Business owners use several financial analysis tools to understand the profitability of their business and take necessary actions. One such tool is to find the break-even point, which determines exactly how much sales are required to cover the costs and start booking profits. In other words, the break-even point is the sales level at which total revenue generated is equal to the total cost (fixed and variable), meaning that at the break-even point of a company, the profit is zero. The break-even point helps small business owners and entrepreneurs to fix their product prices and also in performing cost-volume-profit analysis.
If you are a businessman or a finance professional, it’s important for you to understand the economics of break-even point and how to calculate it for profit and price analysis. This course can help you get started with the basics of business finance.
What is the Break-Even Formula?
The break-even point of a company is calculated to find out the amount of sales required to cover its expenses. It’s calculated using the following formula:
Break-even point (BEP) in unit sales = total fixed costs / (sale price – variable cost)
This is the break-even formula that companies use to calculate the number of units required to be sold in order to cover its expenses, without making a profit or loss. If the company sells more than the BEP, it books a profit whereas if the sales are less than the BEP, the company takes a loss. To calculate the break-even point in unit sales, you need to know the fixed costs, variable costs and the price of the product. For more details on break-even calculations and analysis, visit our online course on financial accounting for startup businesses.
Using the Break-Even Formula
Companies use break-even analysis to decide the price of their products, understand the costs involved and deciding on the volume of sales to be achieved to make the business profitable. We will explain this concept with an example:
Say, a company XYZ sells a product A at $250 and incurs a variable cost per unit of $60 and a fixed cost of $5 million. Then, the break-even point would be calculated as:
BEP in number of units= 5,000,000 / (250-60) = 26,316 units
And BEP in terms of sales value = 26,316 units x $250 = $6,579,000
So, the company makes a break-even analysis and finds out that it needs to sell more than 26,316 units to make profits. Now let’s consider the following scenario wherein the company feels it cannot sell that many units; in such a case, the management would then decide on taking the following actions to ensure profitability:
- Try to reduce the fixed costs (by reducing overhead expenses, rent etc.)
- Try to reduce the variable costs (by reducing wages, raw material costs etc.)
- Increase the selling price of the products
By adjusting any of these above mentioned values, the break-even point can be reduced to ensure that enough sales are achieved to cover the expenses. These decision-making situations that arise out of a break-even analysis benefit the company in taking appropriate remedial action so as to ensure viability of the business. Find out more on break-even formula and its importance in our course on financial budgeting.
The break-even analysis helps businesses on key operational aspects such as:
- Finding out when the break-even would be achieved to start marking profits
- To understand the impact of a marketing activity on revenue generation
- To understand the relationship between sales, costs and profits thereby conducting a financial analysis of the overall business
Limitations of break-even analysis
While the break-even formula helps businesses estimate product pricing, fixed costs and total revenue, there are certain things that cannot be determined thereby leading to some limitations as mentioned below:
- The break-even analysis only provides a cost estimation but doesn’t give any indication on the likely sales to be achieved with respect to the various product pricing strategies developed
- The assumption made for break-even point calculation is that the fixed costs and variable cost per unit of output are constant; this may not be true when you scale up your operations or increase wages for instance
- Break-even analysis also assumes that the entire quantity of good produced will be sold; inventories are not taken into consideration
- In a multi-product situation, break-even calculations assume a constant sales mix i.e. the relative proportions of product sold and produced are constant, which may not be true
In short, while break-even formula can definitely be used as a tool to understand the relationship between costs, volume and profit, you need other financial tools and estimation techniques to gauge the profitability of your business in a much better way. Get more insights in our course on cost accounting for entrepreneurs and small business owners.