We've all heard the term "breaking even." It sounds pretty self-explanatory, but in reality, there's a little more to break-even analysis.
In short, the break-even point is that golden number your business must surpass to make a profit. Knowing your break-even point is important because it tells you how much revenue (sales) your business has to generate to cover expenses. Anything above this amount provides you with extra cash to reinvest in your business and/or pay your own salary. But calculating the break-even point is like trying to predict weather. Shifting variables make it difficult to lock down firm figures with perfect accuracy. However, there is a simple process called a break-even analysis that helps you understand how profits change as revenues fluctuate. It is a useful tool for forecasting your break-even point in any given situation.
A break-even analysis explores the relationship between expenses and revenues. Revenues are the amounts you earn for selling your product. Expenses are your operating and production costs. There are three types of expenses:
- Variable expenses are tied to your revenues. Revenues go up, variable expenses go up. Revenues go down, variable expenses go down. Materials are variable expenses that fluctuate with revenues. The more product you sell, the more money you must spend on materials to make your product. Disposal services, sales tax, and shipping are other examples of variable expenses that increase or decrease with your revenue numbers.
- Fixed expenses remain constant even when your revenues rise or fall. Your rent is a fixed expense that will not change with the number of products you sell from day to day. Labour, depreciation, and utilities are other examples of fixed expenses.
- Mixed expenses are part variable and part fixed. Sales commissions, for example, add a variable expense to fixed labour costs. The best way to handle mixed expenses in your break-even analysis is to divide them up. Place the variable portion with your variable expenses and the fixed portion with your fixed expenses.
Contribution Margin Equation
Now that you understand the basics of revenues and expenses, let's play with some break-even analysis. We begin by calculating contribution margin, which is the amount of money left over from selling one unit of product after the total variable expenses of producing it are covered. Here is the contribution margin equation:
Revenue per unit — variable expenses per unit = contribution margin per unit
Let's pop some hypothetical numbers into the equation for demonstration purposes. First, add up your variable expenses. If you think the following list is a gross oversimplification, you're correct. Your real-life list may be longer and your figures much different. For the sake of clarity we'll keep this one simple. Here is your imaginary list of variable expenses per one product unit:
Sales commissions................$ 7
Waste disposal fees...............$ 1
Total variable expenses = $20
Variable expenses to produce one product unit total $20. If you were to sell each unit for $100, here is what your contribution margin equation would look like per unit:
($ 20 Variable expenses)
= $ 80 Contribution margin
The contribution margin tells you that your variable expenses of $20 per unit are covered and you have $80 per unit to contribute to your fixed expenses.
The Break-Even Point Equation
Now that we know your contribution margin, we can factor in your fixed expenses to calculate your break-even point. Here is the break-even point equation:
Fixed expenses per day ÷ contribution margin per unit = break-even point in units per day
Again, let's apply some simple hypothetical figures to clarify. First, let's find the sum of your fixed expenses per day:
Total fixed expenses = $480
That results in the following question: how many units would you have to sell to meet your fixed expenses of $480 per day? Using the break-even point calculation, we can easily find the answer by dividing your fixed expenses per day by your contribution margin per unit:
$480 Fixed expenses
÷ $ 80 Contribution margin
= 6 Units break-even point
You must sell six units per day to cover your expenses. Every unit that your business sells beyond six per day will make you a profit.
Would you like to draw a fixed salary from your profit or put money aside for business improvements? You can determine how many units per day your business has to sell after the break-even point to fulfill your goals. Simply add the amount to your fixed expenses. Say you want to draw $400 per day in salary. Using our established scenario, you can add that $400 to your total daily fixed expenses of $480 for a new total of $880 fixed expenses per day. Let's run the break-even point equation again to find out how many units you must sell per day to generate a $400 profit:
$880 Fixed expenses
÷ $ 80 Contribution margin
= 11 Units
You already know that selling six units per day covers your expenses. To make an additional $400 per day to cover your salary or business plans you must sell five additional units every day for total daily sales of 11 units. Think you can do it? That's the joy of running a business!
Break-Even Point in Revenue Dollars
You can determine the break-even point in revenue dollars instead of units by dividing the company's total fixed expenses by the contribution margin ratio (contribution margin divided by revenues). Let's walk through it using our established figures. First, calculate your contribution margin ratio:
$80 Contribution margin
÷ $100 Revenues
= $ 0.80 (80%) Contribution margin ratio
Your contribution margin ratio is 80%. Now you can find out your break-even point in revenue dollars by dividing your total fixed expenses by your contribution margin ratio:
$480 Total fixed expenses
÷ 80% Contribution margin ratio
= $600 Break-even point in revenue dollars
Translation: you must make $600 a day in revenue to cover your expenses. You can verify the break-even point of $600 in daily revenue by referring back to the break-even point in units. We calculated that you need to sell six units per day to break even. At $100 per unit the necessary sales in dollars would be $600. Math is awesome.
So that's a brief introduction to break-even analysis. Now that you know how to do it, you can play with various scenarios to forecast profitability. And keep in mind, break-even analysis is a living thing; it's never final. What if you found a cheaper material? Or maybe new equipment would decrease your labour costs? Or maybe your rent's about to go up. There are countless factors that will impact profit per product unit, but break-even analysis allows you to quickly run the numbers and get a snapshot.