What’s it: The breakeven point is the point where revenue equals total costs. At that point, the company’s sales level is not high enough to profit but not low enough to incur a loss.
Why is the breakeven point important
Businesses use breakeven analysis to provide information in decision making. Management knows how much they have to sell to cover all production costs. Furthermore, when they set a profit target, they can include it to calculate the target sales volume.
Marketing departments use such information to design marketing strategies. Management uses breakeven volume as a minimum sales target. And, the marketing department must be able to achieve it. As sales pass, each unit sold adds to their profit.
Calculating the breakeven point
At breakeven, total costs equal total revenue. To calculate total costs, you add up total fixed costs by total variable costs. Meanwhile, total revenue is equal to the price per unit times the quantity sold. Thus, the basic breakeven formula is:
- Total costs = Total revenue
- Total fixed costs + Total variable costs = Price x Quantity sold
Beyond that point, when revenue exceeds total costs, the company records a profit. Conversely, when costs exceed revenue, the company incurs a loss.
Calculating the breakeven volume
Breakeven volume is the minimum sales volume to generate revenue equal to total costs. In this case, we are assuming the selling price per unit as a given – determined outside the formula. To calculate it, you can use the following formula:
- Breakeven volume = Total fixed costs / (Selling price per unit – Variable costs per unit)
In this case, the difference between the selling price per unit and the variable cost per unit (average variable cost) represents the contribution margin per unit.
Take a simple example. A company sells a product for $12,000 per unit. To produce it, the firm bears total fixed costs of $100,000 and variable costs per unit of $2,000.
If the company sells only one product, it earns $10,000 after paying the direct costs (variable costs), which are $12,000-$2,000. That is the contribution margin per unit. Since fixed costs are $100,000, the firm must sell 10 units = $100,000 / ($12,000-$2,000) to break even.
In general, the lower the fixed costs, the less the breakeven volume. For example, in the above case, if fixed costs are $20, then the breakeven volume is 2 units.
Furthermore, companies often target a profit for each of their sales. To accommodate these targets, you add them to the total fixed costs.
- Target breakeven volume = (Total fixed costs + Target profit) / (Selling price per unit – Variable costs per unit)
In the previous example, let’s say the company was targeting a profit of $40. To achieve this, the company must sell as many as 14 units = ($100,000 + $40,000) / ($12,000-$2,000).
So, by selling 14 units, the firm gets a profit of $40 = (14 units x $12,000) – $100,000 – (14 units x $2,000).
Calculating the breakeven price
The breakeven price is the selling price to cover total costs, assuming constant sales volume. To calculate it, you need data on fixed costs, variable costs, and sales volume.
Take the previous formula:
- Total fixed cost + Total variable cost = Price x Quantity sold
- Price = (Total fixed cost + Total variable cost) / Quantity sold = Fixed costs per unit + Variable costs per unit
Another term for the cost per unit is the average cost.
To apply the formula, let’s take a simple example. A company reports a sales volume of 1,000 units. It bears total variable costs of $25,000 and total fixed costs of $40,000.
In that case, to cover the costs, the firm sets a price of $65 per unit = ($40 + $25) / 1,000.
Contribution margin
The contribution margin is the difference between revenue and total variable cost. We also call this the total contribution. Since variable costs represent direct costs, the total contribution is the rupiah left after paying direct costs.
- Contribution margin per unit = Price – Variable cost per unit
- Contribution margin = (Price – Variable cost per unit) x Quantity sold = Revenue – Total variable cost
The contribution margin tells you the potential profit and shows how much the sales cover the fixed costs. The first sale must cover variable costs, such as raw materials and other inputs. Without variable costs, the company cannot produce a product.
If the contribution margin equals the total fixed costs, the company breaks even. Thus, to make a profit, the contribution margin must be higher than the fixed cost. The higher the difference between the two, the greater the company’s profits.
Effect of changes in prices and costs on the breakeven point
First, the higher price reduces the breakeven quantity. The company gets a higher contribution margin per unit. Since total costs remain unchanged, the company has to sell less volume to cover it.
Conversely, lower prices require the company to sell more volume to break even. Each sale results in a lower contribution margin. Therefore, to cover fixed costs, the company needs a higher sales volume.
In this case, we assume variable costs are unchanged. Also, changes in sales volume are not determined by the law of demand but within its control. Under the law of demand, an increase (decrease) in price decreases (increases) volume.
Second, the increase in costs will raise the breakeven volume. As in the formula above, both variable costs and costs correlate positively with breakeven volume.
Take back the first formula above.
- Breakeven volume = Total fixed costs / (Selling price per unit – Variable costs per unit)
To measure the impact of an increase in fixed costs, assume prices and variable costs are constant. So, the contribution margin per unit remains unchanged. Thus, to cover higher fixed costs, companies must sell more products.
Next, to measure the impact of increases in variable costs, assume fixed costs and prices are unchanged. So, the contribution margin per unit (denominator) falls. As a result, the breakeven volume will be higher.
Advantages of breakeven analysis
The breakeven analysis is relatively simple in its calculations. It is suitable for the analysis of companies with a single product. Apart from that, other benefits of this analysis are:
First, you can more easily interpret the relationship between revenue, price, fixed costs, variable costs, sales volume, and profit. The analysis helps to answer what is the minimum target sales volume to cover costs.
Second, you can predict the impact of changing prices and costs on business profitability and sales targets.
Third, analysis allows us to translate profit targets into sales targets. As I discussed earlier, you have to add the target profit to total fixed costs to get breakeven volume.
Limitations of breakeven analysis
Break-even analysis is not suitable for companies with a wide range of products. Also, the analysis relies on several assumptions for prices, fixed costs, and variable costs. Thus, the accuracy of the assumptions affects the results you get. Here are some of the limitations of the breakeven analysis.
First, constant costs are irrelevant because economies of scale can cause average costs to fall. Thus, when the firm increases production to reach the target volume, the average cost falls. Assuming the price does not change, the reduction in costs decreases the target volume, so the previous analysis results are irrelevant.
The opposite effect applies when an increase in production results in diseconomies of scale and increased average costs.
Second, external factors affect demand and company revenue. During a deteriorating economy, for example, consumer demand falls. As a result, competition increased. That situation may require the company to change its pricing strategy and sales targets. And, it may not match the breakeven analysis results.
Third, some costs are semi-variable. They make it more difficult to break them down into fixed or variable costs and allocate them to products. If the company sells a variety of products, the calculations become increasingly complex.
