Is your small business in the red, profitable, or perhaps somewhere in between? Whatever the financial status of your business venture today, the break-even point can help you improve upon it in the future.
Continue reading to learn the definition of the term and how to calculate the break-even point.
What’s a break-even point?
You might have heard the term “breaking even” used in personal finance to describe a point at which your expenses and income are equal. The term “break-even point” has a similar meaning in business accounting.
The break-even point refers to the point at which total revenue equals total cost. When a business has reached that point for a product or project, it has generated the product or project sales volume needed to cover both the fixed and variable costs of the business during a certain period of time.
The business incurs neither a profit nor a loss at the point of breaking even. The good news? This means your business did not spend more money than it pulled in for a venture. The bad news is that it did not make gains, either.
Why should small businesses know their break-even point?
Calculating the break-even point, a process sometimes undertaken as part of a larger financial analysis, is useful for multiple reasons:
- It tells you how many units of a business offering you need to sell to avoid losses
- It helps you forecast when you will turn a profit
- Fixed and variable costs are identified and controlled
- It helps you identify whether or not your per-unit selling price needs adjustment
- It helps you assess your margin of safety. This figure amounts to actual sales minus break-even sales, which tells you much sales could still fall before a venture turns unprofitable)
- The viability and risk of a venture before undertaking it is assessed
- It can easily and quickly be calculated
How to calculate a break-even point
You can calculate the break-even point either in terms of units or sales dollars.
The formula based on units is:
Break-Even Point (in units) = Fixed Costs ÷ Contribution Margin
- Contribution Margin = Per-Unit Sales Price – Variable Costs
- Fixed costs are those that don’t change as sales volume changes (e.g., insurance or rent)
- Variable costs change based on sales volume (e.g., labor, material and manufacturing costs)
Let’s take a look at an example. MileHigh Inc. wants to calculate its break-even point for a new widget. It estimates its fixed costs at $10,000, variable costs at $1.00 per unit of product and assigns a per-unit sales price of $5.00.
We can calculate the break-even point in units as follows:
$10,000 ÷ ($5.00 – $1.00)
$10,000 ÷ $4.00 = 2,500 units
Therefore, MileHigh Inc. needs to sell 2,500 widgets to cover its fixed and variable costs.
The break-even formula based on sales dollars is:
Break-Even Point (sales in dollars) = Fixed Costs ÷ Contribution Margin Ratio
Contribution Margin Ratio = Contribution Margin ÷ Per-Unit Sales Price
Using the same example above, we can calculate the break-even point in sales dollars as follows:
$10,000 ÷ ($4.00 / $5.00)
$10,000 ÷ $0.80 = $12,500
Therefore, MileHigh needs to sell $12,500 worth of widgets to cover its fixed and variable costs. As you might have noted, making $12,500 is the equivalent of selling 2,500 widgets as noted above. So while they use different variables, both formulas can be used to reach a similar conclusion about the financial prospects of a business venture.
MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.