If you look at your bank account unsure whether you should pay yourself a little extra this month or whether you can afford to spend some money to grow your business, then calculating break-even point is a great place to start to get some financial clarity.
Working out break-even isn’t something just for the corporate giants and their accountants. It’s a number that is useful if you’re a sole trader, start-up and anyone wanting to grow their business.
What is Break-Even?
Put simply, break-even is the point where the income and costs of your business are exactly equal.
If costs exceed income, then a business is loss-making.
But if income exceeds costs, the business is making a profit.
What Are the Advantages of Break Even point?
The great thing about having this number to hand for self-employed business owners is that it represents peace of mind.
You know exactly what you need to earn to cover your costs, including your own salary. It’s basically your sales target!
Of course, for some, the ideal is to be able to turn a profit so they can save some money or invest in their business. But this gives you an informal head-start at knowing precisely which point you’ll start making that profit
Working out your break-even point also helps you to start analysing your costs. Any type of cost analysis gives you the opportunity to save money. Just seeing numbers of a page gives you the starting point to see what you spend money on and check whether you are wasting anything or can find cheaper options.
What Are the Disadvantages of Break Even point?
The main disadvantage is that you need to use a certain amount of estimation and possibly some averages.
That means your break-even point will always be an estimate.
And since you may be using some estimates, if they change you need to recalculate your figures.
That’s no bad thing. As long as you make reasonable estimates you can never go too far wrong. And it’s much better than burying your head in the sand when it comes to your numbers.
Working out break-even involves using just one price for your product or service. So if you have multiple products using an average for all of them can mean your calculation may be flawed.
How to Calculate Break-Even
There are 5 steps involved when it comes to working out break-even point:
- Calculate variable costs
- Calculate fixed costs
- Identify unit sales price
- Identify cost per unit
- Use the break-even formula
Variable costs, as the name suggests, vary according to what you sell.
So let’s say you are a self-employed Esty store owner then example variable costs might include:
- Raw materials;
- Etsy fees;
- Credit card fees.
These costs change according to how many units are sold.
Fixed costs are defined as costs that you need to pay for regardless of how much you sell.
Let’s take a self-employed bookkeeper, their fixed costs would be things like:
- Software subscriptions.
They are costs that you have to pay for just to be in business.
The Break-Even Formula
Once you have worked out your fixed and variable costs you can move onto calculating your break-even point.
The break-even formula you’ll need will depend on the type of business you have. If you produce or manufacture your own products, like an Etsy seller, then you’ll need to use this:
Fixed costs / ( Price per unit – Variable costs per unit) = Break-even point
If you run a business that does not have any cost of sale, then the formula is much simpler:
Fixed costs = Break-even point
An Example of Working Out Breakeven Point
You run an Esty Store making candles. You estimate the following figures:
Total variable costs = £10,500 per year
Total fixed costs = £3,500 per year
Estimated sales are 2,000 units per year at an average price of £15
Here’s how you would work out how many units you need to sell in order to cover all your costs and break-even.
£3,500/(£15 – £5.25) = 358.97 units
What Happens if Your Sales and Costs Change
The formula depends on the numbers you put in. Some of which, like estimated sales and average sales price, you’ll need to do your best to come up with.
If any of these numbers change significantly from your estimates then you should definitely re-calculate your break-even point.
If your fixed costs are lower, your break-even point will go down because you’ll have less to cover.
Using the example above, if fixed costs became £2,500 break-even point would become 256 units (£2,500/(£15 – £5.25)).
In other words, you need to sell less to cover your costs.
Once you have worked out break-even point remember to take a step back and check whether you can reasonably deliver the goods or services you need to in order to cover your costs.
You should also keep reviewing your number and check whether any of your initial estimates have changed. That way you know you have the best possible estimate for making your business decisions.
If you are in a service based industry then calculating your hourly rate may be a more useful calculation to make instead of break-even. You’ll figure out exactly what you need to charge per hour to cover all your costs and taxes.