As an entrepreneur, ensuring your business is profitable is key to both sustainability and growth. But in order to determine what profitability means for your company, you need clearly defined goals and a comprehensive analysis that provides targets to aim for. This will help you make sure your sales outweigh the costs of running your business.
This is where a break even analysis comes in. Whether you’re in the process of writing your business plan or already up and running, a break-even analysis is a great tool that helps guide you when you set the selling price of your products. With this calculation, you can figure out the point at which your fixed and variable costs become equal to your total revenue. This lets you know the number of units you need to sell before your business — you guessed it — breaks even.
Determine your variables
But just how do you calculate when you will break even? Well, there are six key concepts you need to understand before you can determine whether your business is actually turning a profit.
Let’s look at the case of Lilian’s Designer Bag Boutique as a guide when determining what variables go into a break even analysis and how to perform our calculations.
These are business expenses that remain the same every month, no matter how many products or services you sell. Among your fixed costs, you would include expenses like your rent, property taxes, payroll, insurance premiums, and utilities. These costs stay the same — or vary only slightly — whether your business is thriving or experiencing a dry spell.
Imagine that Lilian has just opened her business selling designer bags. She pays $1,000 each month to rent the retail space for her store and approximately $200 in utilities. She hired one other salesperson on a part-time basis to help her manage the store, and pays him $800 monthly. In total, her fixed costs come to $2,000 each month.
2. Variable costs
These costs go up or down, and are directly dependent on the level of production or number of units you make each month. Some examples of variable costs would be:
- Raw materials
- Direct labor costs
- Product shipping costs
- Sales commissions
If demand for your product increases, you’ll need to make more units. While selling more items is ultimately great for your business, it also means your cost of goods will go up. After all, you would need to purchase more raw materials and potentially pay more in direct labor costs to the manufacturer if you outsource production. This would mean proportionally higher costs as your production volume increases.
Alternatively, say the price of gasoline goes up. Even a small increase in the cost per gallon could impact your shipping costs, thereby causing your variable costs to increase.
Returning to Lilian’s store, from January to March, each designer bag cost $25 in raw materials, $30 in direct labor costs, and another $15 in shipping costs. Lilian’s total variable costs per unit for the first quarter of the year totaled $70.
3. Price per unit
This part of the equation probably seems straightforward. As a consumer, you likely know a reasonable selling price for most household goods — you wouldn’t pay $10 for a pack of gum, but it might seem like a good price for a bottle of wine.
However, when it comes to your own company, things get tricky. The price for each individual product is critical to the profitability of your business. After all, it’s ultimately the only variable in your break even calculation that you can control.
When pricing your product or service, you’ll have to take a few things into consideration to make sure you hit just the right balance. If you set the unit selling price too high, people probably won’t buy it, but if you set it too low, you might not be able to cover your fixed and variable costs. To help determine your price, consider these questions:
- What is your competition charging for the same product?
- Do you want to be at the low, middle, or high end of the price range?
- What is your total cost for the unit and how much profit do you want to make above that?
In the case of Lilian’s designer bag boutique, she decides to set a sales price for each bag at $100 because she wants to differentiate her bags from the more mainstream options at national chains but still wants to remain accessible to consumers in her area (while turning a profit).
You’re likely familiar with this one already. Your revenue is how much money you earn through the sale of your product or service during a specified period. It’s calculated by multiplying the number of units sold by the cost per unit.
When it came to designer bag sales this month, business was booming. Lilian successfully sold 500 designer bags, bringing her monthly total sales revenue to $50,000.
5. Contribution margin
The contribution margin is important to your business because it let’s you know how much each unit you sell is contributing toward your total revenue. This is calculated by subtracting your variable expenses from your overall sales revenue. The contribution margin formula looks like this:
Unit contribution margin = unit selling price – variable costs
For instance, Lilian’s designer bags sell for $100 but cost her $70 in variable expenses. Each bag then has a positive contribution margin of $30. On the other hand, if her variable expenses increased to $105 but the price of her bags remained the same, that item would then have a negative contribution margin, as it’s actually costing her $5 to produce and sell.
As a good rule of thumb, the higher a product’s contribution margin the better, as it has a greater positive impact on your company’s overall revenue growth. That dollar amount indicates the total earnings that are left over from the sale of a certain product, which will cover fixed expenses and in turn, turn into a profit.
6. Contribution margin ratio
This is another concept you probably weren’t taught in school, but it isn’t overly complicated. The contribution margin ratio is the contribution margin expressed in terms of a percentage of the unit price.
In other words, the contribution margin tells you the specific dollar amount that each unit contributes to your profit, while the contribution margin ratio tells you the percentage amount that product contributes to your overall profit. To calculate the contribution margin ratio, you can use the following formula:
Contribution margin ratio = contribution margin per unit ÷ price per unit
Returning to Lilian once more, we know that she sells each designer bag for $100 and that her variable cost per unit is $70. As we saw above, the contribution margin is the price of the unit, minus the variable costs. In other words, Lilian’s contribution margin is: $100 – $70 = $30. In other words, for every bag Lilian sells, $30 will go toward her fixed costs.
To calculate her contribution margin ratio, we would then use the contribution margin per bag and divide it by the price per bag, which would be $30 ÷ $100 = 30%.
As a result, when she calculates her contribution margin ratio, Lilian knows that for every dollar of revenue a designer bag makes, 30 cents or 30% is the contribution margin. She can then decide to either use this 30% contribution margin ratio to pay fixed costs or to produce a profit.
A quick review of our break even analysis inputs
Whew! We just did quite a lot of math. And with so many numbers floating around, it’s always helpful to review our inputs before we get to the final break even calculation. We now know there are six different variables that we’ll use to calculate a breakeven analysis:
- Fixed costs
- Variable costs
- Price per unit
- Contribution margin
- Contribution margin ratio
Returning to Lilian’s Designer Bag Boutique as an example, let’s take a moment to review how we determined the number for each of these inputs so that you can feel confident when you get to the final step: the actual break even analysis.
|Lilian’s Designer Bag Boutique: Break Even Analysis Inputs
|Fixed monthly costs||$2,000|
|Variable unit cost||$70|
|Price per unit||$100|
|Units sold this month||500|
|Total sales revenue||= units sold × price per unit|
|= 500 × $100 = $50,000|
|Total variable cost||= units sold x variable cost per unit|
|= 500 × $70 = $35,000|
|Total contribution margin||= total sales – total variable cost|
|= $50,000 – $35,000 = $15,000|
|Unit contribution margin||= total contribution margin ÷ units sold|
|= $15,000 ÷ 500 = $30|
|Contribution margin ratio||= contribution margin per unit ÷ price per unit|
|= $30 ÷ $100 = 30%|
Determining your break-even point
Now that you know what variables you need for your break even analysis inputs, it’s time to actually calculate the point at which your company will be in the black.
There are two ways to do this. You can either determine your break even point by calculating the number of units you’ll need to sell to cover both your fixed and variable costs, or you can calculate the dollar amount of revenue you’ll need to generate to cover expenses. Below, we’ll look at an example of each.
Calculate how many units you need to sell to break even
First, let’s look at how to calculate your break even point in terms of how many units you’ll need to sell. In order to perform this calculation, your equation will look like this:
Break-even point in units = fixed costs ÷ contribution margin per unit
The result will tell you the exact number of units you’ll need to sell in order for your business to support itself. Using the formula above, let’s return once again to Lilian’s Designer Bag Boutique.
Lilian’s break-even point in units = $2,000 ÷ ($30)
By plugging Lilian’s variables into the formula above — dividing $2,000 in fixed costs by $30 contribution margin per unit — we learn that she must sell approximately 67 bags each month to break even. Any units she sells above that add to her profit margin.
Calculate the amount of sales revenue you need to generate to break even
While the example above tells us how many bags Lilian needs to sell to break even, she could also choose to calculate her break even point in terms of sales revenue. However, the equation will change slightly. In this case, her calculation would look like this:
Break-even point in sales revenue = fixed costs ÷ contribution margin ratio
Again, when we plug in the numbers for Lilian’s business, we come up with the following equation:
Lilian’s break-even point in sales revenue = $2,000 ÷ 30%
We find that, in dollars, Lilian would need to sell about $6,700.00 worth of revenue in order to break even each month.
Adjust prices to change your results
Now is where it gets fun. Suppose our fictional bag shop owner wanted to sell fewer bags per month to meet her monthly expenses sooner. She might decide to raise her price per unit, and sell the bags for $150 each, which would result in her breaking even when she sold just 25 bags per month.
Or imagine the opposite. The owner wants her bag on the arm of every woman on the street, so she decides to lower her price to increase her sales volume, thereby making her product more accessible to more people and getting additional product exposure. If she lowered the price to $90, she would break even after selling 100 bags.
Another way to play with the numbers is to see how costs change our break even point. If our designer bag store owner wanted to break even by selling even fewer bags per month, she might want to look at reducing her costs. If she found another supplier or shipping company, and reduced her expenses per unit, she could reduce her costs and reach the break-even point sooner.
Set your prices for a profitable future
The break-even formula doesn’t rely on projections or guessing to determine how many items you’ll need to sell or how much revenue you’ll need to generate each month to keep your business afloat. Instead, it uses hard data to give you real answers about the future profitability of your business. It should, therefore, be part of any comprehensive financial analysis if you want your business not only to grow, but to thrive.