The break-even point is a theoretical concept in business that seems to determine the level of activity (in terms of units sold) which would leave a business with neither profit nor loss. Mainly focused on in terms of manufacturing businesses the concept is useful in many more scenarios including retailers, services and other specialised trades. We shall go into the importance of the Break-Even point, the formula for the break-even point, the different elements of the formula and some practical applications

Why the Break-even Point matters

Break-even point is informative of your lowest acceptable point of operation. It informs of the point at which your business generates as much money as it uses. So perhaps it can inform you of the number of minimum orders you need per month to avoid losing money. In other applications, it can inform you of when to negotiate pricing and how much to negotiate pricing. Airlines do this with last-minute discounted ticket pricing. Where a manufacturer or retailer gets a special order it can be used to make sure that if a special price is negotiated, it is not to the detriment of the business. Finally, it can be used to profit target on specific orders.

How to Calculate Break-Even Point

In order to calculate the simple break-even point for your business there are 4 things you need to know;

What goes in

Selling Price

The price at which individual units of the item will be sold. If you have a mix of products you can assume an ideal mix based on historical operations or reliable industry information.

Variable product costs

Otherwise known as direct costs these are costs directly involved and traceable on a per unit basis to the product. A manufacturer would look labour & material costs, a reseller would look at inventory cost and creative would look at the time taken to create a project such as a website.

Fixed Costs

These are costs the business incurs, for business reasons which do not vary directly with the level of activity. Referred to as fixed because you are liable to pay them whether you produce or not. This includes items such as office rental, warehousing space, internet bills and other similar costs. Sometimes they can referred to as stepped fixed costs which simply means they will increase within a certain range of activity, consider an inventory heavy business that may need to hire extra space to store addition inventory per every 10000 units.

What comes out

Margin

The first product of the break-even point calculation is the margin, this the difference between the selling price and the variable costs of the product. This is a very important financial metric for any business owner and it tells you a lot about any business. Sometimes referred to as Contribution margin (you’ll see why shortly) a product that sells for $100 with direct costs of $50  has a margin of $50. A common mistake is referring to this as profit but it is not.

Break-even point

You arrive at the break-even point by dividing the total fixed costs of the business by the margin per unit. Earlier I said the margin is not profit because the individual products must contribute to the burden of fixed costs. Hence the term contribution margin. Continuing with our product from above, image fixed costs to the business of $15000, the business would need to sell 200 units (10000/50=200) to make zero profit or loss. Put in an easier way to understand, above 200 units and you’re profitable, below 200 and you’re sinking.

The break-even analysis takes away the assumption by many that margin is equal to profit. It also educates us that a profitable product and a profitable business are not the same thing. The full formula for the break-even point is as follows

The other applications I mentioned are simple substitutions in the formula. If you were targeting a certain level of profit after fixed expenses (say $20000 in our example) you would add the $20000 to the fixed costs and therefore have 30000/50=600 units. The revenue target for that would be $60000 (600 units at $100 per unit).

If a client came to ask for a special order of 300 units but wanted to buy them for $75 per unit the new contribution margin would be $25 per unit. Assuming there are no other existing orders and none expected, selling at this price the minimum quantity to break even is 400 (10000/25=400) and therefore it would be advisable to reject the offer.

It can become really complex as we add more variables and scenarios and I would encourage a little more research on the subject. However, if you understood this article you are perfectly capable of making the majority of decisions you will need to use the break-even analysis.