Categories

In business, the break even point (BEP) is the point where total profit is zero and there is no loss. To put it in simpler terms – total costs and total sales are equal. This means that the total sales (unit or revenue) is equal to the total costs with no loss or profit. Determining your BEP requires a break-even analysis, which is a key function in the successful running of any business. Knowing where your break-even point lies means you’ll know what’s required from your business to avoid losing money, and when you will start making a profit. In this article we’ll take a closer look at break-even point and break even analysis, and why both are so important to the success of your business.

The break-even point is a common concept in financial analysis and is used not only by accountants and finance managers, but entrepreneurs and even marketers as well. What it does is put in black and white what exactly the target output of a business should be if it were to avoid running at a loss. This same target also marks the point where the business can then go on to start making a profit. Therefore, a business owner will know precisely what the output levels should be, what pricing strategy would work best, how fixed and variable costs will impact the business – all before creating the first product.

It’s not uncommon for businesses to turn over large amounts of money, but still run at a loss. Therefore, the main purpose of a break-even point lies in identifying the absolute minimum sales required in order to cover costs. It therefore follows on that exceeding this point will mean the business is making a profit. When you fall short of your BEP, steps can be taken to make the necessary changes, like revising your pricing strategy , or reducing costs so that the break-even point can be met. Knowing the BEP also informs strategic decisions about pricing, establishing a sales budget, a cash flow forecast, and creating a solid business plan.

By knowing your break-even point, you’ll be able to determine how:

- Profitable your current product/service offering is
- Far sales will have to decline before you start running at a loss
- Many units you need to sell before you make a profit
- Reducing price or volume of sales will influence your profit
- Much you’ll need to increase price or volume of sales to make up for raised fixed costs

BEP data is invaluable. It gives you all the information required to know the amount of sales and revenue required to begin making a profit, or to track the impact of a marketing campaign on earnings. If you need to restructure or cut costs, your BEP will act as a guide for getting the best results. Entrepreneurs looking to launch their business are advised to present their break-even point to prospective investors, showing that their company has the potential to be viable. It’s therefore clear that a break-even point is integral to the effectiveness of any business at any stage, paving the way for higher returns.

As a small business owner, you already know about the interconnected relationship between the pricing of your products, the costs incurred during creation of that product, and the number of sales achieved. For example, expressing break-even sales as a percentage of actual sales helps managers know when they can expect to break even. Break-even analysis is a tool used to study the aforementioned relationship, calculating the size of production at a particular price that’s needed to cover all costs of that production.

It can therefore be seen how calculating the break-even point is the first and most important step in determining a sales price that will guarantee a profit. Remember to keep in mind that your BEP will never be a static value. It’s a figure that changes from business to business, but also within every individual company depending on how often influencing factors, like fixed costs increase or decrease.

So how do you calculate your break-even point? We’ve outlined the basic process below:

To calculate your BEP within the framework of the break-even analysis you need to know your fixed costs, selling price, and variable costs.

Break-even Point = No. of Units (N) produced to make zero profit

- Revenue – Total Costs = 0
- Total Costs = (Variable Costs*N) + (Fixed Costs)
- Revenue = Price Per Unit*N
- Price Per Unit*N – (Variable Costs*N + Fixed Costs) = 0

Taking the above into account, we can then show that:

N = Fixed Costs/(price per unit – variable costs)

And in order to determine your break-even point, you will need to do a break-even analysis.

It’s important to grasp the separate components to gain a deeper understanding of how this of analysis works:

Fixed costs, or overheads, are expenses which occur every month and remain the same for at least a year. They are directly related to production level but not production quantity. Fixed costs can include things like rent, rates, materials, and salaries. For example, if a carpentry business making tables, chairs, and cupboards employs about 40 people, it will have a lot of fixed costs.

Unlike fixed costs, variable costs change as the volume of production changes. So everything related to your cost of sales, like the cost of fuel, and production and selling costs. If we stay with the example of the carpentry business used previously, its variable costs will include raw material costs, costs of wood, handles, nails, as well as any other additional materials required. Therefore, producing 50 cupboards per month will use less than when 65 cupboards are produced. And this is how variable costs end up varying on a month-to-month basis.

Your analysis will make use of these fixed and variable costs, as well as per unit sales revenue to find your break-even point.

To illustrate how greatly this analysis tool can impact strategic business decisions, let’s go back to the carpentry company. Say for instance they’ve decided to add a new cupboard design to their product offering:

- Expected selling price per unit = R1 000
- Average fixed costs (annually) = R210 000
- Variable costs (production cost per unit) = R400

To find the BEP we’ll use the formula outlined previously: BEP = R210 000/(R1000-R400)

= 350

This means that the company will have to sell 350 units of the new cupboard in order to break even. When they sell the 351^{st} cupboard, they will have made a profit.

The sales department could communicate that they might not be able to sell 350 units and that number should be revised. What if the initial selling price is too high? By decreasing the price, more than 350 units will have to be sold before breaking even. If the purchasing department can get materials at lower cost, then the company will be able to make a profit before 350 units are sold. Every one of these scenarios can be plugged into the above formula, giving you different break-even points and a clear picture of exactly what to expect in any given situation.

For an alternative representation of the same data, you can put the information into graph form. Draw the Total Cost Curve (TC in diagram), which shows the total cost with each potential output level. Then the Fixed Cost Curve (FC), showing the costs that don’t change in relation to the level of output. Finally you’ll have the Total Revenue lines (R1, R2, R3), which show the total revenue at every level of output in relation to the various price points.

Break-even points will show on the graph wherever the TC and revenue lines intersect. At these points of intersection, the horizontal axis will show the break-even quantity and the vertical axis will show the break-even price. The data used to make up this graph – total cost, total revenue, fixed cost – can be found using simple formulas. Instead of setting up complex excel sheets, you can use Okumm to simplify the entire process.

The margin of safety allows a business to know the exact amount that has been gained or lost, and whether these earnings are above or below the break-even point. Within a BEA (break-even analysis) context, the margin of safety refers to the degree by which projected or actual sales exceed break-even sales. We can set it out like this:

- Margin of safety = (current output – break-even output)
- Margin of safety% = (current output – break-even output)/current output x 100

The same working can be used when dealing with budgets, but you will replace “current output” with “budgeted output” instead.

A good place to start with your break even calculations is to make use of your accounting information. You already have all the information you need to find out what your break even point was up till now.

Now you don’t want a historical break even point to plan your future growth but it is a good starting point. Once you have all the information plugged in, you can tweak and change until you are happy with a future target.

Let’s assume that your business, Leather Co manufactures and sell 5 different type of leather products. Your financial report stated the following information

Yearly Revenue: R611 490

Profit: R11 440

Overheads: R350 000

COGS: R250 050

You sold a total of 1607 product during the year.

Summary Report:

Product Name |
Volume Sold |
Cost Price |
Selling Price |
Total Cost |
Total Revenue |

Product 1 | 217 | R250 | R670 | R54 250 | R145 390 |

Product 2 | 210 | R295 | R840 | R61 950 | R176 400 |

Product 3 | 400 | R120 | R250 | R48 000 | R100 000 |

Product 4 | 550 | R85 | R140 | R46 750 | R77 000 |

Product 5 | 230 | R170 | R490 | R39 100 | R112 700 |

Sum of all |
1607 |
R920 | R2 390 | R250 050 |
R611 490 |

Your average cost price is: R250 050 / 1607 = R155,6

Your average selling price is: R611 490 / 1607 = R380,5

To calculate your break even point you plug in the values in to the following formula:

N = Fixed costs / (Sales price per unit – Variable costs)

N = R 350 000 / (R380,5 – R155,6)

N = R 1556

The break even is very close the actual sales achieved. Hence the low profit.

You can also calculate your break even point for each product. You will need to allocate your overheads proportionally to each product based on the selling price and volume of units sold.

Overheads allocation to product 1: (Overhead/ volume of units sold) x (Cost Price of product 1/ Sum of all the cost prices)

Overhead allocation amount = R350 000/ 217 x (R 250/ R 920) = R438

Your break even for product 1 uses the same formula: (Overhead A x Units sold) / (Sales price per unit – Variable costs)

N = (438 x 217) / (690 – 250) = 226

Your break even point for each product is then:

Product 2 = 206

Product 3 = 351

Product 4 = 588

Product 5 = 202

You will find you are below the breakeven point for:

Product 1

Product 4

You turned a profit for product:

Product 2

Product 3

Product 5

Let’s say your plan for the future is as follow: In order to increase your number of sales, you employed a new marketing manager at R10 000/ month and to keep up with the increased production, you purchased new machinery at R80 000. You will depreciate your equipment over 2 years. The total increase in overheads amount to R140 000. You are also confident that because of your new equipment you will be able to deliver a better quality product.

You want to increase your selling price for each product to

Product 1 – R750

Product 2 – R 890

Product 3 – R275

Product 4 – R190

Product 5 – R550

Your new break even point will then be:

N = Fixed costs / (Sales price per unit – Variable costs)

N = R490 000 / (R429,8 – R155,6)

N = 1787

You will want to adjust your target for each product to make sure you don’t run any of them at a loss.

We will split the overhead allocation in relation to the product cost. The formula will be:

N = New Overheads x (Cost Price of product / Sum of all cost prices) / (Selling Price – Cost Price)

Break even point for product 1:

N = 490 000 x (R250 / R920) / (750 – 250)

N = 266

Your break even point for each product is then:

Product 2 = 206

Product 3 = 351

Product 4 = 588

Product 5 = 202

Let’s say your new marketing manager says she can guarantee sales of 2000 products. What will your profit be?

We will use the same formula that we started with, except we won’t assume profit to be zero

Revenue – Total costs = Profit

Total costs = Weighted Cost price x N + Fixed costs

Revenue = Weighted Selling Price x N

Total costs = R168,2 x 2000 + R490 000 = R826 233,6

Revenue = R472,1 x 2000 = R 944 222,4

Profit = 944 222,4 – 826 233,6 = R 117 886,8

Here’s another key purpose for the break-even point – it gives business owners more control over how much money they stand to make or lose. For instance, when sales drop you risk not selling the required units to meet your BEP. In this case your business will run at a loss. However, the break-even formula holds two solutions to this problem:

1 – Raise the per unit price of your product

2 – Reduce costs (variable as well as fixed)

So instead of being reactive to changes in the market after they occur, with your BEP you are able to forecast potential risks and develop the necessary strategies to safeguard your business and its profit. As mentioned previously, the break-even point will never be a static figure, and this is a perfect example of why that is so. Costs may change, sales may drop, but with a break-even point you will be prepared for various scenarios.

The scale of a business greatly impacts fixed as well as variable costs. A small business with low output levels may not have to consider costs of a full HR or finance department. However, as your business grows your will have to deal with several changes. The break even point will have to revised as the business grows. Using the BEP you will be able to plot how your business will react to growth by including added expenses that come with that growth. Plug the expected additional figures into the formula and evaluate the kind of impact of each individual case.

All things considered, it’s clear to see why the relationship between the break-even point and break-even analysis has become invaluable to business owners. These tools are necessary to prevent running at a loss, pinpoint the required benchmark for turning a profit, as well as keeping your business agile and proactive in the midst of changing costs and markets.

An accurate break even analysis will give you confidence in pricing, preparing bids and applying for finance. What’s more, your break-even point is how you as a business owner will be able to see into the future. You can use Okumm to handle all the calculations you allowing you the freedom to adjust your business model and make strategic decisions that build toward your success.

This template supports the sidebar's widgets. Add one or use Full Width layout.

This template supports the sidebar's widgets. Add one or use Full Width layout.

Free Access to the BETA

Beta sign up

We’ll get in touch to setup a meeting at your convenience