When Sarah McCartney launched her perfume business 4160Tuesdays in 2011, she calculated that she needed to sell 10 bottles per day for four years to start making money. This number, known as her break even point, gave McCartney an idea of how long she would need to wait to start turning a profit and allowed her to budget accordingly.
Even now, 11 years later, Sarah continues to use the break even formula when launching new products, as it helps her understand when they should start to be profitable. Here we share more than one break even formula and explore the uses of break even analysis in practice.
Why is it important to calculate break even point?
Break even point is the moment in time when your business makes enough money through sales to cover the costs involved in making and delivering your products or service. Any money your business makes after break even point is profit that you can reinvest for growth or hold in reserve as a buffer for challenging economic or market conditions.
“I would always recommend conducting a break even analysis before you start a business as it will give you a sense of the risk involved and what you need to achieve to succeed,” says James Gribben, head of communications for Be the Business, a not-for-profit organisation supporting business owners. “The same goes when you’re launching a new product or service, letting you decide whether it’s worth expanding your offer and if it justifies startup costs.”
How to calculate break even point
The break even point formula considers the costs involved in making and delivering your products or services against the price you sell them for. The formula for break even is typically used for a specific time period such as a month, quarter or year to help you understand how much you need to sell or how much revenue you need to generate in a given period.
Break even formula
There are two key break even formulas. One calculates break even point based on the number of units you need to sell (quantity). The other calculates break even point based on the monetary value of sales you need to generate (sales in GBP).
The break even point formula based on the number of units you need to sell takes your fixed costs and divides this by your sales price per unit, minus your total variable costs.
Fixed costs
Fixed costs are those that remain constant over a given period of time, despite the number of goods you are producing. In other words, they are costs that must be paid regardless of whether or not you sell anything. For example, your equipment, salaries, insurance and utilities. Fixed costs are also sometimes referred to as overhead costs.
Missing out key fixed costs is one of the most common mistakes business owners make when calculating break even point, says Gribben. “For example, when working from home, people sometimes assume their fixed costs are zero when that’s not the case,” he says.
Some examples of fixed costs associated with working from home include your own salary, as well as rent, mortgage, council tax and utility bills. These can be included in calculations by apportioning an amount based on the number of rooms in your house you use solely for work and the rough number of hours you work from home per week.
Variable Costs
Unlike fixed costs, variable costs change according to the situation. For example, they will go up or down depending on your production volumes. They include items such as the costs of raw materials, packaging and shipping. Gribben notes that as market conditions change, both your fixed and variable costs may change too, so it’s worth updating your break even analysis formula regularly, to ensure any changes are accounted for.
The break even point formula based on sales revenue requires you to first work out the ‘contribution margin'.
Contribution margin
The contribution margin is the profit you would make for the sale of one item. It is calculated by taking the sales price per unit of your product or service and deducting the variable costs.
Sales price per unit
This is the price you are selling your products for. In this way, you can use it to understand how raising or lowering your product prices affects break even point.
Example calculations using the break even formulas
Imagine you are launching a new product line and want to understand how many units you need and how much money you need to make per month to cover your costs.
Fixed Costs: £5,000 per month
Variable Costs: £2.50 per unit produced
Sales Price: £45 per unit
The break even point formula (quantity) is:
£5,000 / (£45 - £2.50) = 118 units
This means that you need to sell 118 units at £45 each to achieve break even point. From there, every unit you sell will generate a profit.
The break even point formula (sales in GBP) is:
Contribution Margin: (£45 - £2.50) / £45 = 0.94
£5,000 / 0.94 = £5,319 per month
This means that you need to sell £5,319 worth of units per month to break even. Any revenue that exceeds that will be profit for the business.
How to analyse your break even calculation
Your break even point calculation can be a really useful tool for understanding where to go next in terms of making your business more effective and profitable, says Gribben. “Look at your fixed and variable costs and if something stands out as being higher than you’d like, use that as a jumping-off point to figure out which costs are putting the most pressure on your business,” he says.
It is also an essential figure for setting targets, as it can help you to understand what you need to do to reach your profit goals and from there, you can work out whether you need to raise prices, cut costs, sell more aggressively or adjust your sales mix, Gribben says.
The break even calculation does have its limitations, since it does not factor in wider economic and market trends such as seasonal downturns, challenging economic conditions and competition. This means it should be analysed in the wider context of your business and the market in which it operates.
Calculating break even is a useful planning tool for new businesses, products and services, by indicating what it takes to cover costs and reach profitability. The American Express® Business Gold Card can help owners to more effectively manage cash flow with up to 54-day payment terms¹, which provide the flexibility to pay expenses and still meet costs at the right time for your business.
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