Break-even Point is a simple financial tool that helps you to determine at what stage, your company, or a new service or a product, will be profitable. In simple words, break-even point analysis will tell you the number of products or services your company should sell to cover its costs, particularly fixed costs.
It is a situation where you are neither making money nor losing money, but all your costs have been covered. 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.
In this blog, we’ll deep dive into how you can calculate it and how it can actually help your business!
Getting the basis right
Before understanding Break-even analysis and how it is useful in studying the relation between the variable cost, fixed cost and revenue. Let’s understand the key difference between all these terms.
Some of the examples of Fixed costs include rent, insurance premiums, or loan payments.
Variable costs are the costs that change with the quantity of output (for example the cost of raw material, wages etc)
Generally, a company with low fixed costs will have a low break-even point of sale. For example, a company with a fixed cost of $ 0 (zero) will automatically have broken even upon the first sale of its product.
It is important to understand 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 generate a loss—not a profit.
Now, let’s understand how you can calculate a break-even point for your business.
Starting with the formula
There are several ways to use this concept. Let’s look at a few of them as well as an example of how to calculate a break-even point.
Since the price per unit minus the variable costs of the 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.
Break-even analysis helps business owners to determine the selling price of their products or services. However, typical variable and fixed costs differ widely among industries. Therefore, the comparison of break-even points is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” break-even point should be made within this context.
A few examples
Since the basic object to determine the break-even point is to calculate the point at which revenues begin to exceed costs, the first step is to separate a company’s costs into those that are variable and those that are fixed. As mentioned earlier, fixed costs include payments like rent, insurance premiums, or loan payments. Variable costs include the cost of materials used in production, wages etc.
| Formula 1
$100000 ———— = 10000 Units ($20-$10) |
Assume that a company manufactures and sells a single product as follows:
Selling price per unit = $ 20
Variable cost per unit = $ 10
Total fixed cost = $ 1, 00,000
| Formula 2
$100000 ———— = 10000 Units $10 |
The break-even sales to cover fixed costs will be 10,000 units.
Selling price per unit = $ 20
Variable cost per unit = $ 10
Contribution = $ 10
Break-even volume = $ 1,00,000 fixed cost/$ 10 contribution margin = 10,000 units
If the company manages to sell more than 10,000 units, it will earn profits because fixed costs remain constant. If they fail to achieve this target, a loss will be incurred. The profits will be equal to the number of units sold in excess of 10,000 units multiplied by the unit contribution margin. For example, if 25,000 units are sold, the company will be operating at 15,000 units above its break-even point and will earn a profit of $ 1, 50,000 (15,000 units x $ 10 contribution margin).
How can a Break-even analysis make a difference?
The break-even point helps business owners determine the time when the business would generate a Profit and assists them with the careful pricing of their products. Typically variable and fixed costs differ widely among different industries. This is why the comparison of break-even points is generally most meaningful among companies within the same industry, and the definition of a “high” or “low” break-even point should be made within this context.