Break-even analysis (or break-even analysis) is a very useful cost accounting technique. It fits into the more general analysis model called cost-volume-profit (CVP) analysis, and helps determine how many units of product your business needs to sell to recover costs and start making profits. To learn how to do break-even analysis follow the few steps below.
Steps
Step 1. Determine your company's fixed costs
Fixed costs are defined as costs that do not depend on the volume of turnover. Rent and utility fees are an example of fixed costs, because you always pay the same amount, no matter how many units of product you sell or produce. Rank all your company's fixed costs for a given period of time and add them up.
Step 2. Determine your company's variable costs
Variable costs are those that vary as the volume of turnover changes. For example, a machine shop that does oil change service for passenger cars will have to buy more oil filters if it does more, so the cost of purchasing oil filters is a variable cost. In fact, since the company has to buy an oil filter for each oil change, this cost can be considered inherent to each oil change made.
Step 3. Determine the price at which you will sell your products
Pricing strategies are a component of a much broader marketing strategy, and they can be quite complex. However, you can be sure that the selling price will be no less than the cost of production (and indeed many antitrust laws exist precisely to make underselling illegal).
Step 4. Calculate the contribution margin
The unit contribution margin represents how much money each unit of product sold makes after recovering its unit variable costs. It is calculated by subtracting the unit variable cost from the unit sales cost. Consider the following example, based on the oil change business.
- Suppose the price of an oil change is 40 euros (note that these calculations work equally well with other currencies as well). Each oil change has three costs associated with it: the purchase of an oil filter (let's say 5 euros), the purchase of engine oil (let's say 5 euros), and the cost of the technician making the change (let's say 10 euros). These are the variable costs associated with an oil change.
- The contribution margin for a single oil change is equal to: 40 - (5 + 5 + 10) = 20 euros. Therefore, carrying out an oil change in favor of a customer brings the company 20 euros in revenues after recovering its variable costs.
Step 5. Calculate the company's break-even point
The break-even point is used to determine the volume of sales you need to achieve to cover all costs. It is calculated by dividing the sum of fixed costs by the contribution margin of the product.
Using the example above, let's imagine that your company's fixed costs for a certain month are equal to 2,000 euros. Therefore, the break-even point is equal to: 2000/20 = 100 units. When the company manages to make 100 oil changes, it reaches the break-even point
Step 6. Determine the expected profits (or losses)
Once you have determined the break-even volume, you can estimate the profit expectations. Remember that each additional unit of product sold will generate revenues equal to the contribution margin. Thus, each unit sold beyond the break-even point will produce a profit equal to its contribution margin, and each unit sold below the break-even point will produce a loss equal to the contribution margin.
- Using the example above, let's imagine your business made 150 oil changes in one month. Only 100 oil changes were required to reach the break-even point, so the additional 50 oil changes generated a profit of 20 euros each, for a total of (50 * 20) = 1,000 euros.
- Now imagine your business only made 90 oil changes in one month. In this case you have not reached the break-even volume, so you have sustained a loss. Each of the 10 oil changes below the break-even volume generated a loss of 20 euros, for a total of (10 * 20) = 200 euros.
