The following is an excerpt from Starting A Business 101 by Michele Cagen. Reprinted with permission from Adams Media, an imprint of Simon and Schuster. Copyright 2023.
Finding Your Break-Even Point
When your company breaks even, it means your revenues exactly equal your expenses, so there’s no profit or loss. The break-even point is where that happens, the precise spot where the revenues can cover all of the expenses. Once you know what that break-even point is, you can make better business decisions and run your business more effectively.
Figuring this out is just the first step. It can take months or years for a small business to finally reach its break-even point and stop running at a loss. Having a sense of when a business stops losing money can make it easier to attract investors, get loans, and manage your business.
How The Break-Even Point Can Help
Calculating the break-even point for your company before you launch helps ensure success. The break-even point tells you the minimum dollar amount of sales required to produce profits and can potentially show other issues that will impact your bottom line. Working out this calculation can help you figure out:
- Optimal pricing and different price points.
- Reasonable sales goals.
- Overlooked expenses.
- Whether this business can be profitable.
- Whether it makes sense to launch a new product or service.
- How well and quickly the business can recover from setbacks.
The break-even point is also a crucial part of your business plan, letting potential investors and lenders know that your business has profit potential.
Break-Even Language
Break-even is an accounting term, and you must use accounting terms and equations to figure out how to calculate it. The lingo can get a little confusing if you haven’t taken courses in cost accounting. So, here’s the basic vocabulary you’ll need to move forward:
- Fixed costs: Expenses that stay the same no matter how much you sell, like rent, salaries, and insurance.
- Variable costs: Expenses that change based on production or sales, such as packing and shipping materials, or production supplies, like glue or screws.
- Semi-variable costs: Expenses that have both a fixed and a variable component, such as electricity or repairs and maintenance.
- Contribution margin: The difference between the unit sales price and variable unit cost of what you’re selling divided by the unit sales price [(unit sales price minus unit variable cost) divided by unit sales price], which lets you know how much each unit helps cover overhead costs.
- Unit: One of what you’re selling; for example, rocking chairs or service hours, where one chair or one hour would be a unit.
Now that you’ve got the lingo down, you’re ready to start calculations.
How To Calculate the Break-Even Point
Determining the break-even point requires a bit of accounting math. You can figure it out by using either dollars or units. In order to calculate the break-even point, you’ll need to have total fixed costs, unit sales price, variable unit cost, and sales projections in units.
Now comes the math. The basic formulas look like this:
Break-even point (units) equals fixed costs divided by (unit sales price minus variable unit cost).
Break-even point (dollars) equals fixed costs divided by contribution margin.
Let’s look at an example. Suppose your business will be selling picture frames. The fixed costs add up to $5,000 per month. The variable costs that go into each picture frame come to $1, and you sell the frames for $10 each. In order to break even, your company would need to sell 556 frames per month: $5,000 / ($10 – $1). Alternately, in dollars, the business would need to generate $5,556 in frames sales to break even: $5,000 / ([$10 – $1] / $10).
Pad Your Predictions
Calculating the break-even point for a start-up relies mainly on estimates, as you’ll have no historical sales and expense data to pull from. Most new entrepreneurs tend to underestimate expenses because they can’t foresee every cost that will come up. So, it makes sense to add an extra 10%–12% to your expected costs to cover any unexpected expenses.
Price, Cost, and Volume Changes
The factors that go into calculating your break-even point won’t stay static over time. On top of that, you may want to change them proactively to see what kind of effect it would have on your company’s profitability. This experimentation can be helpful when your business is struggling, such as during a recession or if there are other issues that drive sales down. If sales decrease, you may not be able to hit the break-even point, which could make it impossible to pay all of your vendors and suppliers. When you face an unexpected decline in sales, you can use the break-even formula to see the effects of different options, such as raising prices or cutting costs.
One option: reducing variable costs by negotiating with suppliers or finding new ones. If you can bring the variable costs down from $1 to seventy-five cents, for example, the break-even point would drop down to 540 frames.
Perhaps you can reduce fixed costs by taking a temporary salary cut—for example, bringing the fixed costs down from $5,000 a month to $4,500 a month. By doing that, your break-even point would drop down to five hundred frames.
Price, costs, and sales volume are all closely connected. The decisions you make about any of these factors will affect your break-even point and your business. So, using the formula to proactively see the expected effects of different choices can help you make better decisions for your company.
Using The Break-Even Point
Once you’ve run a break-even analysis—a set of the different outcomes created by using different assumptions—you’ll be armed with information. For example, in order to break even, your company will need to sell at least five hundred picture frames every month to be viable. Your next step is deciding whether that outcome is realistic.
If selling that quantity seems like a breeze, you could have a successful business on your hands. If it seems possible but difficult, look for other areas to cut expenses so you can achieve a more manageable sales volume goal, or find the funding to carry you through the initial lean period until you can establish a stronger sales volume. If you think it’s nearly impossible to hit that volume, then this may not be a viable business idea.
Another important thing to remember: You cannot predict or control customer demand. If you can’t generate enough interest in your product or service, or if consumer demand for it simply drops off or disappears, your business may not ever be able to break even.
Michele Cagan is a CPA, author, and financial mentor. With more than twenty years of experience, she offers unique insights into personal financial planning, from breaking out of debt and minimizing taxes, to maximizing income and building wealth. Michele has written numerous articles and books about personal finance, investing, and accounting, including The Infographic Guide to Personal Finance, Investing 101, Stock Market 101, 2nd Edition, and Starting A Business 101. In addition to her financial know-how, Michele has a not-so-secret love of painting, Star Wars, and chocolate. She lives in Maryland with her son, dogs, cats, and koi. Get more financial guidance from Michele by visiting SingleMomCPA.com.
