The breakeven point (BEP) is the sales point at which total revenue is equal to total costs. At breakeven point, you neither earn a profit nor incur a loss. Knowing how to calculate the breakeven point is an advantage since it can help you determine the right level of sales needed to break even and, subsequently, earn profit. For small businesses, the breakeven point is a business milestone and knowing your progress toward it is a good measure of your success and performance.
- BEP can be computed in two ways: BEP in sales units and BEP in sales dollars.
- The higher the BEP, the more effort you need to reach it. You should compare the BEP to forecasted sales to determine if it’s attainable.
- Reducing the BEP can be done by reducing fixed costs, reducing variable costs, or increasing selling prices.
How To Calculate the Breakeven Point in Sales Units
The breakeven point in units shows the number of units that needs to be sold to break even. You can use this figure as the reference point for your unit sales goal and as a base figure for evaluating sales efficiency and effectiveness.
The breakeven point formula for BEP in units is:
|Total Fixed Costs
The sales price less the variable cost—shown in the denominator—often is referred to as the Contribution Margin. It represents the amount contributed toward fixed cost and eventually profit for every unit sold.
To illustrate, let’s assume our total fixed costs is $3,000. We sell our products at $16, and the variable cost to produce each unit is $10. How many units do we need to sell to reach BEP?
BEPu = $3,000 ÷ $6 per unit
BEPu = 500 units
Therefore, we need to sell 500 units to break even. In other words, we will fully recover total fixed costs of $3,000 if we sell 500 units, and more sales beyond that 500 units would yield a profit.
In a small business perspective, you can use BEP in units to know the minimum number of units that you need to produce and sell to reach breakeven. That also means that unit sales below 500 will always be at a loss and unit sales above 500 will always be at a profit.
Ideally, we want to have a lower BEP in units. A high BEP in units means that we’ll have a harder time reaching breakeven, especially if sales are slow.
How To Calculate the Breakeven Point in Sales Dollars
Another variation of the breakeven point formula is to compute it in dollars, not in units. BEP in dollars is useful for service-based businesses that don’t count revenues per unit sold. The BEP in dollars formula should look like this:
|Total Fixed Costs
The denominator can also be called the contribution margin ratio (CMR). Total sales less total variable cost is the contribution margin, and if you divide further with total sales, you get the CMR.
To illustrate, let’s assume our total fixed costs is $20,000. Total sales and variable costs are $80,000 and $48,000. How much level of sales is needed to reach BEP?
BEP$ = $20,000 ÷ 40%
BEP$ = $50,000
Therefore, we need to reach total sales of $50,000 to break even.
The Breakeven Point Chart
The best way to understand the BEP is to illustrate it using the BEP chart. This chart illustrates the relationships of profit, revenue, costs, and the BEP.
- The red line represents total fixed costs, and it remains constant in dollar value regardless of the number of units sold.
- The orange line represents total revenue, and it always starts at zero.
- The blue line represents total costs, which includes both the fixed and variable costs.
Notice that the total cost line starts at the fixed cost line. This line increases due to variable costs because variable costs increase at the same rate as sales.
The point at which the revenue line and total cost line intersect is the breakeven point:
- The area below the BEP will always be at loss as shown in the area shaded in red.
- The area above the BEP represents profit, shaded in green.
- The green lines represent the dollar value and quantities at BEP.
Another great use for the breakeven point is to compute the margin of safety. The margin of safety is the difference between actual and breakeven sales. It serves as “cushion” so that you’ll know if current sales level is far or near breakeven sales. For instance, if actual sales is $20,000 and breakeven sales is $8,000, our margin of safety is $12,000.
Assumptions & Limitations of Breakeven Point Analysis
Breakeven point analysis is part of managerial accounting. It is a tool businesses can use to determine the required level of sales before a product becomes profitable and can be compared against forecasts to ensure budgets are within reasonable amounts.
When performing BEP analysis, it’s important that we follow certain assumptions. These assumptions serve as the rules that make the results of BEP analysis true but, unfortunately, these same assumptions are also its limitations.
Why It’s Also a Limitation
1) Variable costs and sales have linear and predictable relationship
In BEP analysis, we assume that each additional unit sold increases variable costs by the same amount.
In the real world, variable costs are rarely perfectly constant across a wide range of production. For instance, variable costs per unit might decrease as more units are produced.
2) Fixed cost, variable cost per unit, and selling price will remain constant
It’s crucial to have these figures constant so that we can predict easily how costs respond to different sales volumes.
Uncontrollable factors, such as economic downturns or inflation, may result in rising costs. Some businesses may adjust selling prices and costing strategies to adapt to these changes.
3) Production equals sales
This assumption states that there is no beginning or ending inventory. Therefore, we assume that we only produce what we sell.
When you produce a good that is placed in inventory rather than sold,, then you’ve incurred the variable cost of producing the item, but have not received the sales price. As long as your inventory level stays constant, this should be a big problem.
4) Volume is the only factor that affects sales and costs
Different volumes of sales yield different outcomes for the business. By using volume as the only factor, businesses can focus on determining how much resources are needed to meet the required volume at BEP.
In the real world, volume is not the only factor. Labor rates, employee benefits, and compliance costs are other factors that can directly affect sales and costs. For instance, labor strikes may force businesses to negotiate with the labor union to provide better wages and benefits.
5) Time value of money is ignored
BEP analysis is only a tool used for interim decision making.
Often, fixed costs arising from debts such as mortgages have interests. Ignoring the effects of the time value of money may affect the quality of information from BEP analysis.
How To Reduce the Breakeven Point
A low breakeven point means that you’ll have to sell fewer products and services to reach breakeven, which means faster recovery of fixed costs. Here are several ways to reduce BEP:
- Review fixed costs: You can start by reviewing all fixed costs and removing those that can be removed. Some fixed costs are controllable while others aren’t. It’s best to focus on controllable fixed costs and determine if you can reduce them or eliminate them.
- Reassess variable costs: If fixed costs can’t be reduced, you can reassess variable costs by looking at the direct costs and overhead. It is relatively easier to control variable costs than fixed costs since most variable costs are directly related to products and services. For instance, you can reduce variable cost by looking for a cheaper raw material or replacing manual labor with machines and automations.
- Increase selling price: Increasing the selling price can effectively reduce the BEP. We don’t recommend this method since it can backfire instantly—unless you can explain to customers why you need to increase prices. You may even lose clients, especially if they find a competitor that sells a similar product at a lower price.
Frequently Asked Questions (FAQs)
You may perform it as often as you need. Since BEP analysis is for internal use, there’s no requirement as to when it should be regularly performed. However, conducting breakeven point analysis before introducing a new product can help you assess if it’s feasible to sell given its BEP and the business’ ability to market it.
Yes, because it is the point where you start earning a profit. Moreover, it is also your reference point for setting sales and profit goals.
Breakeven point analysis is a good tool that small businesses can use to determine the required unit or dollar sales to reach breakeven. It can also be a basis for budgeting and goal-setting as it provides businesses with a snapshot of its fixed costs, total costs, and revenue.