One of the many challenges of being a small business owner is making sure your revenue at least balances out your expenses. After months, if not years of investment, you want your business to sustain itself with its own money. This pivotal moment is called break-even point.
Calculating the break-even point is a financial analysis for businesses that gives you insight on where your company stands financially. Keep reading to learn everything about this calculation and why it matters, and get the break-even formula.
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What is a break-even point?
The break-even point is the moment a business has no profit or loss. “That means the total revenues equal the total costs,” says Bill Ryze, chartered financial consultant (ChFC) and board advisor at Fiona. “It’s the point where the income from sales covers all expenses—fixed and variable.”
Why is it important?
The break-even point isn’t just a milestone, it helps business owners understand how much they need to sell to cover their costs. “It ensures the business sustains itself without incurring any loss,” Ryze says. “The break-even point also helps them decide their pricing strategies, cost management, and financial planning.”
How to calculate a break-even point
To calculate the break-even point, you need to know three variables:
- Fixed costs: These are regular costs that are independent of sales volume. For example, rent and utilities.
- Variable costs: These costs depend on sales volume. For example, manufacturing costs and packaging.
- Sales price of the products: This is the amount you charge customers for each unit sold.
Note: If your company sells a service instead of a product, you can consider a unit to be an hour of work or a specific service package. “These companies incur labor, materials, accessories, overheads, and so on, which enables them to calculate the sales price per unit by determining the total costs of providing their services,” Ryze says. “To that, they can add a markup to ensure profitability. They should also consider market rates and competitor pricing.”
Break-even point formula
The break-even formula consists in the total fixed costs divided by the difference between sales price per unit and variable costs per unit. Here it is:
Fixed costs ÷ (Sales price per unit – Variable costs per unit) = Break-even point in units
The difference between sales price per unit and variable costs per unit is the contribution margin of your business. This amount is what's left to pay the company's fixed costs.
Example:
Skincare Company X has $20,000 in fixed costs monthly, including rent, salaries, and taxes. Their product has an average sales price per unit of $100 and the variable cost per unit is $20. With this information, the owner calculated the break-even point as follows:
20,000 ÷ (100-20) = X
X = 20,000 ÷ 80
X = 250
The break-even point of Makeup Company X is 250, meaning that the company must sell 250 units of their products to cover the business expenses and not lose money.
Benefits of the break-even point analysis
If you have doubts the break-even point is the best financial analysis for your business, here's a list of benefits of this calculus:
- Strategic financial planning: The break-even analysis can help you set sales and pricing strategies to further advance your business financially.
- Better cost management: “It helps in cost control by identifying the point at which the revenue earned covers all costs,” Ryze says. For instance, you may find out that your prices are lower than ideal. “It highlights the minimum sales required to avoid losses and indicates if the sales prices need adjusting by comparing costs and market rates.”
- Better decision-making: As a consequence of a more accurate financial planning and cost management, the break-even analysis assists businesses in evaluating the financial viability of projects or products, which helps in decision-making, Ryze says.
Limitations of the break-even point analysis
The break-even point analysis also has some limitations. Here are the potential drawbacks of this calculation:
- It assumes simplistic figures. “For example, it assumes that costs and revenue are linear and constant, which is mostly untrue in real scenarios,” Ryze says.
- It doesn't account for external factors. The break-even analysis doesn't take competition or economic changes into account.
- The break-even is static analysis. “It’s a snapshot in time that doesn’t reflect the ongoing changes in the business environment,” Ryze says.
Break-even point analysis alternatives
If you need a more extensive assessment of your business health, Ryze recommends sensitive analysis and scenario planning as alternatives for the break-even formula.
“Sensitivity analysis examines how changes in key variables, such as costs or prices, impact outcomes,” he says. Similarly, scenario planning is an analysis that helps companies make flexible long-term plans. “It involves creating different scenarios, such as best case, most likely, and worst case, to evaluate potential future outcomes and plan responses.”
Because those aren't static analyses, they give business owners more than a snapshot of the present, but also a forecast of the future. “They provide a more comprehensive and dynamic view by considering various factors and potential business environmental changes, such as economic shifts, regulatory changes, technological advances, and competitive dynamics,” Ryze says.
However, keep in mind that even with limitations, the break-even point is still an important financial analysis for business and provides insight for next steps. “It’s crucial because it broadly calculates the minimum sales required to generate profits.”