How to Calculate the Break-Even Point – Analysis, Definition, Formula & Examples

March 27, 2023

8 min read

To determine the profitability of one’s business, it is important to calculate the break-even point. The Break-even point is the point where your total expenses match the total revenue, a point without any profit or loss, i.e. break-even. To put it in layman’s terms, the point where you finally recover all the capital costs borne to set up the business.

Components of break-even analysis

There are two components of the break-even analysis:

Fixed costs

Fixed costs are costs that are determined when an idea goes into the production stage and depends on the level of production. Fixed costs include rent, salaries, taxes, interests, labour, depreciation and other operational costs. These costs are free from production and must be incurred even in the absence of production.

Variable costs

Variable costs are expenses that directly relate to the volume of production. Variable costs include raw materials, packaging, transportation, and other expenses related to production.

Why is calculating the break-even point is important?

If a business is making a lot of money, it does not necessarily mean that it is running profitably. Knowing what the break-even point for your business is will help you in deciding costs, allocating sales budgets, and preparing business plans. Additionally, calculating the break-even point is critical in identifying critical sales drivers, whether it is the volume of sales, average production cost, or sales price.

Bu understanding your break-even point, you can identify:

Profitability of current products/services
Point of declining sales where business starts to incur a loss
Number of units to sell before earning profitability
Impact of reducing price/volume of sales
Increase of price or volume of sales to make up for the increase in fixed costs.

Calculating break-even point

There are more than a few ways to calculate your break-even point. It can be based on sales or the number of units.

Break-even point as per units

Break-Even Point (Units)= Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit).

Fixed costs are expenses that do not change irrespective of the number of units sold. Revenue is the price for which products are sold minus variable costs like materials, labor, etc. To calculate the break-even point per unit, you need to divide the fixed cost by revenue per unit, subtracted by variable cost per unit.

Break-even point based on sales

Break-even point= Fixed Costs ÷ Contribution Margin

To calculate Break-even points based on sales, divide fixed costs by the contribution margin. The contribution margin is determined by subtracting variable costs from the price of the product.

To simplify both the formulas mentioned above, the components used can be described as –

i) Fixed costs: Fixed costs include rent (store & production), assets like computers, software, advertising, and PR costs, etc.

ii) Contribution margin: The contribution margin is determined by subtracting the item’s variable cost from the selling price. The differential is used to recover the fixed costs.

iii) Contribution margin ratio: This number is calculated by subtracting fixed costs from the contribution margin. Once the contribution margin ratio is determined, you can proceed to calculate your break-even cost by cutting down on expenses or increasing revenue.

iv) Profit: When your business sales are equal to the fixed and variable costs, you achieve break-even. Any revenue earned beyond that contributes to net profit.

Applying the break-even analysis

Once you have successfully formulated your break-even point, you will have to apply the analysis on actionable tasks to achieve that point.

At this stage, if your current plan seems unfeasible, eg. you may need to sell a lot more products to achieve break even, it is a good time to analyze the situation in a holistic approach.

This is why businesses perform break-even analysis before they start operating or before they market a new product. This helps them figure out if the new venture or product would reap such profits that would make the expenses worthy of reaching that goal.

Break-even planning is done for many activities and operations and isn’t just limited to determining start-ups and product launches. Break-even planning can be used by businesses in their day-to-day planning and operations, such as:

Adjust Price: Businesses can adjust the cost of their products if they think that the current price is too low to achieve the derided results in their targeted time frame.
Material & Labor cost: Break-even analysis could also help you to analyze labor & material costs. If your business is spending too much on labor and materials, you could strategize and implement mechanisms to lower the cost of production without compromising on quality.
Launching New Products: Variable costs and fixed costs should be kept in mind before launching any new product.
Planning: Break-even analysis can help businesses formulate long-term growth strategies by identifying the time frame to cover new fixed costs like the increase in rent when moving to a bigger facility, better production techniques, etc.
Goals: Your business can achieve short and long-term goals in a much more viable way, with clearly aligned objectives within each level of the organization

Break-even analysis is in itself a component of the sensitivity or scenario analysis which is performed for financial modeling purposes. With the Break-even analysis, businesses can solve the number of units they need to sell, the price of each unit, and the cost needed to achieve break-even and start reaping profits for your business.

When is a break-even analysis important?

A break-even analysis is required under the following conditions:

Starting a new business

The analysis of break-even points is very important for start-ups. It helps them to decide the viability of a business idea, along with formulating pricing strategies and costs.

Creating a new product

Break-even analysis is also a key focus area for businesses whenever they launch a new product or service in the market, especially if high costs are involved in manufacturing the product or operating the services.

Alteration in business model

Whenever a business alters its business model, costs can change considerably depending on whether they are downsizing or scaling up. Thus, break-even analysis is also important for organizations to determine selling prices while changing their business models.

Break-Even Analysis FAQs:

1. What is sensitivity analysis?

Sensitivity analysis is a tool used for financial modelling by analyzing different values of independent variables affecting a specific dependent variable under specific conditions. It is used for analysis under various disciplines like Biology, Economics, Maths, etc.

2. What are the benefits of performing break-even analysis?

i) Smarter pricing model ii) Cover fixed costs iii) Set revenue target iv) Identify expenses v) Business funding vi) Starting a new business

3. What are the ways to reduce break-even point?

Following are some of the ways to reduce break-even point: i) Elimination of unwanted fixed and variable costs ii) Control over pricing by reducing discounts, vouchers, coupon, etc. iii) Boost sales pf products yielding high profit iv) Leveraging the latest technology and tools v) Outsourcing production

4. Are there any drawbacks of the Break-Even point?

i) Simple interpretation pf past and future business operations ii) Narrow view of profit determination by considering cost and output only iii) This analysis is based on the assumption that the selling price remains fixed, which is not always the case. iv) Without an effective accounting team, it is important the analysis could yield incorrect results.

5. What is contribution margin in a product?

Contribution margin is the excess of the selling price of product and it’s total variable cost.

6. What to keep in mind before performing break-even analysis?

● Break-even refers to the point where cost of production equals to revenue generated. ● In order to perform break-even analysis efficiently, one needs to have a sound knowledge of costs involved in business ● Break-even analysis is not a decision making tool per se, but a strategic planning tool to determine viability off operations.

7. What are fixed costs?

Fixed costs are business expenses which would remain the same irrespective of production quantities. Fixed costs include: ● Rent ● Depreciation ● Research & Development ● Marketing costs ● Administration costs

8. What are variable costs?

Variable costs are expenses related to the level of output. These can include: ● Raw materials ● Labour ● Fuel ● Maintenance

9. What is margin of safety?

Margin of safety is the extent by which actual or projected sales can exceed the break-even sales. It represents the amount gained or lost which defines how far or near the break-even point is.