As a small business owner, making sales, no matter how successfully, doesn’t ensure your business will make a profit if you don’t understand basic accounting principles. Knowing your break-even analysis is one such principle that can help you make important financial decisions about your business by determining when you will break-even on your investment, and start making a profit.
What is a break-even point (BEP) for a business?
A breakeven point is when total costs and total revenue are equal. It’s the sales level you need to reach to cover all of your costs. Your business cannot be profitable until it has reached this point.
What is a break-even analysis?
A breakeven analysis is a calculation that tells small business owners what quantity of product must be sold to be profitable. It helps entrepreneurs come up with a pricing strategy that will not only cover costs but will generate a gross profit.
How to calculate break-even point
To identify your business’s break-even point per product or service, you must identify all your costs—for both operating your business and making your product. Here’s the formula for a break-even analysis that calculates how many products you need to sell to break even:
Break-even point in quantity of units sold = Fixed costs/(Price per unit – Variable cost per unit)
Types of costs
It’s essential to include all the fixed and variable costs of your business to calculate a break-even point.
Fixed costs
Fixed costs are the costs that stay the same, regardless of other factors like production output. Rent and insurance could be two examples of fixed costs.=
Variable costs
Variable costs depend on how much product is produced and sold. If you manufacture or sell a higher quantity of your product, the variable cost will increase, and vice versa. Raw materials and payment processing fees are two examples of variable costs.
Types of break-even calculations
You can investigate different options for your business using the break-even point. Here are four ways to calculate a break-even point using the formula above.
- Quantity of sales: how many units will I have to sell to reach the break-even point?
- Price per unit: how will changing the sales price per unit affect my break-even point?
- Variable costs: how will changing my variable costs per unit affect my break-even point?
- Fixed costs: how will changing my overall fixed costs affect my break-even point?
Example of a break-even analysis
Imagine a child’s lemonade stand has a fixed cost of $10 per month in rent, paid to the parents. Each glass of lemonade sells for $1, and the variable cost per unit is $0.10 for lemonade ingredients.
Calculation of break-even point by unit
How many glasses of lemonade need to be sold per month to become profitable?
Break-even point in glasses sold = Fixed costs/(Sales price per unit – Variable cost per unit)
10/(1 – 0.10) = Break-even point
Breakeven quantity of sales = 11.11
The break-even analysis indicates the lemonade stand will break even when a little over 11 glasses of lemonade are sold, and will make a profit when 12 glasses of lemonade are sold.
Calculation of break-even point by sales price per unit
Should the child increase the price per unit? While this will depend on a variety of market conditions, break-even analysis can also come in handy here.
Remember our trusty formulas:
Fixed costs/(Sales price per unit – Variable cost per unit) = Break-even point
Say we want the break-even quantity of sales to be 10, and not 11.
10/(Sales price per unit – 0.10) = 10
Sales price per unit = $1.10
In this case, if the child wanted to reach a break-even point at 10 glasses of lemonade, without changing any other variables, the price needs to go up to $1.10 per glass of lemonade.
Calculation of break-even point by fixed costs
Let’s say the lemonade business is booming, and it’s time to hire a sibling at a fixed salary of $1 per month. How will this affect the break-even point? How many glasses of lemonade need to be sold at $1 each to break even?
Fixed costs/(Sales price per unit – Variable cost per unit) = Break-even point
Fixed costs are now $11 instead of $10.
11/(1 – 0.10) = Break-even point
Breakeven quantity of sales = 12.22
If the child’s fixed costs increase by $1 per month, and the selling price remains the same, then just over 12 glasses of lemonade need to be sold to break even, and 13 need to be sold to make a profit.
Calculation of break-even point by variable costs per unit
Now say there is a lemon shortage, and the variable cost per unit increases to $0.50. How many glasses of lemonade will the child need to sell to reach the break-even point?
Fixed costs/(Sales price per unit – Variable cost per unit) = Break-even point
10/(1 – 0.50) = Breakeven quantity of sales
Breakeven quantity of sales = 2
If the variable cost per unit increases to $0.50, the child will have to sell 20 glasses of lemonade to break even and at least 21 to make a profit.
Why is a break-even analysis important?
As the examples above illuminate, there are many ways a break-even analysis can impact an entrepreneur’s business decisions. It can help ascertain how variables in cost, price, and quantity sold can impact your business’s profitability.
Cost calculation
A break-even analysis can help you to determine whether your business will remain profitable if you increase your company’s fixed costs—if you choose to move to a bigger and more expensive office space, for instance, or hire another salaried employee.
Budgeting and setting targets
A break-even analysis can help you budget by providing an estimate of your profitability in an upcoming month, quarter, or year.
Motivational tool
A break-even analysis can help you to set sales benchmarks and, hence, motivate you to work harder when you know the profitability of your business is at stake.
Margin of safety
A margin of safety is the difference between the amount of expected profitability and the break-even point. By comparing the break-even point with the expected profitability you can easily flag when sales aren’t on track to be profitable.
Keep in mind, this information may change over time due to market conditions, and therefore it’s worth conducting a break-even analysis of all of your products and services on a regular basis.
Tips for lowering your break-even point
If the results of your initial break-even analysis aren’t what you had hoped for, let’s look at how you can change your current plan to reach a break-even point that works for your business.
Reduce fixed costs
If your business has a high number of fixed costs, it can create a lot of pressure on expenses with sales revenue. The more you can reduce fixed costs, the less revenue your business will need to earn to break even.
For example, if you’re considering opening a storefront but the rent for your preferred space represents a high fixed cost for your business, you might opt for a smaller storefront or explore subleasing a portion of your space.
Reduce variable costs
Variable costs, such as manufacturing or shipping, fluctuate based on your sales volume. To reduce your variable costs, you might consider negotiating a lower cost by offering to purchase a minimum quantity every month.
If you sell a product, you could research lower-cost materials to manufacture your goods or investigate more affordable shipping methods.
It can sometimes be easier for more established businesses to reduce their variable costs because they can often negotiate volume purchase discounts with their suppliers.
Increase your selling price
If you’re unable to break even based on the current price of your product or service, you may need to increase that price. By raising your price, you reduce how much you need to sell in order to break even.
When evaluating this option, it’s important to consider what your customers are willing to pay and how their expectations may change if your product or service goes up in price. For example, your customers may expect a higher-quality product or more responsive customer service.
In some cases, your sales volume may decline as your prices go up, but as long as the increase in price is greater than the dip in sales volume, it may still be the right option for your business.
Improve your sales mix
Rather than raising prices across the board, if your business sells multiple products or services, you could focus on increasing the sales of products and services with high contribution margins.
This might mean pivoting your marketing efforts to emphasize high-margin products or, if you employ salespeople, increasing commissions on these higher-ticket items.
What are the limitations of a break-even analysis?
Breakeven analysis is a helpful tool for many entrepreneurs, but it’s important to know its limitations when using this calculation in your business plan.
Doesn’t account for customer demand
A break-even analysis can offer a sense of how much you need to sell to break even, but it doesn’t tell you if your business can actually succeed in selling everything it produces.
Consumer demand for particular products and services is rarely stable over time, which means customer interest in your business may go up and down.
Many businesses end up with unsold stock. In addition to losing money by paying to produce items that don’t sell, this may also create additional storage or insurance costs for your business.
The break-even analysis calculation also doesn’t account for new competitors entering the market that could impact the demand for your product or compel you to re-evaluate your pricing model to be more competitive.
May not work for businesses with multiple products
While break-even analysis for a single product is fairly straightforward, the calculation gets more complex if your business sells more than one product or service.
If your business offers more than one product or service, your fixed and variable costs may be split among various products. It can be challenging to decide which products to assign to which costs to perform your break-even analysis.
A break-even analysis is most useful for businesses that sell one product. Entrepreneurs who sell multiple products, on the other hand, may find the calculation limiting.
Less effective for long-term planning
The break-even analysis can be useful for short-term planning but its accuracy tends to diminish over time as the costs used in your initial calculation naturally fluctuate.
For example, rent could increase, interest rates on your business loans could rise or fall, or your suppliers’ prices might increase or decrease.
A break-even analysis represents a snapshot of your business at a single point in time, limiting its ability to help you plan for the future.
Key takeaways
A break-even analysis is a simple tool for entrepreneurs to estimate their business’s profitability. By understanding the variables impacting your break-even point, you can better evaluate elements of your pricing model that may need adjusting to give your business the best possible chance to earn a profit.
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