How to Calculate and Lower Your Business‘s Break Even Point

As a business owner, profitability is always top of mind. But before you can turn a profit, you first need to break even. Your break even point is the point at which your total costs and total revenue are equal. In other words, you‘ve made enough money to cover your expenses for a given period.

While it‘s a critical milestone, your break even point is not a one-time goal post. Your break even point will change continuously as your costs and revenue fluctuate. As such, it‘s important to track your break even point on an ongoing basis—whether it be weekly, monthly, quarterly or annually.

Reaching your break even point means you can breathe a small sigh of relief, but it‘s just the first step toward sustained profitability. Regularly calculating this metric will give you vital insights into the health of your business and how much you need to sell to stay in the black. Here‘s what you need to know.

Why Your Break Even Point Is Crucial

At a casino, you might "break even" by gambling $200 and winning the same amount. But in a business context, it‘s not that simple.

Sure, revenue is revenue, right? Not exactly. If your sales just barely cover your expenses, you haven‘t actually reached profitability. You have no financial cushion to fall back on. Even a small dip in sales or unexpected cost could quickly put you in the red.

This is where knowing your break even point comes in. Calculating this figure tells you the minimum performance your business must achieve to avoid losing money. It sets the stage for everything that follows. Here‘s why:

  • Viability: If your break even point is unrealistically high compared to projected demand, it may be a sign that your business model isn‘t viable. Entrepreneurs are optimistic by nature, but the numbers don‘t lie.

  • Goal setting: Your break even point gives you a tangible sales target to work towards. This informs everything from your pricing strategy to your marketing budget.

  • Forecasting: When you know how much you need to sell to cover costs, you can better predict your cash flow and plan for growth. For example, if you‘re anticipating a slow season, you can adjust your budget accordingly to stay above water.

  • Decision making: Should you hire that new employee? Invest in that equipment upgrade? Your break even point can guide these choices. If hiring someone new will significantly increase your break even point, it may not be the right move.

In short, your break even point is a cornerstone financial metric. Ignore it at your peril. Now, let‘s dive into how to actually calculate it.

Calculating Your Break Even Point

Before we get to the formula, let‘s review a few key terms:

  • Fixed costs: These are expenses that stay relatively constant regardless of how much you sell, such as rent, equipment, and salaried labor.
  • Variable costs: Also known as the cost of goods sold (COGS), these are expenses that increase or decrease based on sales volume, such as raw materials, commissions, and shipping fees.
  • Contribution margin: This is the difference between the selling price of a product and its variable costs. It represents the amount available to cover fixed costs.
  • Contribution margin ratio: This is the contribution margin expressed as a percentage of the selling price. It shows how much of each sales dollar is available to pay fixed costs.

Got it? Good. The break even point equation is:

Break Even Point = Fixed Costs ÷ Contribution Margin

Here‘s how to calculate contribution margin:

  • Contribution Margin = Price – Variable Costs
  • Contribution Margin Ratio = Contribution Margin ÷ Price

Let‘s look at an example:

Say you sell handcrafted bowls for $50 each. Your variable costs are $20 per bowl. Therefore, your contribution margin is $30 ($50 – $20) and your contribution margin ratio is 60% ($30 ÷ $50).

If your monthly fixed costs are $3,000, your break even point is:

$3,000 ÷ $30 = 100 bowls

At this sales volume, your total revenue will be $5,000 (100 bowls x $50) and your total costs will also be $5,000 ($2,000 variable + $3,000 fixed). Sell one more bowl and you‘ll be profitable. Sell one less and you‘ll post a loss.

You can also express your break even point in total sales dollars. Just divide your fixed costs by the contribution margin ratio:

$3,000 ÷ 0.60 = $5,000 in total sales

The table below shows the business‘s profit/loss at different sales volumes:

# of Bowls Revenue Variable Costs Fixed Costs Profit/Loss
50 $2,500 $1,000 $3,000 ($1,500)
75 $3,750 $1,500 $3,000 ($750)
100 $5,000 $2,000 $3,000 $0
125 $6,250 $2,500 $3,000 $750
150 $7,500 $3,000 $3,000 $1,500

As you can see, the higher the sales volume, the greater the profit thanks to the business‘s positive contribution margin. Each bowl sold above the break even point contributes $30 to net profit.

Industry Context

To put these numbers in perspective, let‘s look at some real-world data. According to an analysis by Sageworks, the average small business has annual revenues of $44,000 and a net profit margin of 7.2%. However, this varies widely by industry.

For example, small retailers have an average profit margin of just 2%, while accounting firms enjoy margins around 18%. This underscores the importance of benchmarking your break even point against industry standards. What‘s normal for one type of business may be unsustainable for another.

Margin of Safety

Your break even point is the lower limit of sales you can sustain without losing money. But most businesses don‘t want to operate on the razor‘s edge. That‘s where margin of safety comes in.

Margin of safety refers to the difference between your current sales and your break even sales. The larger this buffer, the more room you have to weather unexpected slowdowns.

To calculate margin of safety in units, simply subtract your break even quantity from your actual sales quantity:

Margin of Safety = Current Sales Quantity – Break Even Quantity

Let‘s say the bowl maker expects to sell 120 bowls per month. Their margin of safety is:

120 bowls – 100 bowls = 20 bowls

Those extra 20 bowls create a healthy cushion. Even if sales dip by 15%, they‘ll still be profitable. The same concept applies when calculating margin of safety using total sales dollars.

Strategies to Lower Your Break Even Point

Reaching break even is an important landmark. But what if you want to arrive at profitability faster? The key is to lower your break even point through a combination of increasing contribution margin and reducing fixed costs. Here are some strategies to consider:

Boost Your Contribution Margin

  • Raise prices: Increasing prices improves your contribution margin per unit, assuming demand stays constant. Use market research and customer feedback to find the optimal price point.
  • Reduce variable costs: Lowering your COGS frees up more money to cover fixed expenses. Look for ways to streamline production, negotiate better rates with suppliers, and reduce waste.
  • Repackage offerings: Could you offer a smaller size at a lower price point to appeal to more price-sensitive customers? Or a luxury version with premium pricing? Varying your product mix can help you capture more contribution margin.

Trim Fixed Costs

  • Embrace automation: Investing in technology that reduces manual labor can significantly cut personnel costs over time. For example, using chatbots for customer service or inventory management software.
  • Outsource strategically: Do you really need a full-time in-house bookkeeper? In many cases, outsourcing to a freelancer or agency can provide the same services at a fraction of the fixed cost.
  • Renegotiate contracts: From your office lease to your software subscriptions, regularly shopping around for the best deal can uncover major savings. Don‘t be afraid to negotiate aggressively, especially if you‘re a veteran customer.

Let‘s see how this might play out for our bowl business. If they can cut variable costs by $5 per unit by sourcing less expensive raw materials, their contribution margin per bowl increases to $35 and their contribution margin ratio rises to 70% ($35 ÷ $50).

Assuming no changes in fixed costs, their new break even point is:

$3,000 ÷ $35 = 86 bowls

They‘ve lowered their break even point by 14 units per month, accelerating their path to profitability.

Break Even Point for Multiple Products

So far we‘ve focused on break even point for a single product. But what if your business sells multiple products or services? The basic formula still applies, but the calculations get a bit more complex.

The key is to calculate a weighted average contribution margin. This involves finding the contribution margin ratio for each product and then weighing them based on their percentage of total sales mix. Here‘s an example:

Say the bowl maker also sells ceramic mugs at a price of $20 with variable costs of $5. The mugs have a contribution margin of $15 and a contribution margin ratio of 75%. If mugs are expected to be 30% of the total sales mix, then the weighted average contribution margin is:

(Bowls: 70% x 60%) + (Mugs: 30% x 75%) = 64.5%

Assuming fixed costs are still $3,000, the break even point in total sales is:

$3,000 ÷ 0.645 = $4,651

To calculate the break even point in units for each product, simply multiply the sales mix percentage by the total units. If the business expects to sell 120 total pieces, that breaks down to:

  • Bowls: 120 x 70% = 84 units
  • Mugs: 120 x 30% = 36 units

The key takeaway is that having a diverse product mix with varying contribution margins gives you more levers to pull to reach break even.

Putting Your Break Even Point Into Action

Knowing your break even point is one thing. Actually using that information to drive profitability is another. Here are some action steps to make your break even insights work for you:

  1. Set sales targets: Use your break even point to establish monthly, quarterly, and annual sales goals for your team. Make sure to account for seasonality and other factors that could impact demand.

  2. Monitor your margins: Create a system for tracking your contribution margins and break even points on a regular basis. This could be as simple as a spreadsheet or as robust as a real-time dashboard in your accounting software.

  3. Scenario plan: Plug different price points, cost structures, and sales mixes into your break even formula to see how the numbers change. This can help you stress-test your strategies and prepare for contingencies.

  4. Communicate with stakeholders: Share your break even analysis with your employees, investors, and advisors. This transparency can foster a sense of shared ownership and accountability.

  5. Celebrate the wins: Hitting break even is a big deal! Take time to acknowledge this milestone with your team and use it as motivation to keep pushing forward.

Wrapping Up

At the end of the day, reaching break even is just the beginning. It‘s the foundation upon which you build sustainable, long-term profitability. By understanding and tracking your break even point, you can make more informed decisions, set smarter goals, and ultimately steer your business toward financial success.

Is it a simple calculation? Yes. But don‘t underestimate its power. As the old saying goes, "You can‘t manage what you don‘t measure." So start measuring your break even point today and watch your profits soar tomorrow.

Tags: