How to Calculate the Breakeven Point for Your Business (Part 2)
This is part 2 of article we posted earlier at (URL).
Article provided by Herb Kimble
Breakeven Point Based on Total Costs
Once you have determined the total fixed and variable costs, you can calculate the breakeven point based on actual costs and sales as follows:
Sales at the breakeven point = Fixed costs divided by [1 – (Variable costs / Actual sales)]
Breakeven Point Based on Margin Percentage
The gross margin is the excess of revenues over variable costs:
Total sales revenue – total variable costs = Gross margin
The gross margin percentage is calculated as follows:
Gross margin % = (Sales price – variable costs) / sales price
Therefore, another way of applying the formula for calculating the breakeven point is based on the gross margin percentage:
Sales at the breakeven point = Total fixed costs / gross margin %
Another derivation of the formula for calculating the breakeven point based on the gross margin percentage is that you can determine the sales volume you must realize in order to achieve a certain percentage of gain above the breakeven point, according to the following formula:
Sales that must be realized = Sales at the breakeven point + Variable costs as a percentage of sales at the break even point + Desired margin percentage above the breakeven point.
Breakeven Point in Terms of Number of Units
To determine the number of units you must sell in order to reach the breakeven point, you would use the following formula:
Number of units at the breakeven point = Total direct costs / (Unit sales price – Unit variable cost)
Example
In the month of January, ABC Company had sales revenue of $14,000. Its fixed costs for the month were $5,000 and its variable costs were $7,000.
Breakeven point calculated based on total sales and costs:
Sales at the breakeven point = 5,000 (fixed costs) divided by [1 – (7,000 in variable costs / 14,000 in actual sales)] = 5,000 / 0.5 = 10,000
The company has to cover the $5,000 in fixed costs every month, and the ratio of variable costs to sales is 50% ($7,000 / $14,000), so when the company has sales of $10,000 for the month, it can cover the fixed costs of $5,000 and the variable costs of $5,000 (50% of $10,000).
The gross margin is 50%: (14,000 in sales – 7,000 in variable costs) / 14,000 in sales. If the company sells its product at $20 each, its gross margin per unit is $10. The company would have to sell 250 units per month to cover its fixed costs ($20 x 250 = $5,000), but this would not cover the variable costs.
By applying the formula for calculating the breakeven point based on the gross margin percentage, we have the following:
Breakeven point = $5,000 (fixed costs) / 0.50 (gross margin percentage) = $10,000.
The result is the same: the company must have sales of $10,000 to reach the breakeven point.
Now, to determine how many units you have to sell, you could simply divide the sales amount needed to reach the breakeven point ($10,000) by the price per unit ($20 in this example) to arrive at 500 units per month.
Using the formula to calculate the breakeven point in terms of the number of units:
Breakeven point = $5,000 (fixed costs) / [$20 (unit price) – $10 (unit variable cost)] = $5,000 / $10 = 500 units
When the Gross Margin Percentage Changes
From the foregoing, it can be concluded that if the margin decreases, due to a price reduction or an increase in variable costs, you would have to sell more to reach the breakeven point. For example, if the margin decreases to 40%:
Breakeven point = $5,000 (fixed costs) / 0.40 = $12,500
If the decrease in the margin is due to higher variable costs; that is, the price remains the same at $20 per unit and the unit variable cost increases from $10 to $12, you would have to sell 625 units ($12,500 / $20) to reach the breakeven point instead of 500 units as in the above example.
If the decrease in the margin is due to a reduction in the selling price, from $20 to $16.67, and the variable cost remains the same at $10 per unit, you would have to sell approximately 750 units ($12,500 / $16.67) in order to reach the breakeven point.
If the decrease in the margin is due partly to an increase in variable costs, from $10 per unit to $11, and partly to a reduction in the selling price, from $20 per unit to $18.33, you would have to sell 682 units ($12,500 / 18.33) to reach the breakeven point.
From the foregoing, it can be concluded that: (1) a lower gross margin requires you to sell more in order to reach the breakeven point, and (2) the additional quantity of units you must sell to reach the breakeven point is higher when the decrease in the margin is due to a price reduction, than it is when the decrease is due to an increase in variable costs.
There are various factors that enter into the decision to reduce prices, including overall market conditions, the company’s position in the market, what competitors are doing, and the company’s commercial strategy, for example whether or not it wants to compete based on price.
But by clearly understanding the breakeven point and what it means in terms of the number of units you must sell in order to be profitable, you can make more informed decisions regarding price setting.
The Breakeven Point and Managing the Business
When a business works with various different products or services, the calculation of the breakeven point is more complex. You can use the above-referenced formulas on an overall basis, but if you can determine the fixed and variable costs that apply to each of the business’s products or services, you can determine a breakeven point by product or service. This provides you with a tool to be able to allocate resources and efforts where you can obtain the greatest return.
The calculation of the breakeven point represents an important aspect in determining the mix of products and services a business offers. Based solely on the margin that each product or service contributes, you could decide to concentrate more resources on the more profitable products or services, and even discontinue those that do not reach the breakeven point. But it is also important to consider the breakeven point within the context of the business strategy. There could be products or services that contribute little or nothing to the gross margin, but that are essential in order to offer the overall level of quality and service that the business wants to provide its customers.
For example, it could be that the main product is highly profitable, and in addition, supplemental or auxiliary products are offered that do not contribute much to the gross margin, but that are things the customers needs or wants, and prefers to buy from the same business. The inverse could also be the case, in that not much is gained with the principal product, but the accessory products and additional services are very profitable. The whole package of products and services should be taken into consideration.
Due to variations in costs over time, in addition to possible changes in the efficiency with which resources are used, it is beneficial to determine the breakeven point again on a regular basis. The breakeven point represents the situation at a given moment in time, taking into account the price of the product or service and the fixed and variable costs that exist at that time. Any change in the elements that make up the calculation of the breakeven point will change the breakeven point itself.
This article was written by Herb Kimble. Herb Kimble runs a film production company called CineFocus Productions in Los Angeles. He is also working toward the release of a streaming network, called urban Flix. Find out more info about Herb Kimble, on his About.me page.