Break-Even Analysis

What It Measures
Break-even is the point at which a product or service stops costing money to produce and sell, and starts
generating a profit for your business. This means sales have reached sufficient volume to cover the variable
and fixed costs of producing and distributing your product.

Why It Is Important
The ultimate goal of any business is to make money, but break-even analysis can also provide valuable
information for profitable businesses in terms of setting price levels, targeting optimal variable/fixed price
combinations and determining the financial attractiveness of various strategies for a business.
Break-even analysis allows a business to understand what the minimum level of sales needed is to ensure
that it does not make a loss, and how sensitive the break-even point is to changes in fixed or variable
expenses. It can help you to understand and examine the profit drivers of your business.

How It Works in Practice

Say you are an entrepreneur looking to sell t-shirts across Europe. You will want to know how many t-shirts
you need to sell before your venture generates a profit. This figure can then be compared to your sales
forecasts to judge the likely success of your venture. There are two ways of calculating break-even points, as
shown below.
The variable cost of producing a single t-shirt is $1. The fixed costs of the business over a year (those costs
that won’t vary month to month) include items such as telecommunications, rent, and insurance, and total
$25,000 in year one. The unit price you are expecting for each t-shirt is $5 and your projected sales in year
one are 50,000 units.
To calculate break-even, either draw a chart showing:
• sales revenue at different levels of output;
• fixed costs at different levels of output;
• total costs at different levels of output;
The point where total cost equals total sales revenue is the break-even point.
Or use the data available to calculate the contribution of each unit sold or made. This is the difference
between the sales revenue and the variable cost of each unit. Using the example of the t-shirts, each t-shirt
brings in $5 of revenue against $1 in variable costs. The contribution of each unit is said to be $4, because
the unit makes a $4 contribution towards fixed costs.
The number of units needed to be sold to break even is therefore the total fixed cost divided by the
contribution per unit. The t-shirt venture would need to sell enough t-shirts to cover fixed costs ($25,000)
divided by the unit contribution ($4)—in other words, 6,250 shirts.
Break-even analysis is particularly useful in comparing alternative scenarios. For example, you might
consider what happens if labor costs rise and the variable cost of producing a t-shirt doubles to $2? In this
scenario, the contribution per shirt falls to $3 but fixed costs remain $25,000—meaning the business needs
to now sell 25,000/3 t-shirts to reach break-even (8,334 shirts).
The simple formula for this method is:
Break-even sales ($) = Fixed costs ÷ (Contribution margin ÷ Total sales)

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Tricks of the Trade
• Fundamentally, there are only three ways to reduce break-even: lower direct costs to increase the
gross margin; reduce fixed expenses and lower necessary total costs; or raise prices to increase
revenues.
• Categorizing costs as fixed or variable is essential for break-even analysis. Fixed costs are those not
related to the volume of production, often referred to as “overheads.” These costs will remain static
even if you do not produce any goods, and include items such as staff salaries, insurance, property
taxes, and interest. Variable costs are those related to production output or sales, and might include
raw materials, commission, packaging, and shipping costs. Without a good understanding of your
costs, break-even analysis will be meaningless.
• Remember that the break-even point is not a static figure. You should compare projections to real-life
results every three to six months, and make adjustments if necessary. In particular, expenses tend to
increase over time and you may fall below break-even point because you think it is lower than it has
become.
• When conducting break-even analysis, you might want to add in a margin for profit. For example, you
might want to target a specific profit margin goal and this can be incorporated into break-even analysis
as follows:
Break-even ($) = (Fixed costs + Profit goal) ÷ (Contribution margin ÷ Total sales)
• Another refinement of the break-even analysis is the “sensitivity analysis.” This refers to using the
break-even point to evaluate different scenarios. For example, what happens if you increase prices by
25%? What happens if unit sales fall by 20%? Using a spreadsheet, it is very simple to perform such
calculations quickly, allowing you to look at different situations.

More Info
Articles:
• “Fixed, variable costs and break-even.” The Times 100. Online at: www.thetimes100.co.uk/theory/
theory--fixed-variable-costs-break-even--122.php
• “Mind Your Business—Break-even analysis: Debts, revenues and costs.” Biz/ed (November 18, 2008).
Online at: www.bized.co.uk/current/mind/2008_9/181108.htm

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