Conducting a break-even analysis is a crucial tool for small business owners. If you’re planning on launching a business, writing a business plan, or just exploring a new product, knowing your break-even point can tell you whether or not a product or service is a good idea.
In this guide, we’ll cover what a break-even point is, why it’s critical to calculate, how to calculate it, and additional factors you should consider.
What is the break-even point?
The break-even point is where an asset’s market price equals its original cost. Put another way; the break-even point is when the total revenues of a certain production level equal the total expenses of producing that product. For small business owners, it’s essentially the amount that you need to earn in order to cover your costs.
Why you should know your break-even point
So, why is knowing your break-even point so important? Here are a few important reasons to consider.
Risk comes in various forms, but break-even points can help you understand the viability of certain products before they’re even launched.
For example, before even sending an order to a factory, you can already know how many units you need to sell and what expenses will go into making that product. Understanding this is key whether you’re launching a business for the first time or starting a new product line.
Identify unseen expenses
Running a break-even analysis forces you to outline all potential expenses associated with an initiative. Expenses that you’d otherwise miss without it. Usually, these expenses come from the fixed and variable costs of production. In this process, you can often identify unexpected expenses that you may not have considered before.
Appropriately price your products/services
Because your break-even point concerns the price relationship to your expenses, you can calculate different break-even points based on sold units or different pricing schemes. For example, you may find that your product is unprofitable at a certain price point except at extremely large scales.
If that’s the case, you can explore higher price points. However, it’s important that you do not do this in isolation. Instead, use this exercise to understand potential pricing options and begin testing them with your target customers.
Prepare for funding
If you’re seeking funding for your business, this information is often expected or required by lenders and investors. It helps them gauge the viability of your idea and determine what level of funding is appropriate. For you as a business owner, it can help you determine how much funding you think you’ll need and even identify how you’ll use those funds.
How to calculate the break-even point
To calculate your break-even point, you’ll need to know the following:
- Fixed costs: Expenses that remain consistent no matter your sales volume.
- Variable costs: Expenses that change depending on your sales/production volume.
- Sales price: The price that you intend to sell the product/service for.
Break-even point formula
The break-even point is calculated using your fixed costs and your contribution margin. The contribution margin is the selling price of the product minus the total variable costs. Your selling price is usually the amount you place on any customer invoices.
The contribution margin formula is:
Contribution Margin = Selling Price – Total Variable Costs
Once you have the contribution margin, you then take the total fixed costs per unit and divide those costs by the contribution margin. This will give you the break-even number of units required to offset your costs.
The break-even point formula is:
Break-Even Point = Fixed Costs / Contribution Margin
Break-even point example
Now that you know the formula for calculating your break-even point let’s put it into practice.
Imagine you are the owner of a small paper company and considering adding a new line of paper to your available products. You expect to sell a ream of paper for $5.00.
The variable costs of the ream of the paper include:
- $1.00 for the paper itself
- $0.50 for the packaging of the ream
- $0.50 of costs to package each ream
According to this information, you have $2.00 in variable costs. Using the formula mentioned above, we can calculate the contribution margin for your paper ream:
$5.00 – $2.00 = $3.00
Next, we’ll incorporate fixed costs to determine how many units need to be sold. After holding an office meeting in the conference room, you determine that the following fixed costs are associated with producing reams of paper:
- $50.00 in salaries
- $50.00 in office rent
- $50.00 for monthly shipments from the paper factory
Your total fixed costs come to: $50.00 + $50.00 + $50.00 = $150.00.
Lastly, we’ll calculate the break-even point: $150.00 / $3.00 = 50 units. To break even, you would need to sell 50 reams of paper.
Maximizing your break-even point formulas
You can also utilize this calculation to figure out your break-even point in dollars. This is done by dividing the total fixed costs by the contribution margin ratio. You can figure out your contribution margin ratio by taking the contribution margin per unit and dividing it by the sales price.
Your contribution margin ratio using the data from the above example is:
$3.00 (your contribution margin) / $5.00 (price per one ream of paper) = 60%.
Finally, divide your total fixed costs ($150.00) by your contribution margin ratio (60%) to calculate the break-even point in dollars:
$150.00 / 60% = $250.00 in sales
You can confirm your findings by multiplying your break-even point in units (50) by the sales price ($5.00):
50 x $5.00 = $250.00
What is a standard break-even time period?
The standard break-even period is hard to predict and fully depends on your business. However, once you know your break-even point, you can gauge the time it will take to break even more accurately.
Your break-even period is the amount of time it takes you to sell enough units to break even. This means that the only thing holding back your ability to break even is how fast you sell your units.
The formula to calculate your break-even time period is:
Break-Even Time Period = Break-Even Units / Amount Sold per Period (Period)
If we return to the paper company example, we can estimate what the break-even period is. After reviewing your financials, you learn that the average number of reams you expect to sell daily is 5. Now, take your number of break-even units (50) and divide them by the amount sold in a given period (5):
50 / 5 = 10. Under this analysis, you would break even in approximately 10 days.
However, it’s important to remember that fixed costs, which are an important part of calculating your break-even point, may accumulate faster than you can sell your product. In that case, you’ll need to factor this into your analysis.
How to lower your break-even point
Everyone wants to lower their break-even point because it typically leads to greater profitability at a faster rate. But how do you lower your break-even point? The key thing to remember is that it’s a ratio of your fixed and variable costs. To reduce your break-even point, you’ll need to lower one or both.
One of the most efficient ways to reduce your break-even point is to start by reducing variable costs. Keep in mind that variable costs are associated with each unit. Other fixed costs, those that exist regardless, like the $20-$80 you pay for your employees’ no medical life insurance every month, can be more difficult to eliminate because they are essential.
What you can do with a break-even analysis
Conducting an initial break-even analysis is incredibly useful when starting a business. But, did you know that you can use it on an ongoing basis as part of your management process? Here are a few key uses you can leverage.
Determine if your prices are correct
A break-even analysis can be used to continuously audit and fine-tune your pricing strategy. If you find sales are missing expectations, you can reference this calculation to easily understand what quantities must be sold if you decide to adjust the price.
Explore current fixed and variable costs
You can also explore how different costs impact your bottom line. At the end of the day, your business needs to know what costs are impacting its ability to generate revenue. A break-even analysis can help you understand whether some products may be costing you more money than their worth. For example, products with low contribution margins or ratios might be too expensive to keep in production.
Narrow down financial scenarios
Finally, you can use your break-even analyses as part of any forecast scenarios that you explore. By changing numbers in your formula, you can test different types of prices and quantities based on perceived consumer interest. This can help inform a larger analysis of your sales, cash, and expenses based on how reasonable your price and volume adjustments are.
Other metrics to consider
Now that you understand break-even points and break-even analysis, you’ll be able to put them to work for your business. Remember, this is just a piece of measuring business performance and there are other valuable metrics you should be tracking. You can do this manually with spreadsheets, leverage budgeting and accounting software, or better explore future performance with LivePlan’s performance tracking and forecasting features.
Whatever option you choose, the important thing is that you are aware of these metrics and actively using them. It will help you better understand the health of your business, make more strategic decisions, and ultimately grow your business.