The break even point ( BEP ) is a fundamental concept in the financial management of a business.
I believe that business owners and entrepreneurs need to have a great understanding of break even point analysis and the associated cost-volume-profit relationship and cash flow management if they are going to create a long term successful business.
It’s not difficult to calculate and understand and it will give you a much deeper understanding of the dynamics of your business and how you make money in it.
What Is The Break Even Point?
The Break Even Point for a business is the sales volume or sales value where the business neither makes a profit or a loss but is said to break even.
While arithmetically, the break even point is very precise, in general if a business is trading at a small profit or loss, it is said to be breaking even.
That’s because small fluctuations in what happens will mean that some months, it will make a small profit and in other months, when things don’t go so well, there will be a small loss.
When It Is Useful To Calculate The Break Even Level of Sales?
It is helpful:
- When a business start-up is making its initial business planning, it can test various assumptions about costs, prices and demand to assess the viability of the business.
- After a new business has started, the cost and selling price assumptions will have turned into some kind of reality. Calculating the break even point again lets it check the likelihood of success.
- If an established business is struggling with low profitability or making losses, break even point analysis helps to focus attention on contribution margins and fixed costs.
I also believe in monitoring the break even point even if a business is doing well. It is a good financial discipline to stop costs getting out of control and to watch for margins reducing as selling prices are discounted to win extra business.
The Two Main Ways To Calculate The Break Even Point
In this article I will explain both ways to calculate the break even point:
- Where sales volume can be monitored by a measure of volume.
- Where sales volume is hard to measure and sales value is used.
The Cost Volume Profit Relationship
I have explained about the concept of contribution and the two different types of costs – variable costs and fixed costs in this article.
If you are not familiar with these ideas, I recommend you read the article before you continue with this one.
How To Calculate The Break Even Point Level of Sales By Volume
Some businesses monitor sales through a common volume measurement. In metals industries, this is often tonnes, in liquids, it is litres and in professional services, hours can be used.
To calculate the BEP by volume you need to know:
- The level of fixed costs for the period
- The contribution rate / margin per unit
The Break Even Point Formula is
Contribution rate per unit
As an example, if fixed costs are £100,000 for the year and the contribution margin per unit is £40, then
BEP = 100,000 / 40 = 2,500 units
i.e. 2,500 units must be sold at an average contribution of £40 each to avoid making a loss.
If you don’t know the average contribution margin per unit, you can calculate it from:
average selling price per unit minus the average variable cost per unit
In the above example, this could have been, a selling price of £120 and variable cost of £80.
If you know the BEP by volume and the average selling price, you can calculate the value of sales revenue needed to reach break even.
The BEP sales value = the BEP by volume multiplied by the average selling price.
In this example, £120 x 2,500 units = £300,000.
How To Calculate The Break Even Point Level of Sales By Value Using The Contribution Margin %
Some businesses don’t have an easy volume measure because there is too much variety in what they sell. Think of a supermarket for example and everything it sells.
In these situations, the break even point is calculated in terms of money.
To calculate BEP by value, you need to know:
- The fixed costs per period
- The average contribution margin as a % of sales value.
The Break Even Point Formula is
Contribution Margin %
If fixed costs are £100,000 per year and the contribution margin % is 33.33%, then
BEP = 100,000/33.33% = £300,000
You can find out the contribution margin by looking at the accounts and dividing the sales revenue total into the value of contribution shown.
Variations In The Break Even Level
The BEP can be very sensitive to change, especially if both changes go in the same direction:
- It gets lower if fixed costs reduce and contribution rates increase
- It gets higher if fixed costs increase and contribution rates decrease.
For example, the BEP by sales value above had fixed costs of £100,000 and a contribution margin % of 33.33% giving a BEP of £300,000.
If fixed costs increase by 10% to £110,000 and contribution margin falls by 10% to 30%…
the new BEP calculation is 110,000/30% = £366,667
That’s an increase in the break even level of sales of 22.2%.
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