When running a business, a lot of costs are involved- there are labour, materials, rent, marketing expenses, and insurance. To make profits, the total revenue from sales should be more than the cost of production.
However, before you make profits, there is a point where revenue from sales will be equal to the cost of production. And that point is called the breakeven point. Your business has to reach the point of breakeven to be profitable.
Is the breakeven point essential in a business? The answer is a big yes. The success of any business depends on making the right decisions. Knowing breakeven points helps business owners make smart decisions about production levels, pricing, and marketing. Such decisions are crucial to making profits and the growth of a business.
But how do businesses calculate the breakeven point? Find out from the steps below.
Steps to Calculate Breakeven Point
Finding the breakeven point begins with calculating business operation fixed and variable costs. Fixed costs are business expenses incurred once when business activities start. Examples of fixed costs include labour expenses, depreciation costs, rents, salaries, taxes, and energy costs.
On the other hand, variable costs are business expenses that fluctuate. The variable cost can decrease or increase depending on the volume of production. Examples of business variable costs include:
- Packaging costs.
- Fuel.
- The cost of raw materials.
- Other expenses related to production.
After getting fixed and variable costs, a business owner can use the formula below to calculate the breakeven point.
Breakeven point = FIXED COST ÷ (COST PER UNIT - VARIABLE COST)
What is Breakeven Point Example?
Let's assume Company XYZ sells pens. In 2021, the company realized that it uses a fixed cost of ₹50,000 and a variable cost of ₹2 per pen. As a result, the company sells each at a price of ₹ 10. So, what is the breakeven point of the company?
Solution
Fixed cost = ₹50,000, variable cost = ₹2, and price per unit = ₹10. Using the formula above, the breakeven point will be as follows.
Breakeven point= 50000 ÷ (10-2)
= 50000 ÷ 8
= 6,250.
So, company XYZ has to sell 6,250 units of pens to break even.
5 Importance of Breakeven Point Analysis
Budgeting and Target Setting
Budgeting is a vital component of any business. It's easy to estimate how much you need to produce goods or services and make a profit using breakeven analysis. In addition, setting business or company targets becomes easy with the point of breaking even. A correct estimation of a breakeven point helps companies to set more realistic targets. You know exactly how much sales you need to be profitable.
The Breakeven Point Helps to Monitor and Control Costs
Fixed costs and variable costs affect a company's profit margin. When fixed and variable costs go down, the profit margin increases. On the other hand, if the two types of cost rise, the margin profit becomes small. With breakeven point analysis, companies can detect effects that change production costs, making it easier to control. Changes in the cost of production affect the points of breaking even.
Helps to Design a Pricing Strategy
Change in the pricing of a product affects the breakeven point. For example, raising the selling price lowers the number of products sold for breaking even. Equally, reducing the selling price requires a company to sell more products to break even.
Do you intend to create a long-term pricing strategy? If yes, breakeven point analysis is critical. For example, after paying off the investment costs, you may keep prices the same. That means you get constant profits throughout a trading period. However, you can reduce prices since there are no investment debts after breakeven. Lowering prices increases sales volume, giving business-benefits of economies of scale.
Breakeven Point Analysis Influences Business Financial Strategies
Businesses can break even using multiple ways. You can increase sales or raise the selling price of products, which increases the profit margin. Reducing business expenses through cost-cutting measures also helps to break even with ease. Therefore, knowing the breakeven point informs the financial strategy to implement.
Effects on Marketing Considerations
When considering a sale or discount, breakeven points help determine if a business makes a profit at the same price. Marketing promotions are suitable for a business. However, it's essential to determine if the promotion cost is worth the current overhead expenses.
Will promotion cost lead to a new breakeven point? Does your business deal with different products? Knowing the actual breakeven point of products helps to decide whether to drop a product.
Effective Tips to Lower Breakeven Point
Minimizing Variable Costs
Variable costs increase or decrease depending on sales volume. For example, more manufacturing materials and shipping mean more variable costs. You can negotiate to buy and ship a minimum quantity at lower costs every month, which reduces variable costs.
The cost of manufacturing materials varies depending on suppliers. Researching suppliers with the lowest price and lower variable costs. Established businesses can also lower variable costs by purchasing large volumes of materials at discounts.
Reduce Fixed Costs
High fixed costs put pressure on expenses and sales revenue. Reduced fixed costs mean a business needs less sales revenue to break even. For example, when opening a storefront, your choice of space can be more expensive, leading to high fixed costs.
You may take that space but sublease a portion of the room, which reduces the cost of renting. On the other hand, getting a small storefront costing less lowers the fixed cost.
Increasing the Selling Price of a Unit
You can consider increasing the current price of products if it doesn't break even as expected. Increasing the cost per unit reduces the number of products you need to sell to meet the breakeven point.
Before increasing the prices, figure out the willingness of customers to pay higher prices. Buyers' can still buy when prices rise. But high prices should be accompanied by improved quality.
In summary, a business attains a breakeven point when sales and cost of production are equal. Calculation of breakeven requires finding fixed and variable costs first. The point of breakeven is essential in managing the cost of running a business.in addition, breakeven analysis helps firms develop effective pricing strategies to profit.
FAQs
What is a breakeven point?
It's an accounting term where revenue generated from sales equals the cost of production within a business period.
Does all business need breakeven point analysis?
Yes. Breakeven analysis helps the business to manage the cost of production, pricing, and even marketing of products.
How do I calculate the breakeven point of my business?
To calculate the breakeven point, a business should establish the total fixed and variable costs. After that, the total fixed cost is divided by the selling price per unit, less the variable cost.
What should a business owner do when the business is not meeting the breakeven point?
Businesses can lower the breakeven point when the current price isn't breaking the even point. Here is how to reduce the breakeven point.
- Increase the selling price of the products per unit.
- Reduce the fixed and variable cost, which lowers the number of units to sell to breakeven
- Improving the sales mix can reduce the breakeven point where you sell more products in demand.
Does breakeven point analysis have any limitations?
Yes, breakeven analysis does not account for buyers' demands. It only offers a sense of how many units a product should sell. A company might remain with unsold products when the projected demand isn't attained as expected.