As a small business owner, you are keenly aware of the importance of having a clear sense of financial positioning. Understanding where you are financially helps you shape strategy, priorities, and operations.
One of the most essential financial calculations you should have at your fingertips is the break-even point. Based on your sales and expenses, the break-even point represents the moment when each additional sale generates a profit.As seen in the recent post, Business Plan Calculators: The Quick Guide, there are excellent tools available to help you learn how to calculate the break-even point for your new business.
Using our step-by-step guide and one of the many small business plan calculators helps you determine your break-even point.
Defining the Break-Even Point
Simply put, the break-even point is where total revenue is equal to total costs. It is the point a business has reached on a product or project where the sales volume has been sufficient to cover both fixed costs and variable costs. Your business is no longer spending more than it brings in, but it has not made any gains, either.
Knowing your break-even point helps you:
- Understand the number of units necessary to avoid losses.
- Forecast when the business first turns a profit.
- Gain a deeper understanding of fixed and variable costs and how to control them.
- Identify potential per-unit pricing changes.
- Assess the viability and risk of a new venture before launching.
Types of Break-Even Point Calculations
Before running a break-even point calculation, it is important to be clear on certain terms:
- Fixed costs: These are expenses that are not affected by sales volume, such as rent, loan payments, marketing costs, and franchise fees.
- Variable costs: These costs are those that change with the number of sales made, such as materials and manufacturing expenses.
- Contribution margin: This is calculated by taking the selling price of a unit and subtracting the variable costs for that unit. For example, if your product sells for $500 and the costs of making the item are $300, your contribution margin is $200 per unit sold. You can use this margin to pay your fixed costs. Any money left over is your net profit.
- Contribution margin ratio: This is usually expressed as a percentage and is calculated by taking the contribution margin and subtracting revenue per unit.
To illustrate, consider a company that has the following figures:
- Fixed costs: $10,000
- Variable costs per unit: $300
- Selling price per unit: $500
- Expected unit sales: 60
There are two ways to calculate a break-even point commonly used among businesses – using product units sold or sales dollars.
To calculate the unit-based break-even point, use the following formula:
Break-Even Point in Units = Fixed Costs ÷
(Selling Price Per Unit – Variable Costs Per Unit)
Here is the calculation using our example figures:
50 Units = $10,000 ÷ ($500-$300)
If 60 units are sold, then the company would have a net profit of $2,000.
The other method used is the revenue-based break-even point. It’s calculated by using this formula:
Break-Even Point in Revenue = Fixed Costs ÷ Contribution Margin Ratio
Contribution Margin = Price of Product – Variable Costs
Contribution Margin Ratio = Contribution Margin (per unit) – Revenue (per unit)
In our example, the contribution margin is $500 - $300 = $200. The contribution margin ratio is $200 ÷ $500 = 0.4
The revenue break-even point is:
$25,000 = $10,000 ÷ 0.4
The company would need to generate $25,000 in sales to break even.
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