# Essential Elements of the Break-Even Analysis

The essential elements of break-even analysis relate to the assumed behavior of certain costs

within the cost structure. To use this model, the firm must place all its costs in two categories—

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variable costs and fixed costs—and also determine the range of volume that may be sold over the

period. Let’s examine these components.

Variable Costs

Variable costs tend to vary as the output volume changes. Variable costs are incurred per each

unit of output. For example, direct materials are considered a variable cost because they vary

directly with the quantity of products produced. If I am producing 50 widgets and each one

requires \$10.00 of material costs, then the variable cost of material is \$10.00 per unit. Of course,

materials are not the only variable cost component of a product. Other common variable costs

include

• direct labor

• direct materials

• utility costs (associated with the production area)

• packaging

• freight-out (on products sold)

• freight-in (on materials)

• sales commissions

The above variable costs are additive to create a total variable cost per unit for each product

being sold. To illustrate, let’s create the variable cost per unit for one widget.

Direct labor \$ 5.00/unit

Direct materials \$10.00/unit

Packaging \$ 1.00/unit

Utility cost \$ 4.00/unit

Total variable cost = \$20.00/unit

The following tabular and linear graphical relationships further illustrate the concept of variable

costs.

Variable Cost Relationship

Units Sold Variable Cost/Unit Total Variable Costs

(Units x Cost/Unit) \$20.00 \$ 0.00

1 \$20.00 \$ 20.00

5 \$20.00 \$ 100.00

10 \$20.00 \$ 200.00

20 \$20.00 \$ 400.00

50 \$20.00 \$1,000.00

Fixed Costs

In addition to variable costs, there are many costs encountered in business that are constant and

do not vary in total as the sales volume or the quantity of output changes over some range of

output. For example, administrative salaries are generally considered fixed because they are

normally the same month after month and do not normally fluctuate with volume. Other typical

examples of fixed costs are:

Depreciation \$20,000 annual change

Amortization \$ 3,000 annual change

Insurance premiums \$ 8,000 annual expense

Property taxes \$ 6,000 annual expense

Computer systems \$ 5,000 annual lease cost

Overhead \$10,000 supervisory costs

Lease costs \$ 8,000 annual office lease

Total fixed costs \$60,000 Total annual fixed

Fixed costs for a period are also additive. The total fixed cost for a given period (month, quarter,

or year) is unchanged regardless of the quantity of product output or sales. Note, however, over

some longer relevant range, say a decade, these fixed costs may become variable. Theoretically,

in the really long run there are no fixed costs, because with enough time every cost becomes

variable.

Using the previously developed unit variable cost (\$20.00) and annual fixed cost (\$60,000) the

following tabular and linear graphical relationships further illustrate the concept of variable

costs.

Variable Cost Relationship

Units Sold Fixed Cost Total Variable Cost

(units cost/unit)

\$60,000 \$ 0.00

1,000 \$60,000 \$ 20,000

5,000 \$60,000 \$ 100,000

10,000 \$60,000 \$ 200,000

20,000 \$60,000 \$ 400,000