Every company owner wants to grow sales and increase profits, but the first order of business — whatever it is that your business does — is to calculate your break-even point. In economics, the break-even point is where the total costs and total revenue are equal or even.
In short, this means the break-even point is the total level of sales required to cover all your business’s costs. From the break-even point onwards, any further revenue that you bring in would be profit.
The concept of a break-even point can be applied on either a macro or a micro level: You can assess the break-even point for an individual product, a company division, or your entire organisation.
Needless to say, the primary goal of any business is to cover all of your costs and not lose money. By having a strong grasp of your break-even point, you can ensure that your business remains as profitable as possible going forward.
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 × units sold) – (variable cost per unit × units sold) – fixed costs in total dollars = $0 Profit
However, it’s worth noting 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 the break-even point, you need to cover all of your fixed costs
- This formula provides the level of sales that covers all costs (variable and fixed) but that generates $0 in profit. So to be successful, you’ll have to go above and beyond this point
You can think about your break-even point in terms of the number of units you need to sell or as the total amount of revenue that your sales need to bring into the company.
Why break-even analysis is important
The break-even formula is a great tool for helping you make informed business decisions. Here are a few major instances where it can be useful.
Let’s assume that a company budgets to sell 50,000 units of a particular product during the year. By definition, fixed costs (such as rent) are known, but variable costs are not.
The break-even formula can help you calculate your total variable costs. Once you have a better idea of both your fixed costs and your variable costs, you can work out the total amount of money that the business needs to spend in order to generate sales of 50,000 units.
New product launch
The break-even formula is a crucial tool if you’re looking to calculate your sales price for a new product launch. After all, there’s little point in launching a new product if it’s not going to break even — this would be an incredibly unwise business decision.
You can change each of the variables in the break-even formula and determine the impact it would have on the company’s profits.
For instance, what would happen to the company’s profit margins if your office rent doubled in price? How many more units would you need to sell, and would this affect the cost of goods sold?
In other words, would you have to therefore increase your prices? If so, by how much?
Margin of safety
While business owners always hope for the best, they also have to plan (and budget) for the worst.
Margin of safety basically looks at how bad things would have to get before the business is only just reaching its break-even point.
Imagine a competitor launches an innovative new product that takes the market by storm. How low would your sales have to drop (at your product’s current price) for you to reach your break-even point (and no longer be making a net profit)?
When calculating your margin of safety, you’d need to also conduct a cost-volume-profit analysis — this looks at how your company’s profits would change if either the production costs or the volume of products you sold changed.
What the break-even point formula can help you understand
In addition to helping you make important business decisions, the break-even point formula can help you look at these factors concerning the price of your products.
Variable cost per unit
Variable cost per unit refers to any costs which aren’t set in stone (and may change depending on a number of factors). For example, if you’re a restaurant, the price of fish might vary on a seasonal basis depending on how much was caught.
By having a strong grasp of your break-even point, you’ll be able to work out how much fish you need to sell (and at what price) to turn a profit.
Revenue per unit
Revenue per unit is as simple as it sounds — how much money (revenue) each unit brings in once it’s sold.
If your revenue per unit is too low (say you’re only selling the fish at $1 more than what you bought it for), then you’ll struggle to reach your break-even point. If it’s too high, you’ll struggle to attract willing customers, which means you’ll also struggle to reach your break-even point.
A company’s cash flow — how much money is coming in versus how much is going out — is directly proportional to the break-even point. As soon as you move past your break-even point, your company has a positive cash flow.
Meet Susan: A break-even analysis example
Let’s take a look at how your break-even point works in action with a real world example.
Susan owns PineRidge Furniture, and she is analysing her break-even point for a dining room table product line. PineRidge sells each table for $500, the variable costs per-unit are $380, and the 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
This means that 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 the break-even point based on her new assumptions.
If, for example, she increases the price per-unit, the number of units that need to be sold to reach her break-even point will be lower (as she’s increasing her gross profit margin).
Let’s imagine that Susan has done some analysis and realises that her competitors all sell similar dining room tables for $900. She still wants customers to be attracted to her comparatively great prices, so Susan decides to experiment with selling them at $800 each.
How would that look on her break-even point analysis (assuming the costs stayed the same)?
$800X – $380X – $200,000 = $0 Profit
$420X – $200,000 = $0
$420X = $200,000
X = 477 units
As you can see, by increasing her prices to $800, Susan needs to sell only a fraction of the units that she previously needed to sell in order to reach her break-even point.
But that’s not the only way that she can improve her margins.
She could, for example, suddenly meet a new supplier who offers significantly cheaper materials. By working with them, she’d be able to drastically reduce her manufacturing costs — and increase her gross margin in that way.
How break-even analysis helps you reach your target profit
The break-even formula can also be adjusted to calculate the number of units that must be sold to reach a specific amount of profit (also called your target profit).
Assume that PineRidge keeps the same sales price, variable costs, and fixed costs as before — but that Susan sets the target profit to $30,000.
According to the formula, here are the number of units that need to be sold in order to reach the desired $30,000 target profit:
- $500X – $380X – $200,000 = $30,000 profit
- $120X – $200,000 = $30,000
- $120X = $230,000
- X = 1,917 units
By replacing the $0 (signifying the break-even point) at the end of the formula with the target profit, the equation will now work out how many units Susan needs to sell to reach a profit of $30,000. In this case, that’s 1,917 units.
Increase profits using financial analysis
It goes without saying that business owners should use financial analysis when looking to increase their profits. Here are some strategies that can be informed by your break-even analysis.
Imagine that Susan is just starting her business. She’s the only full-time employee and is therefore responsible for all of the company’s sales. She knows her fixed and variable costs, but she’s struggling to figure out her sales price. So, she decides to run the break-even formula.
If she sells the tables for $500 each, she’d have to sell 1,667 units. Bearing in mind that she’s the only employee, and that she’s also responsible for running the entire business, this is far too much.
So, she runs the formula again, pricing the tables at $800 each. This time, she sees that in order to break even, she only needs to sell 477 units. Hard, but doable. Great — she now knows that she needs to go towards the $800 price range rather than $500.
Susan is having a hard time increasing her profit margin.
She’s tinkered with the unit price but that doesn’t seem to be having much of an effect. If she goes too high, she dissuades potential customers — but if she goes too low, she has to sell too many tables to ever break even.
She looks at the break-even point formula and realises there’s still something she might be able to do. While her fixed costs aren’t changing any time soon, she thinks she might be able to lower her variable costs. By doing so and keeping her sales price the same, she’ll dramatically improve her margins.
If PineRidge’s biggest variable cost is wood, Susan can search around and try to find a firm that has cheaper (but still high-quality) materials. She manages to find a firm who can reduce her variable costs by half. Great, so how would that affect her break-even point?
$800X – $190X – $200,000 = $0 Profit
$610X – $200,000 = $0
$610X = $200,000
X = 328 units
If her variable costs are halved, Susan now only has to sell 328 units, rather than 477, to break even.
PineRidge’s progress has stalled. Despite tinkering with the sales price and reducing the variable costs by half, Susan can’t seem to improve her gross profit year on year. The only thing left to do is reduce her 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.
Imagine that Susan is wanting to turn over $300,000 worth of profit, she’s selling her tables for $800 each and has her variable costs at $190 per unit.
Assuming her fixed costs stay the same, this is what she’s looking at:
- $800X – $190X – $200,000 = $300,000 profit
- $610X – $200,000 = $300,000
- $610X = $500,000
- X = 820 units
Susan would therefore have to sell 820 units to reach her target profit. However, over the past few years, her sales numbers have stalled to around 700 units — so she needs another way to reach this $300,000 goal.
In order to reduce her fixed costs, Susan takes some drastic measures. She lowers her personal salary and moves to a significantly cheaper office space.
As a result, she manages to reduce her fixed costs by 50% — meaning they equal a total of $100,000.
- $800X – $190X – $100,000 = $300,000 profit
- $610X – $100,000 = $300,000
- $610X = $400,000
- X = 655 units
Great! By halving her fixed costs, Susan is now able to sell a reasonable amount of tables at a competitive price and still meet her target profit goals.
The brilliance of the break-even point
It’s imperative that you know your product, team, and company’s break-even point in detail. A thousand and one factors can affect profits, but if you’ve got a strong grasp on the numbers, you can always counteract such challenges.
Of course, no business intends to merely break even.
But, if you understand what you need to in order to reach this goal — how setting your ideal unit price and altering your costs will affect the amount you need to sell — you can begin to work out how to make a substantial profit. So, use the break-even point formula to set your business up for success.