A company’s breakeven point is the point at which its sales exactly cover its expenses. Why is this important?
“Determining the break-even point allows a company to determine the level of sales needed to cover all costs (fixed and variable) and start earning a profit.” – CPA Canada
To calculate a company’s breakeven point in sales volume, you need to know the values of three variables:
- Fixed Costs
- Variable Costs
- The Selling Price of the Product/Service
How to Calculate the Breakeven Point
In basic math terms, use the following formula:
Fixed Costs / (Price per Unit – Variable Costs) = Breakeven Point in Units
In other words, the breakeven point is equal to the total fixed costs divided by the difference between the unit price and the variable costs. Note that in this formula, fixed costs are stated as a total of all overhead for the business, whereas price per unit and variable costs are stated as per unit costs – the price for each individual product or service unit sold.
An Example of Finding the Breakeven Point
Altacorp Ltd. has calculated that it has fixed costs that consist of its lease, factory equipment, manger salary, and property taxes. Those fixed costs add up to $60,000 per year. Their product is “The Widget”.
Their variable costs associated with producing “The Widget” are raw material, factory labor, and sales commissions. Variable costs have been calculated to be $0.80 per unit. “The Widget” is priced at $2.00 per unit.
Given this information, we can calculate the breakeven point for Altacorp Ltd.’s “The Widget” product, using our formula from above:
$60,000 / ($2.00 – $0.80) = 50,000
Fixed Costs / (Price per Unit – Variable Costs) = Breakeven Point in Units
What this answer means is that Altacorp Ltd. must produce and sell 50,000 “Widgets” per year in order to cover their total expenses, both fixed and variable. At this level of sales, they will make no profit but will just break even.
What Happens to the Breakeven Point if Sales Change?
What if your sales change? For example, if the economy is in a recession, your sales might drop. If sales drop, then you may risk not selling enough to meet your breakeven point. In the example of Altacorp Ltd., you might not sell the 50,000 units necessary to break even. In that case, you would not be able to pay all your expenses. What can you do in this situation? If you look at the breakeven formula, you can see that there are two solutions to this problem: you can either raise the price of your product or service or you can find ways to cut your costs, both fixed and variable.
How Cutting Costs Affects the Breakeven Point
Imagine that you find a way to cut your fixed costs by reducing your own salary by $10,000. That makes your fixed costs drop from $60,000 to $50,000. Using the same formula and holding all other variables the same, the breakeven point would be:
$50,000 / ($2.00 – $0.80) = 41,666
Fixed Costs / (Price per Unit – Variable Costs) = Breakeven Point in Units
Predictably, cutting your fixed costs drops your breakeven point. On the other hand, if you reduce your variable costs by cutting your costs of goods sold to $0.60 per unit, holding other variables the same, then your breakeven point becomes:
$60,000 / ($2.00 – $0.60) = 42,857
Fixed Costs / (Price per Unit – Variable Costs) = Breakeven Point in Units
From this example, you can see that if you can reduce the cost variables, you can lower your breakeven point without having to raise your price.
Relationships Between Fixed Costs, Variable Costs, Price, and Volume
As the owner of a small business, you can see that any decisions you make about pricing your product or service, the costs you incur in your business, and sales volume are interrelated.
These important numbers are a useful guide for your start-up when you are considering how to price your products and services. They are also important numbers to think about whenever you are introducing new products and services into your existing business.
You are now well on your way to understanding the basics of financials. All of the material you have learned so far helps you speak to your financial team with confidence and shows you how healthy your business is.
