Performing your break-even analysis is an essential function in economics and cost accounting. By understanding how to calculate break-even points in both units and revenue, you can figure out how many of a certain product you need to sell to cover your costs.
These figures also provide vital insights into break-even price and production efficiency. Let’s take a look at how you can perform this type of analysis.
A break-even analysis is an economic and business concept that refers to the precise point whereby total revenue and total cost are equal.
Businesses that reach the break-even price will have a $0 profit/loss at the end of the year. This calculation is vital for determining business strategy when it comes to pricing, sales, and managing fixed and variable costs.
Figuring out how to determine break-even point will ultimately tell you at which point you start to make a profit.
If a business doesn’t expect to reach its break-even point until the third financial quarter, this could indicate something is deeply wrong with how the organization operates.
The break-even point can be calculated both in terms of units sold and dollar revenue.
Do you need to know how to find the break-even point?
This is a relatively simple calculation to perform. Before discussing the formula and working through an example, you will need to pinpoint specific figures first.
The break-even analysis formula is the mathematical calculation you need to follow each time you perform this type of analysis. Larger businesses with more comprehensive product ranges can carry out this calculation for each specific product.
Here’s the break-even formula for units:
Break-Even Volume in Units = Fixed Costs/(Revenue Per Unit – Variable Costs Per Unit)
We will break down each aspect of this formula, so you know what numbers you need to find the break-even point in units.
Fixed costs are the expenses incurred by the business that never change depending on output. These costs may still change from year to year, but they are not based on increases or decreases in your overall business production.
Examples of fixed costs include rental costs, utilities, employee salaries, office supplies, and the costs of building machinery.
For most businesses, these costs will remain relatively static each time you carry out a break-even calculation.
Revenue per unit, or sales per unit, is simply the selling price of the unit. This is what the customer pays for the product.
Variable costs changed based on production. These are the costs that change regularly.
Examples of variable costs include the raw materials used to manufacture the product and the salary of employees directly involved in the manufacturing process.
For most companies, variable costs will be their largest expense.
It’s also important to mention that revenue per unit and variable costs per unit are used to determine the contribution margin.
The contribution margin can be determined by subtracting variable costs per unit from revenue per unit.
The remaining amount is used to offset fixed costs.
For example, if a company sells a product for $10 and variable costs per unit are $2 per unit, the contribution margin is $8 per unit.
You need this figure to calculate the break-even point in dollars.
For many business owners, the math behind profitability is difficult to understand. Fear not, though, as we will examine how to compute a break-even point using real-world examples in the following text.
The next calculation will look into break-even points in units. Knowing how to find break-even quantity tells you how many of a certain product a business needs to sell to cover its fixed and variable costs.
The Big Sneaker Company wants to know how to find break-even quantity for its latest pair of sneakers. The owner is interested to know how many sneakers the business has to sell to cover its costs.
In this case, each pair of sneakers is priced at $60. The fixed costs for the Big Sneaker Company are $30,000, whereas the variable costs are $25 per unit.
So, what would the break-even point be?
$300,000/ ($60-$25) = 8,571
In other words, the Big Sneaker Company needs to sell 8,571 pairs of sneakers to cover its fixed and variable costs. If it sold exactly 8,571 sneakers, its profit/loss would be reported as $0.
Now, let’s look at how the Big Sneaker Company can implement changes to alter the break-even point.
For their second year, they decide to outsource much of their production to China. By doing this, the Big Sneaker Company reduces both its fixed and variable costs.
They continue to sell their sneakers for $60 per pair, but their fixed costs are now just $100,000, and their variable costs have been trimmed to $10.
$100,000/ ($60-$10) = 2,000
In year two, the Big Sneaker Company now has to sell just 2,000 pairs of sneakers to cover both their fixed and variable costs. Suddenly, the company’s future appears much brighter.
Finally, let’s take a look at year three.
The Big Sneaker Company has a new competitor producing a similar pair of sneakers for a much lower price. The business needs to lower its prices to compete.
Since it’s reduced its fixed and variable costs by so much, it decides to decrease its sneaker prices to $40 per unit.
Its break even point now looks like this:
$100,000/ ($40-$10) = 3,333
To break even in its third year, it must now sell 3,333 pairs of sneakers at the new price.
In this second example, the Big Sneaker Company wants to calculate the break-even point in dollars.
Again, we will use the above three examples.
The break-even analysis formula you need to use here is:
Break-Even Volume in Sales Dollars = Fixed Costs/Contribution Margin Ratio
To calculate the contribution margin ratio, you need to use the following formula:
Contribution Margin Ratio = (Sales – Variable Costs) / Sales
So, in year one, the Big Sneaker Company has a sales price of $60 and variable costs per unit of $25.
The contribution margin ratio is calculated like so:
($60 - $25) / $60 = 0.58
If we take this figure, the break-even volume in sales dollars would be:
$300,000 / 0.58 = $514,241
We can confirm this figure by multiplying the break-even volume in units, which was 8,571, and multiplying it by the sales price.
Note, there is some difference in number simply because contribution margins tend to be more complex in real-world business environments. However, as long as you’re in the same ballpark, you know you’ve performed the calculation correctly.
In these examples, we have reduced the number of decimal places to keep things simple.
We’ll also carry out the same calculation for year two of the Big Sneaker Company.
($60 - $10) / $60 = 0.83
$100,000 / 0.83 = $120,481
As we can see, the Big Sneaker Company’s second year move to China has reduced the number of dollars it has to generate through sales by nearly $400,000. This would indicate a hugely successful move for this business.
If we use its year three price decrease to calculate the dollar break even point, it would look like this.
($40 - $10) / $40 = 0.75
$100,000 / 0.75 = $133,333
Even though it’s decreased its unit price by 33%, the actual change in sales dollars needed to reach the break-even point isn’t that different. This shows just how influential reducing fixed and variable costs can be.
You may look at the break-even analysis formula and wonder if it’s worth your time.
It’s a valid point. Business owners want to avoid getting bogged down in numbers and paper calculations. If you’re going to perform one calculation, this is the one to perform. The insights you gain from these numbers are invaluable.
Here are just some of the reasons why you should take the time to find your break-even point.
Determining how changing both fixed and variable costs can guide you in setting budgets for the year ahead.
By altering your prices, you can reduce or increase the number of units you need to sell. This is particularly helpful when displaying the effects on the break-even point graphically. Of course, marketing considerations and your competitors have to be taken into account when deciding on a sales price.
Putting your fixed and variable costs into the context of a break-even point can help you to control your costs. A higher break-even point may indicate that your costs are unsustainable and that you need to make changes.
If material and production costs are high, break-even analysis can reveal whether a product is viable to produce in the first place. Big hikes in raw material costs may make a business’s flagship product unviable to produce and sell in its current form.
Setting the break-even point as a target can be used to motivate your staff. If you anticipate that you’ll hit your break-even point by June and you hit it by May, this can serve as a form of motivation.
As we can see, break-even calculations play a huge role in directing the future of your business. When performed regularly, they show business owners where to direct their efforts and demonstrate whether the way the business operates needs to change.
The outcome of a break-even calculation plays an influential role in future planning for any business. The wrong figures, however, can lead to businesses making the wrong decisions.
Central to this methodology is a point of sale (POS) system that reports accurate figures every single time. One of the best investments you can make is in your POS equipment. Doing so will allow you to have the correct raw data to make the best decisions.
Contact Revel today to find out more about implementing a business enterprise POS system, and let us help you achieve more than just breaking even!