When you own your own business, fixed costs are a constant concern. When you're still in product development and have no sales, ongoing expenses eat away at your capital. Even once you have a product to sell, you'll still have to sell enough of it just to get back to break-even. Only then will additional sales earn you a profit. Knowing what your break-even point is will help you come up with realistic sales goals that will ensure the long-term viability of your business.
What goes into determining the break-even point?
There are generally four things that you need to know in order to come up with the break-even point:
- Your total fixed costs independent of how many units of your product you sell.
- The variable cost of each unit you produce.
- The sales price at which you sell the units you produce.
- How many units you expect to sell.
Taking these one by one, total fixed costs include expenses that you have to pay even if you don't produce a single unit of product. That can include rent, lease payments for equipment, compensation for salaried employees, and interest payments on debt. Utility bills also sometimes fall into this category, especially for services for which there's a fixed charge regardless of usage.
Variable costs for unit production, on the other hand, are the portion of your total costs that vary depending on how much you produce. With most products, this includes the input cost of the raw materials needed to make the product, labor costs for hourly workers whose workload depends on production levels, and the energy necessary in the production process.
When you compare the variable cost for unit production with the sales price you expect to get from selling the product, you get what's known as contribution margin. This figure tells you how much you'll keep from each sale after accounting for those variable costs. For every unit you sell, you first decrease the amount of operating loss that stems from fixed costs. Then, once you reach the break-even point, additional sales will create and add to your operating profit. As long as you sell your product for more than your variable cost, the more you sell, the better your operating results will be.
Figuring out the break-even point
You can determine your break-even point by hand, but simple calculators are also adequate to the task. The one below is easy to use.
Editor's note: The following language is provided by CalcXML, which built the calculator below.
Consider a simple example to see how the calculator works. Say that you have a small company that makes low-cost items. It has $10,000 in monthly fixed costs, and each unit of the product costs an additional $1 to make. Units sell for $5, and you anticipate being able to sell 4,000 units per month.
When you run those numbers through the calculator, you'll see that under these assumptions, you'll earn a $6,000 profit. Your break-even point is 2,500 units sold, because when you take the $5 you sell the product for and subtract the $1 each unit costs, you get a per-unit contribution margin of $4. $10,000 in fixed costs divided by $4 equals 2,500, so if you sell exactly 2,500 units, then you'll break even. Sell fewer than that, and you'll lose money, but sell more than the break-even amount, and you'll end up with profit.
Note that there are several things you can do to lower your break-even point. Cutting your fixed costs is the most obvious choice, but you can also aim to raise your sales price. Even if that eats into demand somewhat, using pricing power will sometimes boost your overall profitability if you retain enough sales to benefit from the higher unit price.
Make your business prosper
The value of knowing the break-even point is to understand fully just how much of your product you need to sell. You'll always want to set long-term sales goals to exceed the break-even point, and as your business grows, making sure that you keep sales volumes well ahead of breaking even will give you the best opportunity to generate sustainable profits for years to come.
The Motley Fool has a disclosure policy.