How to Determine the Break-Even Point of Your Business?
For many small to medium businesses, turning a profit can be a challenging endeavor. Often, it takes considerable time to build a customer base and establish a reputation before actual profits start rolling in. The pivotal moment when a business covers its fixed and variable costs and begins making a profit is known as the break-even point. Calculating this point provides crucial insights, such as the necessary investment to launch the business, components to include in the monthly operating budget, and appropriate pricing for goods and services. This article defines the break-even point, delves into its calculation intricacies, and highlights the valuable advantages of conducting a break-even point analysis.
What is the break-even point?
In accounting terms, the break-even point of a company is the point in time when the total revenue of the enterprise is equal to its expenses, meaning both its fixed costs and its variable costs.
Fixed costs are any expenses (known as liabilities) that do not change depending on the number of goods or services your business sells or produces. This includes things like rent, utilities, marketing campaigns and so on. Variable costs are expenses that do change according to the production or sales rates of your business. They include the cost of raw materials, equipment costs, wages and so on.
So, when your business is able to generate enough money to pay for all its costs it has reached its break-even point. It is important to realise that at the break-even point, your business is not as yet generating profits. It simply has made enough money to cover its operating costs.
Why is the break-even point important?
The break-even point gives a business owner a clear picture of the actual cost of running their enterprise. The break-even point shows you how much money you will need to budget for when calculating your monthly expenses. Knowing at what point your business will break even will dictate how much you charge for your goods or services.
If you require start-up funding, your projected break-even point will provide potential investors with a clear picture of how viable your business is and how profitable your business may be in the future.
How to determine your business’s break-even point
There are two basic formulas that you can use when calculating the break-even point of a business. The first method is to determine the break-even point based on the number of units that your business has sold. The second method is by calculating the break-even point based on the number of sales in Pounds Sterling (GBP).
Calculating your break-even point based on units
When calculating the break-even point based on units, you must divide the fixed costs of the business by the revenue generated per unit minus the variable costs per unit.
The break-even point equation based on units looks like this:
Fixed costs / Revenue per unit – Variable cost per unit
Let’s look at an example. A business has total fixed costs of £2,000 per month. It costs the business 30 pence to produce a unit. The business sells units for £1.50 per item. The equation to determine the break-even point would be:
- 2,000/1.20 (1.50 - .30)
In this very simple example, and we can see immediately that the business will need to sell approximately 1,667 (1,666.66) units every month to reach the break-even point.
Calculating your break-even point based on sales
The other way to calculate a break-even point is to do so based on sales in GBP. To do so, we divide the fixed costs of the business by the contribution margin. The figure reached when we subtract variable costs per unit from the unit’s sale price is known as the contribution margin.
The break-even point equation based on sales looks like this:
Fixed costs / contribution margin
Unit price – Variable costs = contribution margin
We can see that the business will need to sell approximately £2,500 worth of units per month to break even. This figure can then be confirmed by multiplying the unit figure of 1,667 from the first equation by the sales cost of each unit 1,667 x 1.50 = 2,500.50.
The benefits of a break-even analysis
Analysing the break-even point of a business will provide the owner with valuable insight into how viable their enterprise is. After determining the break-even point of the business, you should consider whether the numbers are achievable. Can you realistically expect to sell enough units in a month to cover your fixed costs? Potential lenders and investors will look carefully into this aspect of your break-even analysis before committing funds to your venture.
A break-even analysis is also useful for existing businesses. The break-even analysis can identify if you are selling your goods or services at too low a price. It can demonstrate that the cost of materials is too high. If you plan on expanding your business, the break-even analysis can show you how much working capital your products or services will need to generate to cover your new fixed costs.
Along with your cash flow statement, how much bad debt your business holds and your ROI projections, a break-even analysis provides insights into the financial health of your business. These types of accounting analyses are also required for tax purposes or if you wish to have a third-party audit your business.
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