How to Calculate the Break-Even Point – Analysis, Definition, Formula & Examples
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 which 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 profitable. 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 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, labour, etc. To calculate the break-even point as 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 contribution margin. 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, softwares and advertising and PR costs, etc.
ii) Contribution margin: Contribution margin is determined by subtracting item’s variable cost from the selling price. The differential is used to recover fixed cost.
iii) Contribution margin ratio: This number is calculated by subtracting fixed costs from 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 equal to the fixed and variable cost, 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 analyse 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 costing 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 analyse labor & material costs. If your business is spending too much on labour and materials, you could strategize and implement mechanisms to lower cost of production without compromising on quality.
- Launching New Products: Variable cost and fixed cost 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 modelling purposes. With the Break-even analysis, businesses can solve the number of units they need to sell, 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 in the following conditions:
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.
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