Break even analysis is a key financial tool that every business uses to find out how much they would have to sell in order to cover their fixed expenses. You as a business owner should know about what are your fixed and variable expenses. Break-even point is calculated to determine how much volume of sales you need in order to make profits. It is also an important part of cost-volume-profit analysis.
What is Breakeven Point?
A company break-even point is the point where business sales are equal to both variable and fixed expenses. The company will need to sell enough units in order to be no profit or no loss. This point is called break-even point.
If company sells fewer units of its products, it will incur loss as it will not be able to cover all fixed and variable expense or in other words, if it sells more, it will make profits. To calculate a break-even point, you will need to remember three things:
- Fixed Expenses: Fixed expenses are those expenses that do not change irrespective of sales volume such as rent, salary, insurance, utilities, office, depreciation, fees etc.
- Variable Expenses: Variable expenses are those expenses which tend to change with the volume of sales such as cost of goods sold.
- Price: The price of the product is the price set by the company to sell at wholesale price or cost of manufacturing the product plus mark up.
The Formula for calculating Breakeven Point:
Fixed Cost/(Sell Price-Variable cost)= Breakeven Points (In units)
In the above example, the fixed costs are stated as a total cost whereas the variable cost is stated as per unit cost. In other words the variable cost is calculated by deducting variable cost per unit from sell price per unit. It is also called contribution margin. In other words, the contribution margin is calculated as follows:
Contribution margin =Sell price per unit – variable cost per unit
Example: ABC Inc. has its fixed cost consisting of rent for property, executives’ salaries, property taxes and depreciation on fixed assets for up to $120,000. Its variable cost consisting raw material, factory labor, and sales commission calculated as $1.60 per unit, the product selling price is at $4.00 each.
Given the above example, we can calculate the ABC breakeven point as follows:
Break-Even Point: Fixed Cost/ (Selling Price-Variable Cost)
Break-even Point (BEP): $120,000.00/ ($4.00-$1.60)
Give the above example, Company would need to sell 50,000 units to cover its fixed expenses. This is called Break-even point where company will be making no profits and no loss. So If company need to make profit, it would need to sell more than 50,000 units.
3 ways to lower your Break-Even Point:
Let’s say, if the economy is in downturn or recession, the sales volume will drop as there will be less demand for the product company sell. In that case, company will not sell enough to cover its fixed expenses.
In the above example, ABC Company will not be able to sell 50,000 units to cover its fixed expenses. Here is what company can do to sustain in the downturn market.
- Company can either increase its sales price so it can meet its fixed expenses. Or
- It would have to cut down its fixed expenses so even if the sales volume down, it can still cover fixed cost.
- Up-sell and Cross-sell
Let’s say you have found a way to reduce your fixed cost. You are getting a cut in your salary by $20,000. Now the fixed cost will be amounted to $100,000. The new break-even point will look like as follows:
Break-even Point (BEP): 100,000.00/ ($4.00-$1.60)
= 41,666 Units
As you can say, the company will now need to sell 41,666 units as compared wit 50,000 units to cover its fixed cost.
In another example, let’s say you don’t want to make a cut in your salary, instead you would like to raise product selling price per unit.
The new selling price is $4.50
Break-even point= 120,000/ ($4.50-$1.60) =41,379 units
In both the example, you will need to sell lesser units to cover your fixed expenses. However, the better option is number two where company to raise its selling price.
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