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?
What is a variable cost?
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?
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
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.
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
What is break-even ratio and safety margin ratio?
Break-even point ratio
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.
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
How to utilize the break-even point in management
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!