Posted by Kanika Sinha
March 2, 2022 | 6-minute read (1209 words)
Potential investors not only want to understand what return to expect on their investments in the business but also to discern the point when they will realize this return. And that’s why it’s crucial for businesses to conduct a break-even analysis. It helps them determine costs — fixed and variable — and set prices appropriately and thereby forecast when they are likely to become profitable.
Central to the break-even analysis is the concept of the break-even point.
What is the accounting break-even point?
A business’s break-even point is the necessary level of output where revenues equal costs — or better said, the inflection point at which a company begins to generate a profit.
If a business has reached its break-even point, this means it is operating at neither a net loss nor a net gain (i.e., “broken even”). All incremental revenue beyond this point would contribute toward the accumulation of more profits for the company.
What is the break-even point formula?
There are two basic formulas to derive the break-even point. One is based on the number of units of product sold and the other on points in sales dollars.
How to calculate a break-even point based on units: This method involves dividing the fixed costs by the contribution margin wherein the contribution margin is determined by subtracting the variable costs from the sale price of a product.
How to calculate a break-even point based on sales dollars: This method entails dividing the fixed costs by the contribution margin ratio which is determined by dividing the contribution margin per unit by the product’s sale price.
|Break-even point (units) =
|| Contribution margin
(selling price – variable costs)
To get a better understanding of the above formulas, let’s take a more detailed look at their components:
Fixed costs: These are business costs that are not affected by the number of items sold or production volumes, such as interest expense, rent paid for storefronts or production facilities, computers and software. It also includes insurance, salaries and fees paid for services like graphic design, advertising and public relations.
Variable costs: As the name suggests, this cost is directly associated with production and varies with the level of output. For example, the cost of raw materials used as components of a product typically varies based on the number of units produced.
Revenue: It is the money generated from normal business operations and is commonly calculated as the average sales price times the number of units sold.
Contribution margin: It is calculated by subtracting a product’s variable costs from the selling price. For example, if you’re selling a product for $100 and the cost of materials and labor comes to $40, then the contribution margin would be ($100-$40) $60. This measure, which is $60 in the example, is then used to cover your fixed costs, and if there is any money left after that, it would be your net profit.
Contribution margin ratio: It is calculated by dividing contribution margin per unit divided by the sale price.
How to calculate a break-even point in accounting
Let’s say that a company sells products priced at $20 per unit. In terms of its cost structure, we assume that fixed costs consist of the lease, depreciation of its assets, salaries, and property taxes amounting to a total of $50,000 per year. The variable costs associated with producing the product, including raw material, factory labor and sales commissions, compute to $10 per unit.
The contribution margin, that equals (selling price – variable costs), comes out to be $10.
|Break-even point (sales dollars) =
|| Contribution margin ratio
(contribution margin per unit ÷ selling price)
Thus, using the formula, the break-even point comes to be 5,000 units where the company will report a net profit or loss of $0.
Alternatively, you can compute the break-even point by dividing the fixed costs by the contribution margin ratio. Based on the given example, the contribution margin ratio equals $10÷$20 or 50%.
|Break-even point (units) =
| 5,000 =
Therefore, the break-even point in sales dollars comes out to be $100,000. Hence, all incremental sales beyond this point would contribute toward the accumulation of profits.
Application of break-even point formula
Determining your break-even point isn’t the end of your calculations. Once you crunch the numbers, you might discern that you have to sell a lot more products/services than you realized to break even.
The next step should be to ask yourself whether the current business plan is realistic, or whether you need to introduce some changes like raising prices or finding a way to cut costs, or both. Further, you should also consider whether your products/services will succeed. Just because the break-even analysis gives you the number of products you need to sell, there’s no guarantee that they will actually sell in the market.
Ideally, the break-even point should be determined before starting a business so that you get a good idea of the risks involved and are able to figure out if the business is worth it. However, that doesn’t mean that this metric does not hold any value for existing businesses. They can use the break-even point before launching a new product/ service to find out if their potential profit is worth the startup costs.
Examples of break-even points in accounting
The accounting break-even analysis isn’t just useful for business planning and forecasting the profit-making stage. Here are some ways that you can use this financial tool in your daily operations and planning.
Prices: If your break-even analysis shows that your current price is too low to let you break even in your desired timeframe, then you might want to increase the cost of your products/services. However, make sure to check the cost of comparable items so that you don’t end up pricing yourself out of the market.
Materials: It will help you ascertain if your cost of materials and labor are unsustainable. In case, they are, you will have to figure out a way to maintain your desired level of quality while lowering your costs.
Capital allocation: Having an understanding of the required output to break even can help you set revenue targets accordingly, thus aiding in better allocation of capital.
Planning: When you have figured out how much money you need to make, it becomes easier for you to set longer-term goals. For instance, if you are planning a business expansion and thinking of moving into a larger space, you are likely to experience higher rent. Perusing the break-even point, you can determine how many more items you need to sell to cover new fixed costs.
Goal setting: Knowing the exact number of units you need to sell or the amount of money you need to make to break even will help you set more concrete sales goals. Additionally, having a specific number to target in mind will serve as a powerful motivational tool for your team.
New launches: Estimating the break-even point on an individualized product-level basis can help you assess the economic viability of adding a new product/service.
|Break-even point (sales dollars) =
||Contribution margin ratio
| 100,000 =