What is a Break-Even Analysis?

A break-even analysis is kind of like setting the trajectory for a spaceship...

If you want a spaceship to land on its target, you need to account for certain constants (like the speed of light and the spaceship’s mass) as well as variables (the amount of fuel in the rocket, the force of gravity, etc.). Similarly, for a business to land on its feet and stay profitable, it needs to take its fixed and variable costs into account to determine how much revenue it needs to break even.

A break-even analysis is a type of financial analysis that companies use to determine the volume of sales they need to “break even,” or just cover expenses.

If sales fall below the break-even point (BEP), the company will take a loss. If sales exceed it, the company will make a profit.

Break-even analysis is integral to any business plan. Almost all businesses have upfront expenses, so companies need to know whether a product has a good chance of making a profit despite them. For example, if a business is looking at $20,000 in upfront costs to manufacture a product but only predicts $18,000 in sales, it likely needs to reevaluate its business plan.

Companies also perform break-even analyses to help set the right prices for products or determine how high their expenses can be while still making a profit — or at least not taking a loss.

For example, imagine a business called Steve’s Spaghetti needs to sell 2,000 boxes of spaghetti to break even. If the company is just barely breaking even as is, it could use its current sales data to determine whether renting a bigger, more expensive storefront makes sense. Unless the company expects a massive increase in sales from the expansion, the break-even analysis may indicate that the increased expenses would be a significant risk.

Traders and investors can use a break-even analysis to help determine when they’ll break even on their investments. Instead of factoring in costs like rent and employee salaries, investors look at fees associated with investing.

For example, if a stock trader knows it costs $20 in fees to execute a trade (let’s assume $10 to buy the stock and $10 to sell it), he or she can use that information to assess whether the trade makes sense.

If the trader expects to make more than $20 off the transaction (not accounting for fees), then the trade may make sense. If he or she expects to make less than $20 (again, not accounting for fees), the trade will be a loss.

No matter what a break-even analysis is used for, the break-even point (BEP) is the point at which a business or investment is neither profitable nor unprofitable.

To understand how a break-even analysis works, it helps to understand a bit of terminology:

-Fixed costs are business expenses that don’t directly change based on production volume. These include things like lease payments, rent payments, property taxes, utilities, interest, and employee salaries.

-Variable costs are expenses that are directly related to production volume. These include raw material costs, direct labor costs, and sales commissions.

-Contribution margin is a product’s revenue minus its variable costs. Unit contribution margin is how much profit each individual sale makes in the absence of any fixed costs — in other words, how much it contributes to a business’s overall revenue. You can calculate this by taking a product’s sales price (its revenue) and subtracting all variable costs (the cost of producing it). For example, if a product costs $10 to make and sells for $20, the unit contribution margin is $10.

A break-even analysis looks at the relationship between these three variables. For example, if a pizza shop’s fixed costs are $10,000 per month, and each pizza has a unit contribution margin of $10, it would need to sell at least 1,000 pizzas per month to break even ($10,000/$10). To make a profit, it would need to sell more than 1,000 pizzas per month.

With that figure in mind, the pizza shop can make strategic business decisions: Is it paying too much for ingredients (variable costs)? Should it try to find a cheaper storefront? Or should it raise prices to increase the unit contribution margin?

A break-even analysis won’t be able to answer all those questions on its own — Businesses need to take other market factors into account as well. But it provides a good starting point.

There are two ways to calculate a break-even point. One gives you the BEP in units, while the second gives you the BEP in dollars.

The first break-even point formula gives you the result in sales numbers — how many units you need to produce to break even:

BEP (in units) = Total fixed costs / Unit contribution margin

Suppose a business called Stacey’s Stilettos pays $5,000 per month in fixed costs. Each pair of stilettos sells for $60, and the company pays $40 in variable costs to produce each pair.

To figure out the unit contribution margin, subtract the variable costs from the unit’s selling price. This gives us a unit contribution margin of $20 ($60 - $40 = $20).

We find the BEP in units by dividing the total fixed costs by the unit contribution margin:

BEP = $5,000 / $20

BEP = 250 units

So, Stacey’s Stilettos needs to sell 250 pairs of shoes each month to break even.

The second method gives you the BEP in sales dollars — how much money you need to make to break even:

BEP (in dollars) = Total fixed costs / Unit contribution margin ratio

To find the BEP in dollars, take total fixed costs and divide them by the unit contribution margin ratio (Unit Contribution Margin / Sales Price).

Unit contribution margin ratio = $20 / $60 = 0.33

BEP = $5,000 / 0.33

BEP = $15,151.52

Stacey’s Stiletto’s needs to bring in more than $15,151.52 in sales each month to break even.

You can also use Excel to conduct a break-even analysis. This makes it easier to see how changes in costs and sales prices would affect the BEP without having to redo the calculation by hand each time.

The easiest way to do this is to make columns or rows containing all the variables (variable cost per unit, fixed costs, sales price, etc.). Then, highlight another cell and input “=” followed by one of the above formulas. Simply highlight the cell containing the data for each variable to add it in.

For example, imagine you are using the formula for the BEP in units and have two cells, A1 and A2. A1 contains the data for fixed costs and A2 contains the data for the unit contribution margin. In this case, your Excel formula should be: = A1/A2.

Break-even analyses serve several purposes:

• Setting investment and sales goals: A break-even analysis helps businesses determine the volume of sales they need to come out even. This helps companies figure out how much they need to sell to be profitable. It can also help investors set profit targets.
• Evaluating financial and strategic decisions: A break-even analysis can help a business make important financial and strategic decisions, such as how much it can afford in rent, how much it should pay for raw materials, and how many employees it can afford to hire. It can also help determine whether launching a new product makes financial sense. .
• Pricing: By determining how much it needs to sell to break even, a business can adjust its pricing strategy to meet this goal. But it will also need to consider other factors, like the fair market value of its products (the price they can reasonably fetch on the open market) and price elasticity (how sensitive buyer demand is to price changes).
• Approaching investors: Companies that want funding from investors need a clear business plan. A break-even analysis is an essential part of any business plan, and companies would likely be hard-pressed to find investors without one.