A breakeven analysis determines the sales volume your business needs to start making a profit, based on your fixed costs, variable costs, and selling price. It often is used in conjunction with a sales forecast when developing a pricing strategy, either as part of a marketing plan or a business plan.
The formula for a breakeven analysis is:
Fixed costs/(Revenue per unit-Variable costs per unit)
Fixed costs are expenses that must be paid whether or not any units are produced. They are fixed over a specified period of time or range of production, and examples include:
- Business premises lease (or mortgage) costs over the contract period
- Startup loan payments (if you financed the business startup costs)
- Property taxes
- Vehicle leases (or loan payments if the vehicle is purchased)
- Equipment (machinery, tools, computers, etc.)
- Payroll (if employees are on salary)
- Accounting fees
Fixed costs are easy to calculate for existing businesses, but new businesses must do research to get the most accurate figures available.
Unit costs vary depending on the number of products produced and other factors. For instance, the cost of the materials needed and the labor used to produce units isn't always the same. Examples of variable costs include:
- Wages for commission-based employees (such as salespeople) or contractors
- Utility usage—electricity, gas, or water—that increases with activity
- Raw materials
- Advertising (can be fixed or variable)
- Equipment repair
- Sales tools such as credit card processing fees
Suppose that your fixed costs for producing 30,000 widgets are $30,000 a year.
Your variable costs are $2.20 for materials, $4 for labor, and $0.80 for overhead for a total of $7.
If you choose a selling price of $12.00 for each widget, then:
This means that selling 6,000 widgets at $12 apiece covers your costs of $30,000. Each unit sold beyond 6,000 generates $5 worth of profit. A sample breakdown leading to this calculation might look soething like this:
|Fixed Costs for 30,000 widgets (per year)|
|Total Fixed Costs||$30,000|
|Variable Costs (per unit produced)|
|Total Variable Cost (Per Unit)||$7.00|
|Selling Price Per Unit||$12.00|
|Selling price - variable costs||$5.00|
|#Units to sell/year to breakeven ($30,000 / $5.00)||6000|
|#Units to sell/year to generate $10,000 profit||8000|
|#Units to sell/year to generate $50,000 profit||16000|
Using BreakEven Calculations
A breakeven analysis allows you to apply various scenarios to your breakeven point and possibly increase profits. Some reasons to calculate the analysis include:
- Increasing the selling price: Staying with the example of $12 widgets, increasing the selling price by $1 reduces the number of units you need to sell by 1,000 based on a new calculation: $30,000/($13-$7)=5,000. However, increasing the selling price often is not an option in a highly competitive environment.
- Reducing your fixed costs: If you were able to reduce your fixed costs by $5,000, you also would reduce the breakeven point to 5,000 units sold. Reducing rent and payroll are common ways for businesses to reduce fixed costs, as is relocating to other jurisdictions that have lower business taxes or utility costs.
- Reducing variable costs: Reducing variable costs by $1 also would lower the breakeven point by 5,000 units. Variable costs typically are lowered by reducing material or labor costs. For example, a builder could source lumber from a lower-cost supplier or take advantage of equipment and/or technology to automate production.
- Increasing sales: Assuming breakeven unit sales of 6,000, increasing the number of units sold to 10,000 would boost profits by $20,000 (4,000 units at $5 per unit). This calculation can be used when considering the benefits of advertising. Raising your advertising budget by $5,000 per year would raise your fixed costs to $35,000 and your breakeven point to 7,000. If such an ad campaign raised your unit sales from 6,000 to more than 7,000, it would be considered successful.