Without knowing your break-even point, you can’t make informed business decisions. It’s the key to determining your pricing and profitability and therefore is fundamental to your success.
Your break even calculation identifies the number of sales required (in dollars or units) before all business expenses are covered and profit begins (before tax).
Don’t know what your break-even point is? Then it’s time to work it out.
Step 1 – Calculate fixed and variable costs
The first step is to establish your fixed and variable costs.
Fixed costs are bills your business always has to pay, regardless of its sales volume.
Also known as overhead costs, they could include:
- Salaries for permanent staff
- Rent on your premises
- Interest on debt
This is calculated in total, not on a per-unit basis. You need to know how much money it takes to run your business per year because you’ve got to cover these costs in addition to your direct costs before you can start making a profit.
Variable costs move with your levels of sales. More sales equals more costs, less sales equals less costs.
These are the the costs that go into creating your product or service such as direct materials, direct labour and freight.
- Your total budgeted fixed costs per year.
- An average overall variable cost for each product or service you sell (the Variable Cost per Unit).
- The contribution margin per unit which equals the sales price per unit less the variable costs per unit.
- The contribution margin ratio which equals the contribution margin per unit divided by the sales price per unit.
An example:Bob is a leather craftsman and runs a bag manufacturing business out of a rented workshop near his home. The budgeted fixed costs for this business per year are $100,000 which includes the rent on the shed, wages, bookkeeping costs and advertising etc. Bob’s most popular product is a leather backpack that he sells for $250. It costs him $110 to manufacture the bag (the variable costs per unit) taking into account the leather, thread, zips, direct labour, packaging and freight. Knowing the selling price and variable cost for each unit we can calculate the contribution margin in dollars per unit. The contribution margin is the amount per backpack which can contribute to meet the business’s fixed costs (overheads). In this example, our selling price is $250 and our variable costs are $110 so the contribution margin for each backpack sold is $140. The contribution margin ratio (which we’ll need later on to calculate our break even point) is calculated by dividing our contribution margin ($140) by the sales price per unit ($250) which in this case gives us a ratio of 0.56.
Step 2 – Determine your break-even point
Your break-even point can now be calculated using the following formula:
Fixed Costs ($100,000) divided by Contribution Margin Ratio (0.56) = Break-even Sales Volume ($178,571.43)
Based on these calculations, if Bob sells more than $178,571.43 of bags he’ll make a profit. This equates to 714 bags.
Step 3 – Using your break-even point
Once you’ve worked out your break-even point, the next step is to work out whether the sales volume you’ll need to break even is realistic and achievable.
You can also use your break-even calculation to see the effect of changes in costs on your business. If Bob was able to source cheaper materials and reduce the variable cost per backpack, he’d need to sell fewer units to break even. If his sales then remained the same, he’d make more profit.
Step 4 – Repeat regularly
To be of real value to you, you will need to recalculate your break-even on a regular basis as your selling price, variable costs and fixed costs will change over time.
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