Businesses exist to make a profit. To determine whether a business is profitable or not, we need to calculate the break-even point. The Break-even point defines a position for the business where it has covered all of its costs and is now making a profit. This blog post will explain calculating the break-even point using a simple formula. We will also provide examples to see how it works in practice!
Let us first shift our focus to understand what exactly is a break-even point.
What is a Break-Even Point?
The break-even point is a moment where total costs and revenue are equal. At this instant, there is no net loss or profit.
It is a critical measure to determine if an enterprise will be profitable. It can also help you know when your business may become loss-making and require investment or reaming out funds for future operation.
To calculate the break-even point, we need to understand its three important elements, i.e.:
#1. Fixed Costs
Fixed costs do not change with the amount of product or services a business produces. Instead, they include expenses such as rent, insurance, and wages.
For example, if a business rents a space for $2000 per month, regardless of how much product or services the business produces, that rent expense would be considered a fixed cost.
Fixed costs are important to consider when calculating the break-even point because they must be covered to make any profit.
We need to include all our fixed costs to get an accurate number when calculating the break-even point.
#2. Variable Costs
On the other hand, variable costs change with the amount of product or services a business produces. They include expenses such as raw materials and shipping costs.
For example, if a business orders 100 widgets from a supplier for $100, those widgets would be considered a variable cost.
Variable costs are important to consider when calculating the break-even point because they fluctuate based on how much product or services a business produces.
To get an accurate number, we need to include all our variable costs when calculating the break-even point.
#3. Total Revenue
Total revenue is the amount of money a business takes in from the sale of its products or services.
For example, if a business sells 100 widgets for $200 each, its total revenue would be $2000.
Total revenue is important when calculating the break-even point because it determines how much money the business must bring to cover all of its costs.
When calculating the break-even point, we need to include only our total revenue to get an accurate number.
Now that we understand the break-even point and its principal elements let us look at the formula for calculating Break-Even Point.
The Formula to Calculate Break-Even Point
The formula for calculating the break-even point is as follows:
Break-Even Point = Fixed Costs / (Sales Revenue – Variable Costs)
#1. Break-Even Chart
Walter Rautenstruch, an Industrial engineer and professor at Columbia University In 1930, invented the Break-even chart, which helped him understand how much it would cost for a business or company to reach break-even with their particular product line. He did this to know when there was sufficient profit from sales before continuing production on more items.
A genius idea came into Walter’s head when he observed how companies created their budgets without properly planning to utilize them.
For Example- If money was allocated for advertising campaigns yet no one knew where those expenditures went, clearly showing the lack of system and proper planning by the companies.
A break-even chart is a graphical representation of the information contained in the formula for calculating the break-even point. It helps us visualize how different factors (such as fixed and variable costs) impact the break-even point.
Here is an Example of a Break-even Chart:
Let us try and understand the above graph-
The Chart demonstrates Total Cost and Total Revenue on Y-Axis and Total Sales volume represented on the X-Axis.
There are three lines marked as A, B, and C on the graph.
- Line A: This line represents the Fixed cost, it remains static and doesn’t vary in relation to the sales volume.
- Line B: This line represents the Total Cost, total cost is ascertained by adding variable cost and fixed cost. variable cost changes as per the volume of production.
- Line C: This line represents the sales revenue or total sales.
#2. Evaluation of Break-Even Chart
- The break-even point occurs when the amount produced equals what’s being sold or consumed for in revenue by expenses such as labor costs etc., which will result in profit/losses.
- The dark green area in between the total cost line “b” and the total sales line “c” towards the left side of the break-even point shows the loss-making region for the organization.
- The light green area in between the total cost line “b” and the total sales line “c” towards the right side of the break-even point shows the profit-making region for the organization.
- Profit starts to show when overall output overpowers the minimum volume of output which can be achieved by increasing the efficiency of work. In such a scenario profit increases at a quick pace as compared to the increase in total cost.
- When new equipment is purchased, the break-even point shifts to the right. This means that the company’s profit will be reduced and management should study the market before purchasing any machines.
- When you hire new workers, their wages come at a price. That’s why an increase in variable costs (like hiring) will mean that total cost goes up and shift the break-even point towards the right, which shall result in a decrease in profits.
- The increase in sales volume will cause the breakeven point to shift left. This means that for a given volume, companies can expect higher profits than before due to increased demand.
#3. The Margin of Safety
The excess of total sales over the break-even point is the margin of safety. It measures how much output (in terms of quantity) can fall before a company starts incurring losses.
A business with a large margin of safety can withstand fluctuations in demand. In contrast, one with a small margin of safety may not be able to weather rough economic times as well.
The margin of safety is calculated by subtracting the break-even point from total sales.
#4. The Angle of Incidence
The angle at which the sales revenue line cuts the total cost line is called the angle of incidence.
A large angle of incidence is an indication that you’re in the driver’s seat when it comes to revenue. Therefore, your business will be lucrative with high-profit margins, so long as there are no fluctuations or drops on either side!
Importance of Break-Even Concept
- A break-even analysis helps you to understand the potential benefits and drawbacks of your business model.
- It helps you to identify the sales volume at which your company will start to make a profit or incur losses.
- Once you know your break-even point, you can set realistic sales goals and work on increasing productivity so that you can achieve them. You’ll also be able to budget better by factoring in both fixed and variable costs.
- Assess the impact of price changes on profits
- Evaluate the effects of increasing or decreasing production levels
- Measure the financial impact of adding new products or services
- Analyze the potential for economies of scale
- Make informed decisions about whether to expand your business or not.
Also Read: Top 25 Small Business Ideas In India
Limitations of Break-Even Concept
- The break-even point does not take into account the time value of money
- It does not consider income taxes or other financial obligations
- It is based on a static view of costs and revenues, which may not be accurate in the current market conditions.
- The break-even analysis is a difficult concept to apply when the enterprise produces many different products.
The break-even point is an important concept to understand when making a business decision.
It can help you determine how much revenue your company needs to generate for profits. However, while it is an essential tool for businesses, it has limitations.
The best way to use the break-even point is to understand what it tells you and then find other ways to supplement that information.
For example, using the break-even point formula correctly will tell you how many products or services you need to sell at a specific price to cover all of your costs and make a profit. However, numerous factors go into pricing decisions.
We hope that this blog post has helped you understand the break-even point concept and how to calculate it. If you have any questions, please don’t hesitate to ask us in the comments section below. Thanks for reading!