Every company owner wants to grow sales and profits, but the first order of business must be to calculate your break-even point. The break-even point in economics is the point where the total cost and total revenue is equal or “even”.
This includes the level of sales required to cover all costs, and break-even can be analysed by units sold, or in total sales dollars. You can assess break-even for an individual product, a company division, or your entire organisation.
Simply put, your first sales goal is to cover all of your costs and not lose money. This discussion explains why the concept of break-even is useful, and how you can use this important tool to make informed decisions in your business.
The break-even analysis formula
The break-even formula can be stated in several ways, but the most common version is: [(Sales price per unit) x (Units sold)] – [(Variable cost per unit) x (Units sold)] – (Fixed costs in total dollars) = $0 Profit Note these points regarding the formula:
- Sales price and variable costs are stated per unit sold, and then multiplied by the number of units
- Fixed costs are stated in total dollars, and it’s important to avoid looking at fixed costs on a per unit basis. To calculate break even, you need to cover all of your fixed costs, regardless of the number of units sold
- Profit is set to zero, so that the formula provides the level of sales that covers all costs (variable and fixed), and generates $0 in profit
You can think about break-even point in terms of the number of units you need to sell, or as the total dollar amount of sales needed.
Why break-even analysis is important
The break-even formula is a great tool to make informed business decisions, and here are a few reasons why:
- Cash forecasting: Assume that a company budgets to sell 50,000 units of a particular product during the year. Fixed costs, by definition, are known, but not variable costs. The break-even formula calculates total variable costs, which can be used to determine the total budgeted costs for the year. Finally, the firm can use the cost totals to estimate the total cash needed to generate sales of 50,000 units.
- New product launch: The break-even formula is an important tool to compute your sales price, variable costs, and fixed costs for a new product launch. The formula can help you determine your break-even point, and if your sales price and projected units sold are enough to generate a reasonable profit.
- What-if analysis: A business owner can change each of the variables in the formula and determine the impact on company profit. Many owners use this “what-if” type of analysis to make product decisions.
The formula can help you assess the profitability of your current product line, or consider a new product launch. As you’ll see below, you can set the profit to zero, or to a specific dollar amount of profit.
Meet Susan – A break-even analysis example
Susan owns PineRidge Furniture, and she is analysing her break-even point on a dining room table product line. PineRidge sells each table for $500, the variable costs per unit are $380, and total fixed costs equal $200,000.
Here is the break-even point, assuming that “X” equals units sold to break even:
$500X – $380X – $200,000 = $0 Profit
$120X – $200,000 = $0
$120X = $200,000
X = 1,667 units
Susan must sell 1,667 units to cover all of the dining room table product line costs and break even. She can also change any of the variables in the formula, and calculate break even based on new assumptions. If, for example, she increases the price per unit, the number of units to reach break even will be lower.
How break-even analysis helps you reach your target profit
The break-even formula can be adjusted to calculate the number of units that must be sold to reach a specific amount of profit, also called target profit.
Assume that PineRidge keeps the assumptions for the sales price, variable costs, and fixed costs the same, and sets the profit to $30,000.
Here are the number of units sold to reach the $30,000 target profit:
- $500X – $380X – $200,000 = $30,000 Profit
- $120X – $200,000 = $30,000
- $120X = $230,000
- X = 1,917 units
To increase profits from break even to $30,000, Susan must increase sales from 1,667 to 1,917 units.
Increase profits using analysis
Business owners use financial analysis to increase profits, and Susan can make changes to the target profit assumptions and generate higher profits. Consider these strategies:
- Sales price: Susan can experiment by increasing the price of her dining room table, and assessing the change in sales. Many business owners don’t realise that customers may be willing to pay more for a particular product. If, however, the price increase turns customers away, she can lower the price back to the original level.
- Variable costs: If PineRidge’s biggest variable cost is wood, the firm can start asking for bids from multiple vendors, in order to lower material costs for wood. Susan may also consider working with new vendors, if the vendor can provide high-quality materials in a timely manner.
- Fixed costs: By definition, fixed costs cannot be changed in the short term, but Susan can take action to reduce costs over the long term. PineRidge, for example, can renegotiate a lower lease payment when the building lease is up for renewal, or ask the company’s insurance agent for a lower quote on business insurance premiums.
By working on each component of the target profit formula, Susan may be able to lower costs, increase total sales, and generate a higher profit on dining room tables.
Applying the contribution margin formula
The contribution margin formula is similar to the break-even formula, and it’s a useful tool that an owner can use to plan for sales and costs.
Contribution margin (CM) is simply (Total sales – variable costs), and you can think of CM as a dollar amount that will cover fixed costs, with any remaining amount as company profit.
Consider the target net income example above, assume that 2,000 units are sold, and compute the profit:
$500 (2,000) – $380 (2,000) – $200,000 = Profit
$120 (2,000) – $200,000 = $40,000 Profit
Since 1,917 units generated the $30,000 target net income, it makes sense that 2,000 units sold would produce an even higher profit.
The CM is ($120) x (2,000 units), or $240,000, and $200,000 in fixed costs are subtracted to arrive at the $40,000 profit. CM demonstrates that increasing total sales, or decreasing fixed costs over time, will generate higher profits.
Many business owners use the break-even point formula, target net income, and contribution margin to make business decisions.
Creating your company dashboard
Every business owner has a set of financial metrics that are the most useful for decision-making. Take a look at the formulas explained here, and consider using them to recognise these benefits:
- The break-even formula calculates the units you must sell to cover all of your costs You can change the units sold, sales price per unit, variable cost per unit, or fixed costs and calculate a new break-even point
- If you have a specific profit goal, you can plug your profit goal into the same formula and determine the sales level you must generate to reach the profit goal
- Use the contribution margin formula to understand how increasing total sales, or decreasing fixed costs over time, will generate higher profits
Create a “financial dashboard” to monitor your company’s performance, reduce costs, and increase profits over time. This strategy will help you become a more effective business owner.