Break-even point – simply explained

Every business pro­fes­sion­al would like to even­tu­al­ly generate profit. But this is only achieved when revenue is higher than costs. And suf­fi­cient­ly high turnover is in most cases not generated right after the company is founded. During the first few years, costs are often higher than turnover. This means that the company is initially situated in the loss zone. Should turnover increase over time, the company will move closer to the profit zone. If costs and turnover are at the same level, the company has reached the break-even point threshold.

The BeP threshold separates the loss zone from the profit zone. At the break-even point, the company makes neither a profit nor a loss.

If you want to determine the BeP for a single product, it will be specified as a quantity of items (single-product analysis). The BeP for several products or for an entire company will be specified, in contrast, as the amount of turnover that must be earned in total (multi-product analysis).

Col­lo­qui­al­ly, BeP also refers to the time at which a company breaks even.

Break-even point

For cal­cu­lat­ing the BeP, you must be familiar with two factors: the company’s turnover and costs. The BeP is reached when turnover and costs balance each other out.

With respect to costs, it’s necessary to make a dis­tinc­tion: In every company, fixed costs and variable costs are incurred. The sum of both is the total cost.

The BeP can be rep­re­sent­ed in this sim­pli­fied formula:

De­f­i­n­i­tion

The break-even point refers to the point where the total costs (fixed costs + variable costs) related to pro­duc­tion or a product are just as high as the total turnover.

Break-even point: the basics

In order to calculate the BeP or break-even point, you must first be familiar with a few cost ac­count­ing terms: fixed costs, variable costs, and con­tri­bu­tion margin.

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Fixed costs

These are always incurred re­gard­less of how much is produced or sold. These costs are in­de­pen­dent of time. They accrue during company holidays as well. Fixed costs include:

  • Rent
  • Salary costs for permanent employees
  • Insurance premiums
  • Lease payments
  • Interest
  • De­pre­ci­a­tion

Variable costs

The amount of variable costs is dependent on the volume that is produced and/or sold. As a result, variable costs fluctuate and are per­for­mance related. Variable costs include:

  • Material con­sump­tion
  • Energy costs
  • Freight and transport costs
  • Costs for temporary workers
  • Piecework wages

If the variable costs increase at the same rate as the pro­duc­tion or sales volume, they are referred to as pro­por­tion­al variable costs. Should the variable costs increase at a faster rate, then they are referred to as pro­gres­sive variable costs. They pro­gres­sive­ly increase, for example, if the main­te­nance costs for machines sharply increase due to increased pro­duc­tion. Variable costs can also be de­gres­sive, meaning that they increase less sharply than the turnover. That can be the case, for example, when you receive volume discounts due to larger purchase volumes.

If you divide a product’s total variable costs by the produced or sold item volume, the result is the variable costs per unit. A product’s sale price should at least be as high as the variable costs per unit, otherwise the company cannot stay in the market for long. This is why the variable costs per unit is also called the absolute minimum price.

The sum of the fixed and variable costs is the total cost.

Con­tri­bu­tion margin

The con­tri­bu­tion margin is what remains after sub­tract­ing the variable costs per unit from the selling price per unit.

The con­tri­bu­tion margin is easy to calculate, provided that you have an overview of your company’s cost structure.

The con­tri­bu­tion margin is available to the company so that it can cover its fixed costs. This means that the higher the con­tri­bu­tion margin, the more fixed costs will be covered by the generated revenue. The con­tri­bu­tion margin is thus a deciding factor for de­ter­min­ing the break-even point. If it is higher than the fixed costs, then the company makes a profit. If the con­tri­bu­tion margin is at $0, then it breaks even.

The break-even point formula

How much of a product must I offset in order to reach the BeP? Every company that wants to break even should ask this question. The cal­cu­la­tion looks like the following:

First of all:

In order to determine the unit amount x at the BeP, these two equations must be set equal to one another and solved for x:

With this single-product analysis, you determine an in­di­vid­ual product’s unit volume. This is necessary for covering this product’s total costs.

Most companies don’t produce and sell just one product, but rather several different products. This makes the cal­cu­la­tion a bit more com­pli­cat­ed as the BeP cannot be rep­re­sent­ed in in­di­vid­ual unit amounts. Ul­ti­mate­ly, the products’ prices and variable costs reach various levels, and the BeP for each product has a different unit volume. In cases like these, the BeP is therefore specified as the minimum turnover that the company must achieve with all its products. With this multi-product analysis, the factor by which each product con­tributes to the coverage of fixed costs must first be cal­cu­lat­ed. From the factors of all products, a standard factor will be de­ter­mined by which fixed costs will be divided. The result is the total turnover that must be generated in order to break even.

Note

Cal­cu­lat­ing the BeP answers two important questions:

1. How many products does the company have to produce and sell in order to cover its fixed costs? (single-product analysis)

2. How much turnover does the company have to generate in order to cover its fixed costs? (multi-product analysis)

Example: A hotdog stand’s break-even point

Keith and Alexandra have been managing a mobile hotdog stand since July. They sell hotdogs at different sites through­out the city and each month incur fixed costs of up to $800 (e.g. site rental, leasing fee for the truck, insurance, elec­tric­i­ty, etc.). Hotdogs cost $0.70 a piece, and also incur a per-hotdog cost of $0.10 for bread, ketchup, and a napkin. They sell the hotdogs for $2.80 each.

Step 1: De­ter­min­ing the per-hotdog con­tri­bu­tion margin

Step 2: Cal­cu­lat­ing the break-even point

Keith and Alexandra must sell 400 hotdogs each month in order to avoid any losses. Once they sell 401 hotdogs, they will have made a profit of $2.00.

Break-even point: graphic rep­re­sen­ta­tion

The BeP is located where the revenue curve and total costs curve intersect on the diagram. At this point, the total costs are just as high as the total revenue, meaning that the company is making neither a profit nor a loss. Should more products be sold, the company will enter the profit zone. Should sales decrease, it will slide into the loss zone.

The break-even point analysis: an important planning tool for your company

The BeP is es­pe­cial­ly an important indicator for emerging companies. It is a warning sign if the minimum revenue or unit sales volume required for the BeP isn’t achieved. If this happens, the company must act im­me­di­ate­ly in order to guarantee its survival. The following are possible practical solutions:

  • Intensify sales efforts
  • Reduce fixed costs
  • Reduce variable costs
  • Dis­con­tin­ue pro­duc­tion or parts thereof

Should you observe the de­vel­op­ment of the BeP over the course of a long period, you can identify if the company is moving closer to it. Using the BeP, you can also predict how much of a decline in revenue the company can take without going into the red.

If you plan to in­cor­po­rate a product into its product range, a BeP analysis helps you establish if the expected sales volume is over or under the BeP. In doing so, you must of course always take into account the fact that the company’s cost structure can change with the expansion of its product range. Fixed costs may increase as salaries for new spe­cial­ists are paid for, or the area being used until now may become in­ad­e­quate requiring more space to be rented. On the other hand, pur­chas­ing con­di­tions for raw materials or parts could improve due to the larger volumes.

Note

Storage costs are not con­sid­ered in the BeP analysis. They must be added sep­a­rate­ly.

The BeP analysis should not be the company’s only tool for analysis. This is because cal­cu­lat­ing a BeP is based on certain premises:

  • The dis­tri­b­u­tion of costs into fixed and variable costs is correct.
  • The pro­duc­tion value cor­re­sponds to the sales volume.
  • The prices and pro­duc­tion program remains con­sis­tent during the period under analysis.

If these premises are not met, the BeP’s sig­nif­i­cance will be limited.

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