In business, the break-even point is the point where a company’s total costs equal to its total revenues. At this point, the business is neither profitable, not incurring losses. Let’s understand it in detail.
Have you ever watched a business negotiation on the hit American reality show, ‘Shark Tank’? You’ll hear the multi-millionaire investors or ‘sharks’ ask potential investors about the present state of their business. To get this information, they use several jargons that you’d probably not have heard of before; ‘patents’, ‘cost per unit’, ‘landed cost’ and ‘evaluation’, for instance. Sharks also ask business owners if they are currently profitable, and if not, when they will reach the break-even point. So what does this point mean? Let’s find out.
What is the break-even point?
Break-even point or BEP is defined as the point at which the total costs or expenses incurred by a business owner to run a business, and the total sales or revenue from running the business is equal. It is the point where the firm does not have any net profits but is not suffering any loss either. It essentially means that the business owners have been able to get back all the money they have invested. From the break-even point, a business can only move upward in terms of profit. As such, the first goal of any business is to reach the break-even point, after which they can start profiting.
Breaking down BEP
As mentioned above, the break-even point is the point where a company’s total costs and total revenues are equal. It is, primarily a number on which a business depends. As a business owner, you can determine your BEP, by taking a hard look at all your costs – from the rent you are paying to the salaries of your employees (labour costs) to the materials that go in creating the final product. You must also look at your pricing structure. Once you’ve done this, you need to contemplate whether your prices are too high or too low to reach the break-even point and whether your business is sustainable.
Calculating the break-even point – the formulae
Two formulae help determine your business’s break-even point. They are as under:
1. Formula based on the number of product units
To calculate the break-even point based on the number of units, you have to divide the costs by the revenue per unit and subtract the variable cost per unit. Fixed costs remain unchanged irrespective of the number of units sold. In contrast, the revenue is the price for which products are sold after subtracting variable costs such as labour and material.
Units Break-Even Point = Fixed Costs ÷ (Revenue per Unit – Variable Cost per Unit)
2. Formula based on sales in rupees
To calculate the break-even point based on sales in rupees, you have to divide the fixed costs by the margin of contribution, which you can determine by subtracting the variable costs from the product’s price. This amount is later used for covering the fixed costs.
Break-Even Point (sales in rupees) = Fixed Costs ÷ Contribution Margin
Contribution Margin = Price of Product – Variable Costs.
Analysing the components of the BEP
1. Fixed Costs:
As mentioned above, fixed costs remain unaffected by the number of units sold, for instance – rent paid for stores and production units, costs associated with calculations and data storage like computers, for instance. It also includes the fees paid for services such as designs, graphics, public relations, advertising, etc.
2. Contribution margin
To calculate the contribution margin, you have to subtract the product’s variable cost from its selling price. So, if you’re selling a product for Rs. 100 and the cost of labour and material are Rs. 35, your contribution margin will be Rs. 65. This amount is then used to cover fixed costs. Also, any money remaining after covering the fixed costs is your net profit.
3. Contribution margin ratio
When you subtract fixed costs from contribution margin, you get a figure, typically expressed in percentage. This is known as the contribution margin ratio, which helps you determine the steps you need to take to reach the break-even point, such as cutting your production costs or increasing your prices.
4. Reaching the break-even point and earning profits:
Once the sales and fixed and variable costs are equal, you will have reached your break-even point, after which your company can report net profits and net losses of Rs. 0.
Final note: For any business, achieving the break-even point is an essential milestone. All sales beyond the BEP are deemed as net profit for the company. However, the road to reaching the BEP is not always easy. For some businesses, it may take months, while others might even up spending years to reach the break-even point.