In business, it is essential to understand the break-even point when launching a new product, expanding your offerings, hiring new staff, or opening a new business.
Before making any financial decisions, you should calculate your break-even point to limit your risk.
A break-even analysis will help you see where your efforts will pay off, giving you insights into whether investing your time and money into an idea is worthwhile.
The break-even analysis will tell you if your efforts will profit you or if you need to secure a loan to sustain the business before you start making profits.
In this article, we will guide you through understanding and calculating your break-even point using the break-even calculation formula.
What is the Break-Even Point?
A break-even analysis is a helpful calculation in finance. It compares the expenses of a new product, service, or business with the unit sell price to identify the break-even point.
In other words, it shows the number of sales required to cover the cost of running a business. At the break-even point, no profit is made, or money is lost.
A break-even analysis is used to determine the break-even point of a business or company.
It is not instead a financial calculation computation but an internal management tool that can be shared with regulators or investors.
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Sometimes, when applying for a loan, a financial institution may ask you to provide this analysis as part of your financial projections.
This calculation considers costs (both fixed and variable) relative to unit price and profit.
Fixed costs are those that do not change, no matter the products or services sold. They include equipment, salaries, rent or mortgage, insurance premiums, taxes, and interest on capital.
Variable costs, on the other hand, are the labor and materials required to produce one unit of a product; their costs change over time with sales. Examples include sales commissions, labor payments, raw materials, utilities, and shipping expenses.
How to Calculate Your Break-Even Point
There are two major basic formulas to help you calculate the break-even point for your business.
One is based on the number of units sold, and the other is based on sales dollars.
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Calculating Break-Even Point Based on Units
In order to determine the break-even point in units, you need to divide the fixed costs by the revenue per unit minus the variable cost per unit.
Fixed costs remain constant regardless of the number of units sold, while revenue represents the selling price minus variable costs such as labor and materials.
Use this formula: Break-Even Point (Units) = Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit).
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Calculating Break-Even Point Based on Sales Dollars
The break-even point in sales dollars is calculated by dividing the fixed costs by the contribution margin.
The contribution margin is calculated by subtracting the variable costs from the product's price. This amount is used to cover the fixed costs.
Use this formula: Break-Even Point (Sales Dollars) = Fixed Costs ÷ Contribution Margin.
The contribution margin is calculated as Contribution Margin = Price of Product – Variable Costs.
To better understand these formulas better, let’s look at their makeup components:
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Fixed Costs
These costs are not affected by the number of items sold. Examples include rent, production facilities, computers, software, and fees for services like graphic design, advertising, and public relations.
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Contribution Margin
This is calculated by subtracting an item’s variable costs from the selling price. If you sell a product for $100 and the cost of materials and labor is $40, then the contribution margin is $60. This $60 covers the fixed costs and any remaining amount is your net profit.
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Contribution Margin Ratio
This figure, usually expressed as a percentage, is calculated by subtracting your fixed costs from your contribution margin. It helps determine what you need to do to break even, such as cutting production costs or raising prices.
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Profit earned following your break-even.
Once your sales cover both your fixed and variable costs, you have hit the break-even point. At this stage, your company will neither make a profit nor incur a loss. As a result, any sales made beyond this point will directly contribute to your net profit.
When to Use a Break-Even Analysis
Businesses use this tool when considering additional costs. These costs come from adding or removing products, hiring employees, adding locations, mergers or acquisitions, or starting a new business.
A break-even analysis is a financial calculation that helps in determining the value and risk of any business.
Here are 3 cases where a break-even analysis can be helpful:
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Business Expansion
A break-even analysis can inform CFOs or business owners about how long it will take for an investment to generate profits.
For example, it can calculate the minimum sales needed to cover the expenses required to enter a new market or open a new location.
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Lower Pricing Strategy
Some businesses lower their prices to outperform competitors. A break-even analysis helps determine how many additional units need to be sold to cover the price reduction.
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Risk Management
A break-even analysis helps manage risks associated with business decisions. For instance, it can evaluate the risks involved in adding or deleting a product from the product mix or implementing new production processes.
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Budgeting
A break-even analysis can also help businesses budget for new staff. Businesses looking to hire new staff can use it to calculate the fixed and variable costs associated with a new employee and the number of sales needed to break even on the price of the new hire.
The Limits of Break-Even Analysis
The break-even analysis is a useful business tool, but it does have limitations.
First and foremost, it overlooks market demand, so it cannot predict the sale of the required units.
Additionally, it requires a decision on the time and effort invested in achieving the break-even point. This means considering whether it's worth dedicating a substantial amount of time and effort over several months to reach it or if it's more beneficial to focus on other profitable activities.
Furthermore, if product demand is low, you might need to adjust your pricing strategy.
Reducing prices can increase the break-even point, meaning you'll need to sell more units to cover costs.
Lowering prices may result in increased variable expenses, which can make it more challenging to achieve the break-even point, so caution is necessary.
Conclusion
A break-even calculation formula is not just a one-time task. It is an ongoing process that needs to be an integral part of your regular financial planning. It will help you adapt to changes in the market environment, adjust your strategies accordingly, and stay aligned with the market competition.
So, it is essential to master the art of break-even analysis because it will equip you with the tools needed to manage the complexities of running a successful business.