In short:
A break-even formula will tell you when and how you can expect to recoup the money you invested.
At break-even point, you have neither made profit nor suffered a loss.
You can lower your break-even point in two ways: either raising prices and lowering costs.
A break-even formula is a useful calculation that compares the expenses of a new product, service or business with its sale price to identify the break-even point.
In other words, it is an analysis that will show the number of sales required to cover the cost of running a business. At the break-even point, there is no profit made or money lost. Sales have reached a point that covers the cost of selling them.
What is a break-even formula?
You can use accounting software to determine your break-even point, but it’s simple enough to calculate yourself. The formula for this is:
Break-even quantity = fixed cost / (sales price per unit – variable cost per unit)
Example:
John decides to open a toy store. To know how many toys he needs to sell to break even on his investment, he uses a break-even formula.
From his calculations, his fixed cost for a year is £10,000 and £0.5 as a variable cost per unit. From a competitor study and other calculations, he decided upon £6 as his unit price. From the formula above, John’s BEP (break-even point) would be:
10,000 / (6-0.5) = 1,819. Thus, John would have to sell 1819 toys within a year to break even.
Example:
John decides to open a toy store. To know how many toys he needs to sell to break even on his investment, he uses a break-even formula.
From his calculations, his fixed cost for a year is £10,000 and £0.50 as a variable cost per unit. From a competitor study and other calculations, he decided upon £6 as his unit price.
From the formula above, John’s BEP (break-even point) would be: 10,000 / (6-0.5) = 1,819.
Thus, John would have to sell 1819 toys within a year to break even.
How does it work?
A break-even formula is used to determine the break-even point of a business or company. This financial calculation isn’t a computation but rather an internal management tool that can be shared with outsiders like regulators or investors. Some financial institutions request this analysis as part of your financial projections when applying for a loan.
This financial calculation considers costs (both fixed and variable) relative to unit price and profit.
Costs that do not change regardless of the products or services sold are known as fixed costs. Costs of equipment, salaries, rent or mortgage, insurance premiums, taxes on property, and interest paid on capital are examples of fixed costs.
Variable costs combine the costs of labour and material required to produce one unit of a product; this cost is influenced by changes in sales. Sales commissions, cost of labour payment, and expenses for raw materials, utilities, and shipping are examples of variable costs.
To calculate the total variable cost, the cost to produce one unit is multiplied by the number of units produced. For instance, if producing a unit costs £20, and you made 20 of them, the total variable cost is £400.
To calculate the contribution margin (sales price – variable costs), you will have to deduct the variable costs from the selling price of the product. So if you sell a product for £100 and the variable cost is £10, then the contribution margin is £90.
Note, the contribution margin contributes to balancing fixed costs. To get the average variable cost, you will have to divide the total variable cost by the number of units produced.
Generally, you get a lower break-even point from lower fixed costs, and that’s only possible when variable costs are less than sales revenue.
Why do you need a break-even formula for your business?
There are many ways in which a break-even formula can prove useful to SMEs.
It’s a key element for carrying out financial projections for new products, product expansion, and start-ups. Analysing the results provides information on the capital required to bring an idea to life, allowing you to see if you need to borrow funds to make it happen.
This analysis can be used for a variety of purposes, including:
New product development: A break-even analysis can help businesses determine the feasibility of a new product launch. By calculating the fixed and variable costs associated with the product, businesses can estimate how many units they need to sell in order to break even.
Product expansion: The use of a break-even formula is helpful when evaluating the potential profitability of expanding a product line. By comparing the fixed and variable costs of the new product to the fixed and variable costs of the existing product line, businesses can estimate how many units they need to sell in order to avoid a loss on the expansion.
Start-ups: Using a break-even formulas is essential for start-ups, as it helps them determine how much capital they need to raise in order to get started. By calculating the fixed and variable costs associated with the start-up, businesses can estimate how many units they need to sell in order to break even and become profitable.
Risk management: It can be used to manage risks associated with various business decisions. For example, businesses can use a break-even formula to evaluate the risks involved in adding or dropping either a product or new production processes.
Budgeting: Break-even analysis can also be used to budget for the addition of new staff. By calculating the fixed and variable costs associated with a new employee, businesses can estimate how many sales they need in order to break even on the cost of an extra member of staff.
Standard duration for a break-even analysis
A standard break-even time is between 6-18 months. If your analysis suggests that it will take longer to reach a break-even point, you may need to alter your plans. This can take the form of increasing the price, reducing the costs, or both. Any break-even point beyond 18 months is a strong risk indicator. Ideally it should be much shorter period.
When to use a break-even formula
Businesses make use of these formulas when there’s potential that additional costs may be incurred. These costs may arise from adding products, employees, locations, or even a new acquisition. It helps to determine the value and risk of any business, especially in any of these two events:
1. Business expansion
A break-even analysis can provide information to CFOs or business owners on the duration required for an investment to generate profits. The formula calculates the minimum sales needed to cover the expenses required to enter a new market or open a new location.
2. Lowering of prices
When trying to outperform competitors, some businesses adopt the strategy of lowering prices. A break-even formula is useful in this scenario as it helps to determine how many additional units must be sold to cover the reduction in price.
Lowering your break-even point
You can lower your break-even point by raising prices and lowering costs. Of course, while this sounds ideal for you, it doesn’t necessarily sound so good for prospective customers. Keep your eye on customer trends and the rest of the market to ensure that your pricing remains competitive.
In addition, you’ll need to consider every element of costs (such as delivery and product quality) before you reduce your price to avoid damaging your brand.There’s no quicker way to lose custom than offering inferior products or service.
Alternatively, should a sudden increase in demand catch you off guard, you may even find that outsourcing certain services may help to reduce your costs.
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