Lesson 7 in the Basic Accounting series:
Your small business’s break-even point is the point where the total revenue equals your total costs associated with the sale of your product or service or an even simpler accounting definition is the point where your business does not have any earnings and does not make a profit or suffer a loss.
Determining Your Break-Even Point:
As small business owners determining our break-even point can be a very handy tool in determining how much to charge for our product or service or where we might be able to even cut some costs. There are accounting break-even points and financial break-even points that share universal applicability whether it is a retail, manufacturing, or service business. Each one uses different measurements.
But before we start figuring at what point we can break even, let’s go back over some accounting terminology such as these important concepts:
- Variable Costs of production: These are expenses that are associated with the production process or production level. They are directly proportioned to the production of your product such as raw material, factory labor, and sales commissions. For example, if you owned a bakery, your variable cost would be the price of raw materials such as flour, sugar, etc.
- Fixed Costs: These are expenses that would be the same even if you did not sell any of your products such as rent, insurance, interest expense, etc.
- Unit Selling Price: The total sales dollars or price you will be selling a single product or service for.
- Contribution Margin: The amount generated after the variable expenses have been covered that will contribute toward the fixed expenses
Keeping those accounting definitions in mind, let’s discuss how to conduct a break-even analysis of your small business by using the break-even point formula:
Breakeven Analysis Formula
Breakeven Point = Fixed Costs/Unit Price – Variable Costs
Using these components of the break-even formula, you can determine how much of your product you will need to sell (total units sold) to break even. Once you have reached that point you have recouped all the costs that you have generated producing your product both fixed and variable. This is a calculation known as the margin of safety.
Figuring Your Contribution Margin:
Another important term used in break-even analysis is contribution margin (see definition above).
The following formula for figuring the unit contribution margin is:
Unit Contribution Margin = Unit Selling Price – Unit Variable Cost
Using the formulas above, let’s figure the breakeven point for a fictional bakery that sells cakes. The amounts and assumptions used in this example are also fictional.
We have figured that our variable cost for each cake we sell is $10. If we sell our cakes for $25 the contribution margin per cake would be:
Contribution Margin per cake = $25 minus $10
Contribution Margin per cake = $15
So the contribution margin per cake tells us that after the variable expenses are covered…$15 per cake will go towards paying the fixed expenses. Assuming we have $300 of fixed expenses per week, the point we break even in cakes per week would be:
Breakeven point in cakes per week = Fixed expenses per week divided by Contribution Margin per cake
Breakeven point in cakes per week = $300/$15 per cake
Breakeven point in cakes per week = 20 cakes per week
From this, we can see we would need to sell at least 20 cakes a week to break even. To double-check this we would use the following schedule:
Projected Net Income for a Week
Sales (20 cakes sold at $25 per cake) = $500 Minus variable expenses (20 cakes at $10 per cake) = $200 Minus fixed expenses =$300 Equals $0 Zero Net Income
Here is a good online break-even calculator to help you with your break-even analysis:
From the general guidelines stemming from the concept of the break-point, you can figure out how to attain the desired profit or profitability goal. You can also analyze the company reach with another critical concept known as CVP analysis which will tell you how a difference in costs will affect the profit.