Running your own small business means getting to grips with the finances, especially if you haven’t yet grown to the stage where you can hire someone to do it for you. This means coming to terms with concepts like the break even point.
If that doesn’t mean anything to you at the moment, don’t panic. We’ll explain what the break-even point is, why it’s important and how you can find out what yours is, including:
- The definition of a break-even point
- What is the break-even formula?
- How to calculate break-even
So here’s our guide to everything you need to know about the break-even point formula.
Break even point definition
We’ll start off with the break even point definition. You can easily define the break even point as a crucial metric that enables a company to determine the point at which it or one of its products will become profitable. When a company's revenue falls below the break-even point, it operates at a loss, but if revenue surpasses this point, the company operates at a profit.
Break-even points have many applications across various contexts. For example, in the property market, the break-even point would represent the amount of money a homeowner would need to generate from a sale to cover the net purchase price. This includes; closing costs, taxes, fees, insurance, interest paid on the mortgage, and expenses related to home improvements and maintenance.
The break-even point would be the exact price at which the homeowner neither gains nor loses any money. For a small business, this can easily be translated into finding the point at which it can start to be profitable, which can be a matter of proverbial life or death for that business, so it’s crucial to be able to work it out accurately.
A break-even analysis is useful in four common scenarios.
- Starting a new business - If you’re considering starting a new business, conducting a break-even analysis is crucial. It will not only help you assess the feasibility of your business idea but also require you to conduct research, be realistic about costs and formulate a pricing strategy.
- Launching a new product - Before committing to a new product, even if it incurs significant expenses, it's important to do a break-even analysis if you already have a business. You'll need to work out the variable costs associated with the new product and establish prices before initiating sales, even if fixed costs like an office lease remain constant.
- Adding a new sales channel - When you add a new sales channel, such as a pop-up shop or shoppable posts on Instagram, your expenses will change, even if your prices don't. Therefore, it's important to ensure you break even, or the financial burden could jeopardise your entire business.
- Changing your business model - If you're considering changing your business model, such as shifting from dropshipping to carrying inventory, conducting a break-even analysis is necessary. Your start-up expenses may vary considerably, and this analysis will assist you in determining if your prices need to be adjusted accordingly.
Doing a break-even analysis can reveal unforeseen expenses that may have gone unnoticed, helping you identify missing costs. By the end of the analysis, you will have a clear picture of your financial commitments, allowing you to avoid any surprises in the future.
Making emotional decisions in business is seldom advisable, but it can be challenging to avoid. Conducting a break-even analysis provides you with objective facts, enabling you to make decisions based on rational data.
A break-even analysis provides you with specific profit goals that you need to achieve, enabling you to set realistic targets and work towards them. It can also be critical in convincing investors of your business plan's feasibility and securing financing.
A break-even analysis holds significant importance in any business plan. It is generally mandatory if you intend to seek investments or loans for your business as you must demonstrate the feasibility of your plan. Additionally, if the analysis appears promising, you will likely feel more confident about taking on the responsibility of financing.
And finally, knowing your break-even point can also help you determine the appropriate pricing for your products based on a sound business model.
What is the break even formula?
What is the formula for a break-even point? The break-even point formula is calculated by dividing the total fixed costs of production by the revenue per unit minus the variable costs per unit.
The break-even formula is:
FIXED COSTS ÷ (SALES PRICE PER UNIT – VARIABLE COSTS PER UNIT)
Fixed costs refer to expenses that remain constant or change minimally, such as your monthly utility expenses and rent.
The sales price per unit is the amount that a company plans to charge consumers for a single unit of the product being analysed.
Variable costs per unit are expenses directly linked to the production of a product, such as labour costs for producing the product or the cost of materials used in production. Variable costs tend to fluctuate and are often a company's largest expense.
How to calculate break even
So now you know what the formula is in theory, but how do you go about calculating the break-even formula? Having the equation is one thing but knowing what to do is another.
To determine the number of units required to achieve profitability, you must calculate your net profit per unit sold and divide your fixed costs by that figure and it’s essential to recognise that product sales must cover expenses beyond production costs.
Here’s how to use the formula for break-even:
- Gather the data - Initially, you should compile a comprehensive list of all expenses associated with operating your business, including product costs, rent, and banking charges. Take a moment to reflect on all expenditures and document them, and then divide them up into fixed costs and variable costs.
- Use the data - The easiest way to use this data and the break-even formula is by inputting them into a spreadsheet. There are templates freely available on the internet that can help you do this, then it’s simply a case of filling it in and getting out the break-even point results that you need.
- Experiment - Now you’ve found the break-even point, why not use the formula to experiment with different numbers to see what impact changes could make to your picture?
So, there you have it, everything you need to know about break even formulas.