How to calculate break even point and use it in your business plan

Break even point analysis and how to apply it

Every business owner will have heard of Break-Even point. It might seem terribly obvious what it is and how to calculate it but it requires a little more consideration than just understanding it. Commerce and industry can throw down some pretty tough challenges that can fundamentally affect a business’ financial position so it’s important to maintain and analyse your break-even point on an ongoing basis, to ensure you always know whether or not your business is making a profit or a loss.

What is the break even point?

The break even point is the point at which total cost and total revenue are equal to one another, essentially meaning you have ‘broken even’.  Another way you could describe it is when profit and loss balances.

When you start out as a business, this expenditure might incorporate wages, rent, business rates, tax, supplies and consumables. As your business grows, so too does its expenditure. For a company to survive it needs to cover these costs with the revenue that it makes.

Start ups will often have a greater cost than revenue initially, with their aim being  to quickly reach their  break even point as to ensure they are not spending more than they make. Consider it getting to a safe base. An enterprise that spends more than it makes is not going to survive very long, unless they have access to investment, but even then investors would expect  to see a return on that.

Once your business starts operating beyond break even point, generating more revenue than cost, it becomes profitable. This means you are covering your costs and have some left over. The difference between your cost and your revenue is your net worth. The lead objective in any company is to grow the net worth by becoming continually more profitable. To do this you need to keep your business costs minimal and maximise sales with a great business strategy.

Of course, you will need to increase your business costs to factor in company growth – additional staff, bigger premises etc, This requires youto run a tight ship on your accounting which means having a good break even analysis – more about that later.

When a company is sold, buyers are looking at its net worth to understand its financial value, although there are other reasons to buy or sell companies, such as data volume and brand name.

How to calculate break even point

The break even point is equal to the total fixed costs divided by the difference between the unit price and the variable costs. In other words start with your fixed business costs and divide this by the figure you get when you subtract your variable costs from your unit price. Here is the formula below:

Fixed cost / (unit price – variable costs) = breakdown point in units.

To find the break even point using this formula you need to know exactly what your costs are for each component.

Fixed costs

These are business costs that generally remain consistent and are unaffected by your sales activities. Fixed costs are you big overheads such as rent and utilities as well as wages for your permanent staff.

Variable costs

These are also costs to the business but ones which vary depending on sales activity. Examples of variable costs include manufacturing costs, supplies, delivery and some wages if you use additional contractors for a job.

Revenue

Your revenue per unit is the selling price of the product.

When considering fixed costs we look at these as a total cost of overheads. The price (revenue) and the variable costs are unit costs.

The main dominator of the formula is the unit aspect – the price per unit, minus the variable cost. This is called the contribution margin. The variable costs are deducted from the price and the contribution margin left is used to cover the company’s fixed costs. It is at this point where your break even point is established.

What is break even analysis, and how to apply it to your business

All enterprises conduct a break even analysis to determine the number of units of the revenue required to cover both the fixed costs and variable costs, to ensure the business is profitable. A breakdown analysis is usually conducted by a management accountant or similar to get a clear financial picture commercially.

There are a few different functions of a break even analysis:

1. To determine fixed costs from variable costs

The process is called classification and it’s undertaken to distinguish which costs are classed as overheads and which are the costs that change according to sales activity. Some costs such as staffing are difficult to classify, especially if you upscale with staff to meet periods of high delivery.

2. To understand the contribution margin

After classification of business costs, you then need to work out the true revenue after the variable costs associated with the product or service have been deducted.

3. To define sales expectations

Once you have your sales price point, minus any associated costs and you know your fixed cost obligations, you can then work out how many sales you need to generate over what period, to break even. You can use this to set sales targets and to drive sales and marketing strategies.

4. To react to change

Break even points are subject to change. If your sales suddenly plummet due to a change in consumer behaviour, technical issues, supply issues or another factor, your business revenue may no longer cover your costs. If your revenue decreases, you can look at things like offers, price increases (subject to situation) or a reduction in overheads.  Lowering your break even point with reduced fixed costs means you are making it easier to cover your costs again.

The break even analysis should be visible to members of the finance office such as CFOs and management accountants as well as heads of sales, marketing and production or operations.

Conclusion

Changes occur all the time in business and very often the reasons for these changes are beyond your control. It’s critical to keep a running break even analysis to see where you might need to raise prices, cut costs or look at new and innovative ways to sell. The components of the break even point formula impact one another.  If one of the units increases or decreases, it’s about adjusting to ensure you are, at the very least breaking even, but more desirably, on a path towards profit growth and a greater net worth.