Q. I’ve just started my business. A friend told me that I should calculate the sales volume I’ll have to reach to achieve breakeven. Can you give me the formula for that calculation?
A. We agree with your friend, understanding your breakeven point is very important. It will help you know how much your sales have to grow before you will reach profitability. With this information you can estimate how long you will need to be able to sustain losses and plan your cash flow accordingly.
We could just give you a formula for calculating breakeven. Unfortunately, just plugging numbers into an equation you don’t understand can result in answers that will lead you in the wrong direction. Understanding just a few details can help you avoid these pitfalls.
In its simplest terms, breakeven occurs when your business is neither making nor losing money. In other words,
Revenue = Total Expenses
For the purposes of calculating breakeven, we can think about two types of Expenses, Fixed Costs and Variable Costs. Fixed Costs are those that do not change as the number of Units you sell grows. For example, if you are a retail store, rent is likely to be the same regardless of the number of Units sold.
On the other hand, Variable Costs are those that increase as the number of Units you sell grows. Again, if you are a retail store, when the number of Units you sell increases, the money you pay for the merchandise you sell will also increase. These costs vary with the number of units sold. Therefore, we can say that:
Total Expense = Variable Costs + Fixed Costs
Variable Costs can be expressed as the number of Units sold times the Variable Cost per Unit. Therefore,
Total Expense = (Units X Variable Cost per Unit) + Fixed Costs
Obviously, the Variable Cost per Unit will not likely be the same for every unit you sell. Some items will be more expensive others will cost less. Therefore, the Variable Cost per Unit will be an average. Total Revenue can be expressed as Price times Units sold. Therefore, at breakeven
Price X Units = (Units X Variable Cost per Unit) + Fixed Costs
Solving for the number of Units that needs to be sold to breakeven yields
Breakeven Units = Fixed Costs / (Price – Variable Cost per Unit)
This makes sense. Price minus Variable Cost per Unit is the amount of money you have to cover Fixed Costs each time you sell a Unit. Let’s say that Fixed Costs are $2,000 per month while the average Price for the things you sell is $2 and the average Variable Cost per Unit is $1. This means that every time you sell a Unit you get $1 toward covering Fixed Costs. Because Fixed Costs are $2,000 per month, you’ll need to sell 2,000 Units each month to breakeven.
Obviously, if you calculate Breakeven Units, this can be converted into Breakeven Revenue. In our example above, Breakeven Units is 2,000, but each unit sells for $2. Therefore, Breakeven Revenue is $4,000 (2,000 X $2). It is also possible to calculate Breakeven Revenue directly without calculating Breakeven Units first. To do this, multiply both sides of the equation above by Price.
Price X Breakeven Units = Fixed Costs X (Price/(Price – Variable Cost per Unit))
(Price – Variable Cost per Unit)/Price = Gross Margin %
Price/(Price – Variable Cost per Unit) = 1/ Gross Margin %
Breakeven Revenue = Price X Breakeven Units
Plugging this into the equation above yields
Breakeven Revenue = Fixed Costs X (1/Gross Margin %)
Breakeven Revenue = Fixed Costs/Gross Margin %
One word of caution; make sure that you understand what costs are really fixed given the revenue change you are contemplating. Costs that are fixed for a 10 percent or 20 percent increase in revenue may well not be fixed if the business has to grow by a factor of 5 times. Make sure you understand how your cost structure will change over the range of growth you need to reach breakeven. Failure to do so can result in grossly underestimating the breakeven, which can result in very bad business decisions.
Understanding your business’ breakeven point is powerful, but you’ll need to ensure you fully understand the economics of the challenge you face. Basing business decisions on an oversimplified analysis can lead to disaster. Getting a good grip on the details outlined above will enable you to avoid this pitfall.