What is the Assumption of Break Even Analysis?

Most of us know what “to break even” means. In the context of a company earning a profit, breaking even means you didn’t lose money, but you also didn’t earn. For some companies just starting out, breaking even isn’t so bad, especially if you’ve invested money to start the business, or you’ve recently put a lot of money into growing it. That’s because it means you’ve at least earned back that investment, and maybe in the next quarter, you’ll start earning. Also, knowing at what point you’ll break even can help you learn how much money you should be spending on products and selling them at to earn a profit.

One way to know whether or not you’ve broken even is to do a break-even analysis. But, this is different from an assumption of a break even analysis. So, what’s the difference? How do you solve, and, most importantly, how do you understand the financial health of your business? 

What is a Break-Even Analysis?

A break-even analysis can be described in several different ways, but ultimately, it refers to an actual calculation/formula that’s used to that weighs the cost of a new business (or, service or product, i.e. something being sold), against the price per unit, in order to solve for the actual point at which you’ll “break-even” after your investment, where all costs are covered. 

To break-even means you’re at a point where you’re neither losing money nor making money. Generally, to solve for break-even analysis, you’ll have to know what your fixed costs are and what your variable costs are. 

Why is it Important to Use a Break-Even Analysis?

A break-even analysis is a good way for businesses that are just getting started to figure out the balance between how much to spend on manufacturing/sourcing/suppliers, etc., vs. how they need to price their products and services in order to break even and then, eventually, make a profit. The same goes for businesses who might be re-investing in themselves, maybe by launching a new product.  

What is the Assumption of a Break-Even Analysis?

Let’s take it a step further. 

There’s also the term called “assumption of a break-even analysis.” This is essentially a theory related to break-even analysis (above), which states that in order to conduct a break-even analysis equation, the formula “assumes” that all costs can be very clearly sorted into a “fixed cost” box and a “variable cost” box. 

As a reminder, below are the definitions of fixed cost and variable cost, as they relate to break-even analysis:

Fixed Cost: These are costs that are locked in place, like the amount you’re paying to lease the building where you hold your business, or what you pay to host your ecommerce website. Though fixed costs can certainly change, they’re generally constant

Variable Cost: These are costs that change as the volume and/or output changes. For instance, if you order more units of a product you’re selling, then the costs will increase. It’s also, in mathematical terms, the sum of marginal costs over all units produced.

Together, fixed costs and variable costs make up “total cost.” 

The problem is, while it would seem easy to separate a business’ costs into one or the other, it’s not always that straightforward. Sometimes, fixed costs and variable costs aren’t so rigid or may have a lot of different factors influencing them.

And, since you need to know both your fixed costs and variable costs to solve for a break-even analysis—again, “assuming” that your costs could be very clearly separated into one or the other—it could run you into some problems if you’re not paying attention. These problems or factors are known as limitations.

The Limitations of a Break-Even Analysis

An assumption of break-even analysis assumes several numbers or factors remain constant, when really, that’s not the case. These assumptions are also known as limitations on a break even analysis. Some of these are:

  • Assumptions that fixes costs remain the same at all levels of activity. But, as mentioned earlier, this can change as activity changes. For instance, the market dictates that now your rent is going to increase, without you being prepared.
  • Assumptions that variable costs vary in proportion to the volume of output. This is not always true.
  • Assumptions that the selling price or price-per-unit won’t change.
  • Assumptions that business conditions won’t change. 
  • Assumptions that in solving the break-even analysis, that only one product is being produced. But, maybe you’re selling your product at different price points, and this can change based on demand. 
  • Etc.

Ultimately, the limitations of a break-even analysis doesn’t take into consideration various “could-be” and “what if” factors, including the amount of capital the business employs to begin with. 

The inflation we’re experiencing now can help you better understand the limitations of a break-even analysis—as the market changes, fixed costs and variable costs can change at a moment’s notice, which means solving for a break-even analysis might not yield the true “break-even” number. 

Assumption of a Break-Even Analysis vs. Break Even Analysis

So, that’s a lot of information to process. Now you know the definition of a break-even analysis and assumption of break-even analysis. 

But, if you’re wondering what the difference is, know that break-even analysis is the formula to help solve for the number at which your business will break even. 

Because this formula involves knowing the fixed cost and variable cost to solve, the term “assumption of a break even analysis” is an idea that when you’re solving for break-even analysis, you’re doing it by assuming those costs are stagnant, as well as assuming other numerical factors are in place when they may not always be set in stone (known as the limitations of a break-even analysis mentioned above). If you use an assumption of break-even analysis, you might get inaccurate results.

What to Consider

Although there are limitations based on the assumption of a break even analysis, the reality is that a break even analysis formula gets pretty close to the real thing depending on the formula you’re using. When solving for your break-even number, the more information you have at your disposal, the more close you’ll get to your break-even number.

To avoid the assumption of a break-even analysis you can use a calculator that helps you figure out your break even amount based on several factors—not just fixed cost and variable cost. You’ll also need to know cost per unit, revenue per unit, margin, and markup, which other calculators don’t take into consideration.

Our calculator especially useful if you’re starting a business and getting quotes from different suppliers, while also analyzing your market and how much you should charge per unit. You might need to calculate for several different scenarios in order to compare that break even number side-by-side and see what options will work best for your business going forward.

This entry was posted in Business, Finance and tagged , , . By Hana LaRock