need to be sold in order to achieve a certain level profitability without break-even calculator.

First, we take the desired dollar amount of profit and divide it by the contribution margin per unit. The computes the number of units we need to sell to produce the profit without taking in consideration the fixed costs. Now we must add back in the break-even point number of units. Here’s what it looks like.

## Example

Let’s take a look at an example of each of these formulas. Barbara is the managerial accountant in charge of a large furniture factory’s production lines and supply chains. She isn’t sure the current year’s couch models are going to turn a profit and what to measure the number of units they will have to produce and sell to cover their expenses and make at $500,000 in profit. Here are the production stats.

- Total fixed costs: $500,000
- Variable costs per unit: $300
- Sale price per unit: $500
- Desired profits: $200,000

First we need to calculate the break-even point per unit, so we will divide the $500,000 of fixed costs by the $200 contribution margin per unit ($500 – $300).

As you can see, the Barbara’s factory will have to sell at least 2,500 units to cover its fixed and variable costs. Anything it sells after the 2,500 marks will go straight to the CM since the fixed costs are already covered.

Next, Barbara can translate the number of units into total sales dollars by multiplying the 2,500 units by the total sales price for each unit of $500.

Now Barbara can go back to the board and say that the company must sell at least 2,500 units or the equivalent of $1,250,000 in sales before any profits are realized. She can also take it a step further and use a break-even point calculator to compute the total number of units that must be produced in order to meet her $200,000 profitability goal by dividing the $200,000 desired profit by the contribution margin then adding the total number of break-even point units.

**Margin of Safety**** (MOS)**

In break-even analysis, margin of safety is the extent by which actual or projected sales exceed the break-even sales. It may be calculated simply as the difference between actual or projected sales and the break-even sales. However, it is best to calculate margin of safety in the form of a ratio. Thus we have the following two formulas to calculate margin of safety:

MOS = Budgeted Sales − Break-even Sales | ||

MOS = | Budgeted Sales − Break-even Sales | |

Budgeted Sales | ||

Margin of Safety can be expressed both in terms of sales units and currency units.

The margin of safety is a measure of risk. It represents the amount of drop in sales which a company can tolerate. Higher the margin of safety, the more the company can withstand fluctuations in sales. A drop in sales greater than margin of safety will cause net loss for the period.

## Example

Use the following information to calculate margin of safety:

Sales Price per Unit | $40 |

Variable Cost per Unit | $32 |

Total Fixed Cost | $7,000 |

Budgeted Sales | $40,000 |

Solution

Breakeven Sales Units | = $7,000 ÷ ($40 – $32) | = 875 |

Budgeted Sales Units | = $40,000 ÷ $40 | = 1,000 |

Margin of Safety | = (1000 − 875) ÷ 1,000 | = 12.5% |

__Difference between Breakeven Point vs. Margin of Safety__

__Difference between Breakeven Point vs. Margin of Safety__

Break-even point (BEP) is the level of sales where a total of fixed and variable cost equals total revenues. In other words, the breakeven point is a level where the company neither makes profit nor loss.

margin of safety (MoS) is a difference between actual/budgeted sales and level of breakeven sales.

Although the breakeven point (level) and margin of safety fall under the broad domain of cost-volume-profit analysis (CVP Analysis), they differ in various aspects. Main points of difference between the breakeven point and margin of safety are as listed below:

Breakeven point means an amount of sales that covers entire fixed and variable cost. Sales lower than the BEP will result in losses, while, the sales above the BEP will generate profit after considering all the costs.

As the name suggests, Margin of Safety is the margin between the actual/budgeted sales and breakeven point. It denotes the level of safety that company enjoys before incurring losses (i.e. falling below the breakeven level).

**Advantages and Use of Breakeven Point Analysis and Margin of Safety Analysis **

### Advantages of Breakeven Point Analysis

- BEP analysis helps in understanding the relationship between fixed cost, variable cost, and the level of profitability.
- It provides the business with a minimum sales level which the company needs to achieve to avoid losses.
- It also indicates how any change in selling price would impact the profitability and BEP.
- BEP can be used as one of the indicators which help in deciding whether to manufacture new product yourself or simply outsource.

### Advantages of Margin of Safety

- It is useful in knowing how much cushion the company has if sales decline before the company starts making losses.
- Higher MoS provides freedom to the management of the company to alter the selling price of their product to gain market share from its competitors.
- Higher margin of safety allows the company to spend more on an advertisement or other activities that can help in improving sales overall.

**Disadvantages of Breakeven Point and Margin of Safety**

- Break-even point analysis is more appropriate in the case of analysis of a single product at a time, it fails to do so appropriately in case of multi-product scenario. Many-a-times it is difficult to classify a cost as fixed or variable
- The margin of safety, if turns out to be very high, may cause management to lead to inappropriate use of excess funds. At times, a higher margin of safety may lead to higher risk taking the behaviour of the management which may not always be required.

**Conclusion**

The CPV Analysis for any company would remain incomplete unless one calculates breakeven point analysis and margin of safety along with other costs and ratios. Though there are limitations of using breakeven point analysis and calculating margin of safety; these continue to remain a vital part of any company cost profit-volume analysis.

SELF-CHECK ACTIVITY

- Describe Break Even Point with formula and example?
- What is Margin of Safety?
- Compare between BEP and MoS with example?