Determining your break-even point is a final step that you need to take and put into a budget. This post solely emphasize on this topic. It comes with formulation and calculation examples that you can follow easily. Let’s say you’re preparing a household budget. How do you know how much you can spend and still break even?
For starters, you figure out how much you’ll earn in the coming year. What do you do next? You calculate all your variable and fixed costs.
Fixed costs are those costs that you cannot reduce based on usage.
These might include your mortgage payments, car payments, and insurance payments. Variable costs are those that you can control based on usage. For instance: if you cut down your long-distance calls by 20 percent, you can reduce your phone bills. If you eat out less, you can save money on food and entertainment. If you send your youngest child to public school rather than private school, you can reduce your educational expenses. As long as your fixed costs + variable costs do not exceed your salary or revenue you know you will break even. This occurs when:
Like you, the goal of every company is to ensure that in the coming year, its fixed costs and variable costs won’t exceed revenues. The process is more complicated than in a household budget, however, since a business’s variable costs are inter-wined with its revenues.
Whereas the variable costs for our household budgets, such as groceries, have nothing to do with our revenue source (our salaries), the variable costs of a company have everything to do with its revenue source its products. If Lie Dharma’s Sporting Goods wants to increase its revenues by selling more basketballs, it will have to make more basketballs. And to make more basketballs, it will have to buy more raw materials and perhaps hire more workers.
So how does a company like Lie Dharma’s know the number of basketballs it must sell to break even?
Contribution Margin (CM)
To feel for its break-even point, Lie Dharma’s Sporting Goods will first determine its contribution margin.
The contribution margin is simply the amount of money left over after variable costs are subtracted from its revenues.
So, for instance, let’s say Lie Dharma’s Sporting Goods sells its basketballs for $10 apiece. And let’s say the variable costs that go into each basketball total $6. The contribution margin on Lie Dharma’s basketballs would be $4.
The reason this $4 is called the contribution margin is because it represents the amount of money left over that ”contributes” to covering a company’s fixed costs and profits.
Contribution Margin = Sales Price per unit Variable Costs per unit
Break Even Point [BEP] by Units
The contribution margin alone tells a company little about how many products it will need to sell to break even. But it is a critical component in a mathematical formula that does. This formula states that;
Break Even = Fixed Costs/(Sales Price per unit – Variable Costs per unit)
Break Even = Fixed Costs/Contribution Margin per unit
To explain how this formula works, lets assume that Lie Dharma’s sells its basketballs for $10 each. Let’s further assume that it has $2 million in fixed costs and that its variable costs amount to $6 per ball. Now, let’s plug in the numbers:
Break Even = $2 million/($10 – $6)
Break Even = $2 million/$4
Break Even = 500,000
This tells us that based on its cost structure; Lie Dharma must make and sell at least 500,000 basketballs to break even.
Break Even Point [BEP] by Sales
Another way to determine a company’s break-even point is through dollars [not units]. To determine this breakeven point, Lie Dharma’s can turn to another simple formula. It states that:
Break even = Fixed costs/[(Sales Price per unit – Variable Costs per unit)/Sales Price per unit]
Break Even = Fixed Costs/(Contribution Margin per unit/Sales Price per unit)
Once again, let’s assume that Lie Dharma’s fixed costs equal $2 million; its variable costs per unit is $6; and its sales price per unit is $10.
Break Even = $2 million/[($10 – $6)/$10]
Break Even = $2 million/($4/$10)
Break Even = $2 million/0.4
Break Even = $5 million
This formula tells Lie Dharma’s Sporting Goods that it will achieve break even once sales of basketballs hits $5 million.
Beyond Break Even
In our example, we know that Lie Dharma’s Sporting Goods will break even when it sells 500,000 basketballs. But the goal of a company is to do better than break evenit’s to actually make a profit. How does a company know how much profit it will make by selling more than its break-even volume?
Simple: Let’s assume that Lie Dharma’s Sporting Goods, knowing that its break-even point is 500,000 basketballs, commits to selling 700,000 balls in the coming year. To figure out how much profit 700,000 basketballs will generate, all the company needs to know is its fixed costs, its variable costs, and its projected revenues.
In our example, Lie Dharma’s still plans to sell its balls for $10 apiece. At 700,000 units, that’s $7 million in revenues. Despite the increased production, its fixed costs remain at $2 million (after all, the definition of a fixed cost is one that does not change based on volume of activity). The company’s variable costs per unit will stay the same, but its overall variable costs will rise. Based on a variable cost per unit of $6 and 700,000 basketballs, we know that Lie Dharma’s total variable costs will be $4.2 million. Given the fact that profits equal revenues minus expenses, Lie Dharma’s can conclude that it will make $800,000 on 700,000 basketballs.
Revenues = $7 million
Fixed Costs = $2 million
Variable Costs = $4.2 million (700,000 basketballs x $6 in Variable Costs per unit)
Profit = $7 million – $2 million – $4.2 million = $800,000
But let’s say that Lie Dharma’s Sporting Goods does not know how many basketballs it will make in the coming year. All it knows is that it wants to generate $1 million in profits next year. Can the company figure that out using this formula? Sure. All it would need to do is to modify it:
Profit = Revenues – Fixed costs – Variable Costs
In this case, we know the intended profit: $1 million. We know that fixed costs will be the same: $2 million. We know variable costs per unit will be the same: $6. And we know how much it intends to price each basketball: $10. All we need to know is what volume of sales will generate the right level of revenues and total variable costs to achieve $1 million in profits.
Profit = (Sales Price per unit x Volume) – Fixed Costs – (Variable Costs per unit x volume)
$1 million = ($10x) – $2 million – ($6x)
$3 million = 10x – 6x
$3 million = 4x
x = 750,000
This formula tells Lie Dharma’s that to make $1 million in profit, it must sell 750,000 basketballs. As you can see, cost is a critical component of profitability. Break even point is one of five essential steps to take on budgeting process.