Understanding the Break-even Analysis

One of the most important concepts in retailing is the break-even point. But understanding this concept can be a little tricky. Let's take a look at what goes into a break-even analysis, how to calculate a break-even point, and what to do with the breakeven point after you've found it. Expenses The first things you have to calculate in a break-even analysis are your expenses or costs. If you have a business, youre going to experience expenses. Expenses are the price of doing business. Anything you have to pay in order to produce the goods or services you sell are expenses. Things like utilities, equipment, raw materials, labor wages, advertising, and insurance are all expenses. Fixed Expenses vs. Variable Expenses There are two main categories of expenses fixed expenses and variable expenses. Just like its name says, a fixed expense is one that is fixed. Its an expense that is experienced before anything is produced or any service is given. Things like manufacturing equipment are fixed expenses. For example, imagine you have to buy a conveyor belt. If you produce zero units, it will cost $3000 to buy it. If you produce 10,000 units, it will still cost $3000. Whether you make a million products or none at all, a fixed expense will stay the same. On the other hand, variable expenses will change depending on how many units are produced. Raw material is a good example of a variable expense. Say that you are in the notebook-making business. The raw materials needed to make one notebook like paper, wire, glue and ink cost 20. If you decide to make 1000 notebooks, your raw materials will cost $200. If you decide to make 100,000 notebooks, your materials will cost $20,000. If you decide to make zero notebooks, your materials wont cost anything (but your business would be pointless, wouldnt it?) Semi-variable Expenses There is another category of expenses semi-variable expenses. These expenses have both fixed and variable characteristics. An example of a semi-variable expense is a fax machine. You could buy a fax machine at a certain price, but it may cost you extra money beyond the original price of the fax machine to send faxes to another country. In this way, the fax machine is a semi-variable expense; the cost is fixed when you buy it, but depending on how often you use it, the amount of the expense will be different.

How to Calculate a Break-even Point After you have determined your expenses and decided which category they belong in, you are ready to calculate your break-even point. A break-even point will give you an idea of how many units must be sold in order to turn a profit. Let's say you are running a manufacturing business. Here is a list of your expenses and contribution margins: Fixed Expenses: Variable Expenses: Selling Price: Contribution Margin: $200 $1.50 per unit $3.50 per unit $2.00 per unit (selling price minus variable expenses)

There are a few ways to calculate a break-even point. One way is to solve it algebraically. Make an equation so that expenses are on one side and revenues are on the other. $200 + $1.50x = $2.00x Then solve for x. 200 = .5x x = 400 In other words, you must sell 400 units to cover your expenses and break even. This also means that the point where you start making money in your manufacturing business is when your profit line crosses your expense line and you begin making money in your business venture. Another way to come up with a break-even point is to solve the problem graphically.

Break-even Chart
In this graph, the yellow line is the sum of the blue line and the red line. So the point that 1200 we are really concerned with is where the profit line and the total expenses line intersect.

1000 800
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Fixed Expenses Variable Expenses Total Expenses Profit

600 400 200 0 0 100 200 300 400 500 Units Sold

Just like before, we see that the break-even point is at 400 units, or $800. Changing Your Variables What would happen if you were able to change the selling price of your products? Say, for example, you began to charge $4.50 instead of $3.50. Your contribution margin would increase to $3.00 per unit. How would this change your break-even point? Mathematically, we would see that $200 + $1.50x = $3.00x 200 = 1.5x x = 133.333 In other words, you would only need to sell 134 units to break even. This break-even point is 66 units less than you would have to sell if the units were sold at $3.50.

Break-even Chart
Contribution Margin of $3 per Unit
1600 1400 1200 1000 800 600 400 200 0 0 100 200 300 400 500 Units Sold Fixed Expenses Variable Expenses Total Expenses Profit

Increasing your contribution margin is one way of lowering your break-even point. Your break-even point would also be lower if you were able to reduce your expenses. If we go back to the very first example and change our variable expenses from $1.50 to $1.10 and reduce our fixed expenses to $140, we would also be able to lower our break-even point without changing our selling price. $140 + $1.10x = $2.00x 140 = .9x x = 155.555 To break even, we would only need to sell 156 units at $3.50 a piece.

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