Wednesday, February 28, 2024

What is break-even point? A simple guide for new businesses

New to the business world and its terminology? Then break-even point is a term you should religiously read up about!

The break-even point is one of the indicators used in a company’s financial analysis and is a useful indicator not only for understanding the current situation but also for making decisions for the future.

But understanding how a break-even point analysis is performed is paramount. If done wrong, your team is left with incorrect data and it can lead to bad business decisions – make sure you get it right!

What is the break-even point?

The break-even point refers to the scale at which the profit calculated by “sales – expenses” becomes zero. This means that if “actual sales > break-even point,” the company will be in the black, and if “actual sales < break-even point,” it will be in the red.

As a company, the management goal is to increase the company’s profits beyond the break-even point, but in addition to simply setting profit plans and sales targets, it is also important to consider the break-even point when identifying the risks and issues faced by the company. It is possible to utilize.

Accounting profits are classified into five types: gross profit, operating profit, ordinary profit, net income before taxes, and net income after taxes, but when determining the break-even point, emphasis is placed on business analysis related to the main business. Therefore, it is common to use operating profit.

Break-even point sales and break-even point volume

Here come the nitty-gritty details that separate the individuals who know break-even on a surface level and those who know it in greater detail.

Break-even points can be divided into two types.

Break-even sales: This is the amount of money you need to make in sales to cover all your costs and expenses, so you’re neither making a profit nor incurring a loss. It’s about the total revenue (money from sales) you must achieve to break even.

Break-even volume: This is the number of units or products you need to sell to reach that break-even point. It’s about the quantity of items you must sell to cover your costs and start making a profit.

Neither one of these two indicators is better than the other, and both should be used depending on the purpose of your break-even point analysis!

On top of setting specific sales targets, we recommend analyzing the profit status of each product. This will provide a greater understanding of the profitability of each product, which should lead to effective management decisions such as increasing or decreasing marketing spend.

How is it calculated?

Before doing the break-even point analysis, you’ll need to classify your company’s costs into 
‘variable costs’ and ‘fixed costs’.

Variable costs: costs that increase or decrease in conjunction with sales.
Fixed costs: costs that remain constant regardless of increases or decreases in sales.

Although some costs such as utilities and personnel often entail a mix of variable and fixed costs.
The general process of classifying variable and fixed costs is called ‘fixed variable decomposition’. Mechanical fixed-variable decomposition based on account items might reduce the accuracy of your analysis.

This is because oversimplifying your categorization will make it harder to determine when your business is making a profit. It’s better to consider the unique characteristics of your company when categorizing the costs because not all of them will fit neatly between fixed and variable. 

What is a variable cost?

If you’re still unsure of what variable costs are, let’s break it down further.

These are costs that increase or decrease in proportion to sales or sales volume, and in extreme terms, they represent costs that can become zero if sales are zero.

Typical examples of variable costs include product purchases in the retail industry and material costs and outsourcing costs in the manufacturing industry. 

The nature of your business might include variable costs such as sales commissions and transportation costs – overall, it’s a lot to consider.

The profit obtained by subtracting variable costs from sales is called “marginal profit.

What is a fixed cost?

Let’s do the same for fixed costs.

Fixed costs are costs that occur regardless of changes in sales or sales volume and are costs that must be borne even if sales are zero.

Specific examples of fixed costs include office and factory rent, personnel costs, utility costs, and depreciation costs.

How to calculate the break-even point

The formula for calculating break-even sales volume is quite straightforward.

Fixed costs ÷ (Sales unit price – Variable costs per unit)

Note that in the above formula, “unit selling price – variable cost per unit” in parentheses represents “marginal profit per unit”, so you can also convert it to the formula below.

Break-even point sales volume = fixed costs ÷ marginal profit per unit

Put simply, the break-even sales volume is an indicator for calculating “how many units must be sold to record marginal profit to cover fixed costs.’”

Next in line is the equation for calculating break-even sales.

Fixed costs ÷ (1 – variable costs/ sales)

Note that in the above formula, “1 – variable costs/sales” in parentheses represents the “ratio of marginal profit to sales (=marginal profit rate)”, so it can also be converted to the formula below.

Break-even point sales = Fixed costs ÷ Marginal profit rate

A concrete example

Assume that your fixed costs per month are $10,000 per month and a vehicle with variable costs of $20,000 per unit is sold for $30,000, then here’s your formula:
 
Break-even point sales volume = 10,000 ÷ (30,000 – 20,000)
 
Fixed costs are not linked to increases or decreases in sales, so if the actual sales volume exceeds the break-even sales volume, “excess sales volume x marginal profit” will be recorded as operating profit.

What is break-even ratio and safety margin ratio?

It might feel overwhelming, but there’s more knowledge to be gained about the break-even point.
 
By calculating the break-even point sales and comparing it with your company’s actual sales, you can analyze the safety of your business.
 
The indicators used at this time are the “break-even point ratio” and “margin of safety”, allowing you to objectively analyze your company’s current situation based on the break-even point sales.

Break-even point ratio

The break-even point ratio is an indicator that expresses “the extent to which current sales must decrease before profits become zero,” and the lower the break-even point ratio, the higher the safety of the business.
 
You can calculate this by using the formula below.

Break-even point sales ÷ Actual sales x 100

It’s simple enough to use and can provide valuable information.

Safety margin rate

The margin of safety is an indicator that shows the extent to which actual sales exceed the break-even point sales, and the higher the value, the higher the safety of management.

Here’s your formula for calculating it.

(Actual sales – break-even sales) ÷ actual sales x 100

Note that the safety margin rate and break-even point ratio are complementary, and the sum always equals 100%. Therefore, the margin of safety can also be calculated as “1 – break-even point ratio”. 

Check out the diagram below.

How to lower the break-even point

The higher the break-even point, the more difficult it is to become profitable, so you’ll certainly want to review your company’s management structure and lower the break-even point as much as possible.
 
There are several ways to lower your break-even point, so be sure to properly analyze your company’s issues and implement an effective approach.
 
Lower fixed costs
 
By reducing fixed costs that are not directly related to acquiring sales, you can lower your break-even point and strengthen your company’s profit structure.
 
In particular, costs such as utility costs, communication costs, and travel and transportation costs can be reduced in some cases by reviewing contract details and internal workflows.
 
In many cases, the rent for an office or other property makes up the majority of fixed costs, so in addition to rent negotiations, relocating the office or using a rental office may be an effective option.
 
Regarding personnel costs, working hours can be shortened by improving operational efficiency, so effective use of human resources can also be expected to reduce fixed costs.
 
Increase marginal profit rate
 
Even with the same sales volume and sales volume, if you can increase the marginal profit rate per product, it is possible to lower the break-even point.
 
There are two ways to increase the marginal profit rate: “increase the unit selling price” or “reduce the variable cost rate.”
 
Regarding “increasing the selling price,” price negotiations are not easy because external factors such as the market environment and competitors have a large influence, but there may be cases where a review is necessary if the marginal profit rate is too low.

How to utilize the break-even point in management

Corporations that want to maximize their management must be able to quickly detect changes or issues in their company, along with their external environment – adaptability is key!
 
Break-even point analysis can be subdivided by business department, store, product, or employee. It can also be used to share a sense of purpose throughout the company, such as setting selling prices, improving cost structure, and setting profit targets.
 
Determining and reviewing sales prices
Have you ever considered doing a break-even point analysis before setting a selling price? Based on your variable costs and fixed costs when selling a new product, you can increase the probability of profitability by conducting this beforehand.
 
There’s also room for determining if your selling price needs to be revised and it’s easier to judge. For example, any changes in variable costs or fixed costs, such as a rise in raw material costs or gas prices can be simulated in a break-even point analysis.
 
Furthermore, if a customer requests a price reduction, it is possible to analyze whether there is room to reduce the price based on the break-even point.
 
Setting profit plans and sales targets

The break-even point not only determines the sales volume at which profit becomes zero, but also allows you to calculate the sales volume and sales volume required to reach a certain profit level.

By creating an annual or monthly profit plan, you can calculate the sales required to achieve your goals, making it easier to formulate specific sales strategies to obtain sales.

To formulate a profit plan and increase sales, it is essential to improve one of the components such as “number of customers,” “spend per customer,” or “purchase frequency.” However, to improve these sales components, it is common to incur costs such as advertising expenses.

And that’s precisely why it’s essential to not only reflect the increase in sales but also the increase in costs.

Visualization of management risks

The higher the break-even point sales, the more difficult it is to turn a profit, so as a general rule, it can be said that “the lower the break-even point sales, the higher the safety of the business.” By analyzing the break-even point for each business division and product group and visualizing the current situation, you can understand the risks of each business and product.

If the break-even point in sales is high and large losses are currently occurring, it may be necessary to make a decision to withdraw after considering management risks.

On the other hand, “businesses with low break-even sales” and “businesses with high marginal profit margins” can be viewed as businesses that the entire company should focus on.

But for businesses and products with high break-even sales, there may be high barriers to entry for competitors. Consider break-even point analysis as a criterion and make appropriate business decisions based on the actual business situation and market environment.

And just like that, you’re ready to make the most out of every break-even point analysis you ever do!

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Amy Menzies

Amy Menzies

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