For anyone starting their business, the most common question they have to ask is, “when will you break even”? So, how to calculate the break-even point and what exactly does it mean in the business context?
Generating revenues the moment you start your business is not possible for any company. So whether it’s a small retail store or you are starting a wholesale business, you need to give your business some time to start generating revenues. The break-even point is when your business generates revenue that is equal to the cost of operation. In simple words, a break-even point helps a business know when will their products become profitable.
If your current revenues fall below the break-even point, it indicates a loss. If it goes above this figure, you are generating a profit. Now, the question is how to calculate the break-even point? Below we have listed the methods you can try to calculate the break-even point for your business. Let’s take a look:
Methods for Calculating the Break-Even Point
There are quite a few break-even point formulas that can help you find this figure for your business. Here are the most popular ones:
- Based on Units
You need fixed cost, variable cost, and the number of units sold for this formula. First things first, subtract the variable cost from the revenue you earn for every unit sold. Divide the result by the fixed cost, and you will get a break-even point for your business.
Variable cost includes the worker’s payroll, cost of materials, etc. Fixed cost is the price that remains the same regardless of the number of units sold. Here’s the formula:
Fixed cost / (Per Unit Revenue – Variable Cost) = Break-Even Point
- Based on Sales Dollars
For this method, you need to calculate the contribution margin, which is the product’s price minus variable cost. Once you have found the contribution margin, divide the fixed cost by this amount to get the break-even point. To understand the formula better, let us first understand each component included in both methods.
- Fixed Cost: It has nothing to do with the items sold. Fixed cost includes the fixed prices that you pay to the landlord, graphic designer, public relations service, and other services you need for an extended period.
- Contribution Margin: To calculate the contribution margin, you need to use the item’s selling price and variable cost. Then, deduct the variable cost from the item’s selling price. For example, if you sell a product for $100 and its variable cost is $30, your contribution margin is $70. This amount will be used to pay for the fixed cost, such as the rent or for computer and software systems. The amount left after you have paid the fixed cost from the contribution margin will be your net profit.
Now that you know the formula for calculating the contribution margin and the break-even point for your business, you can use it to decide how can you raise or lower the selling price or cut your expenses to go above the break-even point.
How You Can Use the Break-even Analysis?
Businesses use the break-even analysis to figure out the break-even point, however, it should not be confused with the final calculation. When you get the numbers, you might realize that you need to sell more products than you imagined in order to arrive at break-even. It is important for a business to find its break-even point and decide whether it should raise the prices of the products, cut costs, or implement both.
At this point, you also need to figure out if your products will sell in the market. Sure, you have got an estimate of the total number of products you are supposed to sell to start making a profit, but that does not guarantee you will be able to achieve the minimum-sales point.
It is better to conduct the break-even analysis for your business using the above formulas before you start your business. It will give you insights into the total variable cost, fixed cost, estimated revenue, and financial risk involved. To put it in simple terms, the break-even analysis gives you a clear picture of whether your business idea is worth it and how long will it take to make your business profitable. For those with an established organization, you should conduct the break-even analysis at the time of launching a new range of products and services. Before you bring any new product to the market, calculate the break-even point to know whether it is worth it.
How Can a Business Use the Break-even Point in their Regular Operations?
You don’t only need the break-even analysis when getting started with your business, but this calculation is needed for many business operations.
For example, if your recent break-even analysis shows that you have priced your items too low and that’s why you are unable to attain the break-even value, then it’s a sign you need to raise the prices. Similarly, if you are paying too much for the raw materials, find ways to lower this price without compromising on the product quality. You can shop around different vendors to find the same raw materials at the lowest price or ask for a discount. The vendors are highly likely to negotiate the deal if you buy raw materials in bulk. If not, you always have the option of switching to another vendor.
Break-even analysis also helps you with planning. When you are planning to expand your business on a global level or open a branch of your company in a new city, you can use the break-even analysis to identify the estimated sales and revenues you need for your expansion project. Similarly, when you are launching something new, always conduct a break-even analysis first.
ConclusionUse the break-even point formula listed above to understand the break-even point of your business. Based on this, you can raise your prices and lower the expenses to reach the break-even point smoothly.