Break-Even Analysis: Formula, Calculation and Examples

Every business owner wants to know one thing early on: how much do I need to sell before I stop losing money?

• Break even analysis helps you find the sales a business needs to cover all its costs. You calculate it with a simple formula: Fixed costs / (selling price per unit minus variable cost per unit).

• At the break even point, a business’s total revenue is equal to its total costs.

• This means the business makes zero profit and zero loss. Every sale after this point adds to profit.

• It uses five parts: fixed costs, variable costs, revenue, contribution margin, and the break even point. You can find the result in units or in sales value and also use it to plan a target profit, check your margin of safety, and lower your break even point.

In this blog, you will learn the formula in plain words, follow a simple calculation, and work through three examples in rupees. By the end, you will be able to find your own break even point with just a pen and a calculator.

What Is Break Even Analysis?

Break even analysis helps to identify the quantity a business needs to sell in order to make enough money to pay for all its costs.

• The purpose of break even analysis is to assist the business in answering such questions as

• What quantity should we sell this month?

• What price can we safely charge?

• Should we launch this new product?

Lenders and investors also require it prior to financing the firm, since it shows how quickly the firm can break even. It is used by various persons for different purposes:

• Business owners use it to fix prices and sales goals.

• Entrepreneurs use it to understand how many units should be sold in order to survive.

• Finance students and analysts use it to analyze costs and profits.

• Traders use the same concept to determine the price at which the trade breaks even.

Key Components of Break Even Analysis

The factors involved in the break-even analysis include fixed costs, variable costs, income, contribution margin, and the break-even point. Income refers to money obtained through sales, while the break-even point refers to sales at which income equals the total cost. The other three require further discussion.

Here is how fixed and variable costs differ.

Contribution margin is what is left from each sale after you pay the variable cost. The formula is selling price per unit minus variable cost per unit. If you sell a shirt for ₹800 and it costs ₹500 to make, the contribution margin is ₹300. That ₹300 goes first toward your fixed costs. Once those are covered, it becomes profit.

Break even tells you how much to sell. Use a Business Model Canvas to plan who you sell to and how you earn. 

Break Even Analysis Formula and How to Calculate It

You will use a few different Break Even Analysis formulas, depending on what you want to find. Here they are side by side.

Margin of safety tells you how far your sales can fall before you start making a loss. In order to find the break-even point, do the following:

• Calculate the total fixed cost.

• Identify the variable cost of one unit.

• Deduct the variable cost from the selling price to calculate the contribution margin.

• Now divide the total fixed cost by the contribution margin.

If your sales amount is lower than this value, you are incurring losses, but if it is higher than that, you are making profits.

Break Even Analysis Examples

Example 1: A product business

Consider that a small clothing brand spends ₹300,000 every month on fixed costs such as rent, staff salaries, and electricity charges. Each T-shirt of this brand is sold at ₹800, while the cost price of manufacturing each T-shirt is ₹500 (materials, labor, and packaging costs).

• Profit left after manufacturing each T-shirt: ₹800 – ₹500 = ₹300. This is referred to as the contribution margin. Contribution margin can be thought of as the money made by the company from the production of each T-shirt towards covering the monthly expenses.

• Number of shirts required to reach break-even: ₹300,000/₹300 = 1,000 shirts. Once 1,000 shirts have been sold, the total ₹300 per shirt equals ₹300,000 and therefore will cover all the monthly expenses.

• Percentage of sales left after reaching the contribution margin: ₹300/₹800 * 100 = 37.5%. This is referred to as the contribution margin ratio, which indicates that from every ₹100 of sales generated, ₹37.50 is left for covering fixed costs.

• Total sales required to reach the break-even point: ₹300,000/37.5% = ₹800,000. This is alternatively arrived at through 1,000 shirts * ₹800.

Example 2: Target profit and margin of safety

The same brand now wants a profit of ₹1,50,000 a month.

• Units needed = (₹3,00,000 + ₹1,50,000) / ₹300 = 1,500 shirts

Say the brand actually sells 1,800 shirts.

• Margin of safety = (1,800 minus 1,000) / 1,800 x 100 = about 44%

Sales could fall by 44% before the brand starts losing money.

Example 3: A service business

An online coaching business has fixed costs of ₹120,000 a month. It charges ₹10,000 per student and spends ₹2,000 per student on the platform and study material.

• Contribution margin = ₹10,000 minus ₹2,000 = ₹8,000

• Break even point = ₹120,000 / ₹8,000 = 15 students

Now say it cuts the fee to ₹9,000 to attract more students. The contribution margin drops to ₹7,000, and the break even point becomes 17.14, which rounds up to 18 students. A small discount means three more students just to break even.

How to Lower Your Break Even Point

Break-even point refers to the level of sales required for you to begin making a profit. By reducing this number, you will make profits at an earlier stage. The following are four ways of achieving this:

• Raise your price a little. If customers are happy to pay a bit more, you earn more from every sale. So you need fewer sales to cover your costs.

• Reduce the cost of producing each unit. Take an example of purchasing materials in bulk, which tends to be cheaper for each piece, hence giving you some extra cash per sale made.

• Lower the constant monthly expenses regardless of how much you have sold. Fixed costs such as salaries, rent, and power bills must be paid no matter what, even when you do not make any sales.

• Sell more of the products that earn you the most. Some products leave you with more money after their cost is paid. This leftover money is called the contribution margin. Pushing those products helps you reach break even faster.

A word of caution on discounts. When you lower the price, you keep less money from every sale, so you now need more sales just to break even. Remember the coaching example, where a ₹1,000 discount meant 3 extra students. A discount only works if it brings in enough new customers to cover what you gave up.

Want to cut your cost per unit? Read what operations management covers and how it keeps production costs down. 

Limitations of Break Even Analysis

Break even analysis is a handy tool, but it cannot tell you everything. Here are the things to keep in mind:

• It does not give you any idea whether your customers would buy from you or not. The figure tells you that you need to sell 1,000 shirts but doesn’t guarantee that there are 1,000 customers for you to sell to.

• It is based on the assumption that prices and costs remain constant. In an actual situation, rent increases, the cost of materials increases due to inflation, and prices rise. In such a case, the break even figure is bound to change as well.

• It is based on the assumption that costs increase at a uniform rate. The calculation considers the cost per additional unit the same, but in the real world, bulk purchases tend to lower the cost per additional unit, and an increase in production means hiring more labor and increasing factory size, thus increasing costs.

• It suits a single-product business model best. It becomes difficult to perform the calculations if the business sells different types of products at different prices.

It provides you with the current status of costs and price levels.

So do not use it alone. Check it against your expected sales and the cash you have on hand, and then make your decision.

Conclusion

The break-even analysis, which uses a simple formula and examples, will help you understand the lowest amount that you need to sell in order for the business to stop making losses.

Take the shirt shop from our example. Its monthly bills were ₹300,000, and it kept ₹300 from every shirt sold. So it had to sell 1,000 shirts just to cover those bills. With it, he knows exactly where the loss ends and the profit begins. He can also see what happens if he wants a profit of ₹150,000 or if he gives a discount. 

The calculation is very simple. Just divide your total fixed cost by the profit generated by one sale, and you get the answer. You can calculate this even prior to the pricing of your services/product, starting your company, and introducing something new. All you have to do is validate it with the actual number of potential buyers.