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The break even point is one of the most important and widely used metrics in the business world. If you’re a small business owner, it can be a decision-making guiding star for everything from pricing products to hiring employees.
Although calculating this metric is fairly straightforward, it can have specific nuances that might affect company growth.
Let’s look at why understanding the concepts and calculations of the break even point are essential to the success of your small business.
What is the break even point?
The break even point is the point where the total revenue made by a business is equal to its total costs. In other words, it’s when how much the business has made in sales equals the amount spent on business expenses. A business that has “broken even” is no longer operating at a loss, but it hasn’t generated any profits either.
Knowing where the break even point is in your business can help you understand the minimum number of sales you need to target to ensure all your running costs are covered.
This metric also lets you assess the overall financial health of your business and identify areas where you could improve processes and profitability — such as pricing, improving your business structure or setting sales goals. Bottom line: You’ll want to figure out what you can change so that you’re not just breaking even month after month, but making a profit.
For example, if your break even point is much higher than your sales revenue, you’ll need to find ways to either sell more, raise your prices or reduce your overhefads.
On the other hand, if sales revenue is much higher than the break even point, it’s a good sign that your business is flourishing. You can be more flexible about product experimentation, investigate new growth opportunities or maybe even give your employees a bonus.
Key break even concepts to keep in mind.
When calculating the break even point for your business, there are a few key concepts to understand.
These are business-related costs that stay the same no matter how much you do or don’t sell. This includes items like:
- Office leases
- Loan repayments
- Employee salaries
- Business insurance
Your fixed costs are an important part of break even calculations. They represent the absolute minimum dollar amount your business has to make before it can start turning a profit.
As the name suggests, these are costs that vary depending on your level of sales. They might include things like:
- Shipping costs
- Raw materials
- Commission payments
- Credit card fees
- Utility bills
When your variable costs increase or decrease, they’ll directly affect your break even point calculations and can impact your profitability if you don’t keep a close eye on them.
Once your variable costs are deducted from your sales revenue, you get the contribution margin. This essentially measures the amount of revenue you have left over after covering these costs.
Your contribution margin can be affected by things like:
- Reducing overhead costs
- Changes in the cost of raw materials
- A reduced volume of product sales
- Increasing the price of your services
It’s important to understand how this margin factors into the break even point, as it shows the total amount of revenue you have on hand to cover your fixed costs and contribute to profits.
If you calculate this metric based on percentages, the closer your contribution margin gets to 100%, the more profitable your business will be.
Your safety margin measures the amount of expected profit that exceeds your break even point.
If your safety margin is too low, it means there’s a good chance your business won’t make enough revenue to reach its break even point. If you have fluctuating sales periods (e.g. highs and lows for seasonal product sales), this can put your business in a tricky situation.
A higher margin of safety means your business has a good buffer if your sales are unstable for any reason, and this is what you ideally want to achieve.
How to calculate your break even point step by step.
Let’s say you run a small business selling cakes (yum!), and you’re wondering how much you need to price each cake at and how many cakes you need to sell to break even.
Identify fixed and variable costs
Your first step is to identify all the different costs for your business and whether these are fixed or variable costs.
You can check your bank statements and accounting records to get the information you need.
For example, your fixed costs might be:
- Kitchen rental
- Health and safety certificates
- Employee salaries
And your variable costs could include:
- Cake ingredients
- Cake decorations
- Utility bills
- Courier costs
Calculate the contribution margin per unit
Next, you’ll be calculating your contribution margin.
If you want to calculate this with a dollar (or unit) amount, the formula is:
Selling price – variable costs = contribution margin
Let’s assume you sell each wedding cake at $200, and your variable costs per unit are $120.
The calculations will look like:
$200 – $120 = $80
For each cake sold, your contribution margin is $80. This amount is used to cover your fixed costs for each cake which will help you reach, and hopefully exceed, your break even point.
Calculating contribution margin as a percentage
Some businesses prefer to calculate this metric as a percentage instead of a dollar amount. So for the above example the percent calculation formula would look like:
Contribution margin percentage = (contribution margin / selling price) x 100
Contribution margin percentage = ($150 / $200) x 100
Contribution margin percentage for each cake = 75%
In practice, this means that 75% of the sale price of each cake can be used to cover all fixed costs and any amount that exceeds this can be taken as profit.
Use the break even formula
The basic formula to calculate your break even point is:
Fixed costs ÷ contribution margin = break even point
To calculate the break-even point of your wedding cakes, start by figuring out the number of cakes you need to sell to cover all your fixed and variable costs.
You’ll also need to take the contribution margin into account — which will be the amount of money you have left over after you’ve covered all the variable costs such as electricity, ingredients and decorations. This amount will go towards covering your fixed costs and (hopefully) any profit you make.
If your fixed costs are $50 and your contribution margin percent is 40%, your calculation will be:
$50 ÷ 40% = $125
This means you’ll need to price each cake at $125 to break even. So if you’re selling each wedding cake at $250, you’ll make a tidy profit of $125 per cake.
Create a visual illustration of your break even point
It’s helpful to plot all of these costs and calculations on a chart to let you see at a glance what the relationships are between your fixed and variable outgoings, sales volume, and overall revenue compared to your break even point for each product or service.
You chart should have four sections to illustrate each of the following:
- Variable costs
- Fixed costs
- Total costs
You can then mark your break even point on the chart once you’ve calculated it.
How to use the break even point as a metric for better decision making.
You should regularly review the break even point for your business for several reasons.
Assess profitability of each product or service
Comparing the break even points of your different products or services can help you determine which ones are more profitable, which ones should be optimized and which ones should be scrapped altogether.
Using the wedding cake example above, you might find that even though this break even point is much higher than, say, your kids’ birthday cakes, you can make a much higher profit from every wedding cake sale.
This could lead you to the decision to become a specialist in wedding cakes instead of trying to cater for all occasions.
Set prices and determine sales targets
Now that you’ve gone solely into the wedding cake business, you can use your break even analysis to establish what your optimal price for a wedding cake is and set the sales targets you need to meet to reach maximum profitability.
Identify how you can reduce costs
Your calculations can also show you the direction you need to take to reduce costs and optimize your business structure.
For example, if you tend to have seasonal sales (the number of weddings you cater will most likely be higher in spring and summer), this is a good time to renegotiate supplier contracts, streamline baking operations and cut back on variable costs where possible.
Analyze the potential impact of market changes
Uncertain economic conditions, together with external factors like new competitors in your market, or the price of eggs and flour skyrocketing, mean you’ll need to keep a firm pulse on your break even point so you can stay nimble and adjust your pricing and sales strategies where needed.
Understanding how to calculate the break even point for your business is essential for making decisions about your products, services, prices and overall direction.
This metric isn’t static, so as your business grows and the market changes, you’ll need to monitor and recalculate your figures to ensure maximum profitability and growth.