“Break-even analysis” is one of those basic business terms that lots of people throw around. But for many people (including those who use the expression), it’s not quite clear exactly what it means, let alone how to run a break-even analysis.
In this article, we will walk you through basic break-even calculations and highlight some variables that will help you create the perfect formula to find your business’s break-even point. If you’re just starting a small business or thinking about starting one, understanding break-even calculations will be invaluable in guiding your path to profitability.
- What is a Break-Even Analysis?
- Building Your Break-Even Formula
- Finding Your Break-Even Point
- Adjusting Prices and Fine-Tuning
- Your Break-Even Analysis for Success
What is a Break-Even Analysis?
A break-even analysis is a company’s method of determining it’s break-even point — the moment when a company is no longer losing money, but it hasn’t started making money yet. If it passes the break-even point, a company is profitable.
Put simply, a break-even analysis calculates how much a company needs to sell to cancel out total costs. If you were running a lemonade stand with no employees and no rent, a break-even analysis would be simple: How many cups of lemonade do I have to sell to cover the cost of the lemonade mix? As we’ll learn, however, a break-even analysis usually needs to take a lot more into account, especially as a business adds employees, facilities, marketing, and other costs.
A break-even analysis will help you with pricing strategies, as you will be able to determine the number of unit sales you need at a given price for your total revenue to pass both your fixed costs and variable costs. (More on fixed and variable costs to come.)
Most business plans will have a rough break-even analysis to either show lenders a company’s approach for profitability or serve as a target sales goal for an internal team. It can also be helpful in the early planning stages of a company. A rough break-even analysis can help founders decide if they’re pursuing the right business model before they go too far down a given path.
Even if you’re an established business, a break-even analysis can help you implement a fresh business strategy or take stock of your business.
Building Your Break-Even Formula
When building your business’s break-even formula, you need to understand six components that will (most likely) go into the calculation. If you’re running a very simple business, like our lemonade stand example from above, you might not need to use all these components, but it’s helpful to understand them regardless.
1. Fixed Costs
Fixed costs are your business’s expenses that never change, no matter how many units you sell. These costs stay consistent no matter what is happening with your business. (Some, like utilities, may vary based on the time of year but will remain more or less the same.)
Fixed costs would include things like rent, property taxes, utilities, and payroll.
2. Variable Costs
Variable costs will go up or down depending on your company’s level of production and the number of additional units that need to be sold during a given month. These costs can include raw materials, shipping costs, sales commissions, or the cost of direct labor needed for production.
Variable costs tend to go up when business is good, but they still need to be accounted for. Likewise, sometimes variable costs are out of your control — like how the price of gas could affect a delivery business. Calculating total variable costs can be more complex than fixed costs, but a good break-even analysis will anticipate and understand these costs and how they can change.
3. Price Per Unit
The price per unit is what you charge for everything you sell. If you sell one thing, this part of the equation is easy. If you sell lots of different products, however, calculating all the various prices per unit can be more complex.
Throw in sale prices or other marketing initiatives, and things can quickly get complicated.
Still, nailing the selling price for your products or services is incredibly important. If you go too high, you risk losing customers. Set it too low, and it may be difficult to cover costs. Business owners need to understand the marketplace and the competition’s price per unit in order to set the right sales price and keep cash flow coming into a business.
Revenue is how much a company earns through sales. You find it by multiplying the cost per unit by the number of units sold during a specific period. Again, as a business grows more complex and offers varying services and products, this calculation can get tricky.
5. Contribution Margin
A contribution margin is how a business figures out how much each unit sold will contribute toward total revenue.
It is calculated by deducting variable expenses from your total sales revenue.
On a per-unit basis, the formula to determine your contribution margin is the unit selling price minus the variable costs to produce the unit. This will give you your unit contribution margin.
Unit selling price – variable costs = contribution margin per unit
Let’s look at this way: Say you sell a pair of shoes for $100. It costs you $65 in raw materials and labor to make — these are your variable expenses. Your unit contribution margin for that pair of shoes is $35.
If the price of labor and materials went up to $110, your unit contribution margin for the shoes would now be negative $10, which is how much you’d be losing money each time you sold a pair of shoes.
Some businesses are OK with negative unit contribution margins for certain products, especially if they can help bring in new customers or grow a business. But most businesses will want a positive number and will try to find the highest dollar amount to bring in without hurting sales.
6. Contribution Margin Ratio
The contribution margin ratio is just another way of expressing the contribution margin, but this time it’s in terms of the percentage of the individual unit price. It’s calculated by dividing the dollar amount of the unit contribution margin by the price per unit.
Unit contribution margin ÷ price per unit = contribution margin ratio
This sounds complicated, but it’s actually really simple. Say we use the example above of the shoes.
When the variable costs are $65, you already know the contribution margin for each unit is $35. To get the contribution margin ratio, you divide that by the cost of the unit:
35 ÷ 100 = 0.35, or 35%
That’s it. That’s your contribution margin ratio.
Finding Your Break-Even Point
You may be asking why we spent all this time learning about contribution margins and contribution margin ratios. While they’re helpful to know by themselves, the real reason is that they will make your break-even calculations incredibly simple.
A break-even point will determine exactly how many units you need to sell to cover both fixed and variable costs, giving you the exact dollar amount of revenue you’ll need to cover total expenses.
Calculate How Many Units to Sell to Break Even
To find your break-even point in units, it’s your fixed costs divided by the contribution margin per unit:
Fixed costs ÷ contribution margin per unit = break-even point in units
Let’s use the shoe analysis from above, and say you have $3,000 a month in fixed costs. To find your break-even point, you’d calculate the following:
$3,000 ÷ 35 = 85.7
Your business would need to sell 86 pairs of shoes monthly to break even. Anything above that will contribute to your profit margin.
Calculate Total Sales Revenue Needed to Break Even
Want to find the break-even point in sales revenue? All you need to do is tweak the above formula to divide by the contribution margin ratio instead of the contribution margin per unit:
Fixed costs ÷ contribution margin ratio = break-even point in total sales
So with the same calculation, we’ll plug in:
$3,000 ÷ 0.35 = $8,571.43
This is the total monthly sales revenue needed to break even.
Adjusting Prices and Fine-Tuning
The great thing about the break-even analysis is you can tweak certain components to change the break-even point. Business owners can raise the price per unit to try to reach a break-even point with fewer sales or drop a price to try to increase sales volume and get to profitability that way.
Finding the sweet spot of cost per unit — while factoring in variable costs that can change due to the amount of production needed — is half the fun of building a business plan. Get it right, and you will be well on your way to running a thriving business.
Your Break-Even Analysis for Success
A good business plan won’t just guess at profitability — it will look at data to determine exactly what a business needs to do to start making money. A thorough and well-run break-even analysis will help business owners understand exactly what they need to do to start earning money. It also lets them zero in on the perfect price point to entice customers and still keep their business profitable.