Every entrepreneur should know and calculate what is the Break even point (BEP) of his activity, or the break-even point in which total revenues and total costs are equal and the business profit is equal to zero.
The BEP allows you to identify how many units of goods a company should produce to match production costs. In other words, the Break even point indicates the exact point in which both the profit and the business losses are equal to zero.
When you have a business or you want to start one, it’s essential to carry out a risk analysis. Break even point analysis is a tool that can significantly reduce risks. It allows, in fact, to know which is the minimum turnover volume that the company must reach in order not to register losses of any kind.
The BEP is not only a tool for forecasting risks, it also represents a valid means of monitoring production activity. The break-even point makes it possible to monitor profits and losses during production and to intervene promptly in the event of a negative trend.
The Break even point is therefore specifically a technical analysis that studies the relationship that exists between three main business factors: fixed costs, variable costs and production volumes (quantity of units produced of a given commodity). The purpose of this analysis is to identify the “break even turnover”, i.e. the amount of revenue needed to cover the total costs.
What is the difference between fixed costs and variable costs?
Expenses that do not vary with the quantity of production. If the company produces 0 units or 100 units, these costs remain unchanged since they do not depend on the production activity. The fixed costs include the expenses related to the technical and organizational structure such as rents of the company spaces or salaries of the employees;
Costs that can vary depending on the quantity of production. In other words, the variable costs increase or decrease based on the number of units produced. Costs related to raw materials, energy consumption or maintenance of company equipment fall into variable costs.
Break even point formula: How is it calculated?
The Break even point (BEP) is calculated using a specific analysis called Break even analysis. The carrying out of this study presupposes the knowledge of fixed costs and variable costs of the company.
There are two different methodologies to carry out the Break even analysis …
Graphical method or profitability diagram
The profitability diagram relates variable costs, fixed costs, revenues and production volumes. Using this type of analysis, the data is reported in a Cartesian plane with the production volumes (quantity) as an independent variable (X-axis). The product costs are instead placed on the ordinate axis. The fixed costs, not being related to the turnover, are reproduced with a straight line parallel to the axis of the abscissas; the variable costs are depicted with a positively inclined line as they vary in relation to turnover. Consequently, a positively inclined line that meets the axis of the ordinates in correspondence of the total fixed costs represents the total costs.
The break-even point or break-even point is therefore determined by the intersection of the total cost line with the total revenue line. Looking at the graph it is therefore clear that the BEP, or the quantity of products to sell necessary to cover the costs, is 300. The area indicated with the “+” sign is the profit zone, in which the turnover exceeds the costs and the BEP. On the contrary, the area indicated with the “-” sign indicates a loss for the company that failed to cover the costs with its revenues. The two lines may not even cross: this eventuality corresponds to a situation with variable costs that are too high and no break-even point.
The analytical method consists of transforming company revenues and total costs into mathematical formulas based on specific calculations. In this case, the Break even point can be determined by performing an equation. The formula can be used for companies that produce one or more products, but must be applied to each product separately. The factors that influence the variation of the BEP are the fixed costs, the selling price and the variable costs:
BEP = CF / (PV – CVU)
Analyzing the formula we deduce that …
- BEP is the Break even point, or the quantity of units to be produced to equalize the costs;
- CF are the fixed costs;
- PV is the selling price of a single unit of the product;
- CVU is the variable unit cost, or the variable cost applied to that single product unit;
- The formula in brackets (PV – CVU) indicates the Contribution Margin, or the incidence of fixed costs on the sale price. In other words, it indicates the quantity that remains by removing the unit variable costs from the sale price. This quantity is that necessary to cover the fixed costs;
- The sum of fixed costs and variable costs represents the total costs: CT = CF + CV.
So, more simply:
BEP = Fixed costs / (Product selling price – Variable unit cost)
Break even point calculation: a practical example
Starting from the formula already explained BEP = CF / (PV – CVU), here is a practical example to understand how to calculate the company break-even point.
- Assuming that the fixed costs are equal to 100.00 Euros, we have CF = 100,000
- The selling price of each product unit is 800 euros, so you have PV = 800
- The variable unit cost of each product is 300, with CVU = 300
So, if BEP = CF / (PV – CVU), we have that:
BEP = 100,000 / (800 – 300) = 200
The quantity of units to be produced necessary to equalize the production costs for that particular product is 200 (BEP). By producing (and selling) 200 units at the established selling price (800 euros), the company can balance production costs and not record losses.
Why is it important to calculate the Break even point? 8 advantages …
Performing a break even analysis and knowing the break even point of your business has many advantages:
1. It is effective for forecasting purposes
The break-even point analysis is effective for the company’s forecasting purposes as it highlights the amount of sales needed to reach a break-even situation. It is therefore a fundamental tool in the preparation of the corporate business plan.
2. Helps to calibrate sales prices
The calculation of the Break even point is useful for identifying the selling price of the company products in an optimal way. The sale price has an important influence on profitability and it is therefore essential to determine it in a perfected way to guarantee profit to the activity.
3. It helps to understand what the fixed and variable costs are
To know which are the fixed corporate costs and above all to understand how to cover them in an ideal way, it is necessary to carry out a Break even analysis.
4. It is a control tool for productive activity
The Break even point is a fundamental control tool for the company as it allows to check the profits and losses during the whole production activity.
5. It sets realistic profit targets
Calculating the Break even point it is easier to establish realistic and concrete gain objectives for the work team as the goals can be set on the basis of precise and already recorded numbers.
6. Reduces risks
Calculating the break-even point considerably reduces the risks for the company as it makes the data necessary to cover all the costs concrete and therefore increases awareness of the business, so it will be easy to avoid any type of operation. Effective and therefore bankrupt.
7. It is useful for planning communication and marketing campaigns
Having available data and concrete elements becomes much less challenging for an entrepreneur to plan marketing campaigns aimed at improving business profit. Calculating the Break even point every business decision becomes rational and weighted as it is supported by previously analyzed numbers and data.
8. It is useful for identifying all business costs
Often while developing a business project it is easy to forget to include some costs in the list of costs to be incurred or already incurred. The Break even analysis can be useful to create in advance a complete list of loans supported by the company, avoiding any type of inattention.
When is it appropriate to calculate the Break even point?
There are three particular situations in which it is particularly recommended to carry out a Break even analysis …
Starting a new business
When planning to open a new business it is essential to carry out a Break even analysis. Calculating the break-even point is useful for assessing the actual feasibility of the project considering all costs in a realistic way.
Launch of a new product
Often launching a new product can result in a considerable increase in business expenses. The fixed costs remain unchanged, but the variable costs change with respect to the new product in question. It is therefore essential to calculate the Break even point to identify the possible ideal selling price of the new product.
Inserting a new sales channel
The addition of a new sales channel, whatever its type, involves a change in variable costs. Also in this case it is essential to carry out a Break even analysis to examine and plan business strategies again.
Break even point: 3 strategies to lower the break-even point
Here are three useful strategies to lower your Break even point …
1. Reduce fixed costs
The fixed costs are directly proportional to the BEP. As a result, the lower the fixed costs, the fewer units of goods will need to be sold to reach the break-even point. The fixed costs are difficult to decrease, but doing so could prove to be the right strategy to also lower the BEP. For example, if you wanted to start a sales business, surely opening an online store could be the best solution. In fact, online sales do not require the fixed cost of the structure and any rent of the company space.
2. Reduce variable costs
Also reducing variable costs is an important operation to try to lower the value of your Break even point. Decreasing variable costs is a difficult and not immediate operation, especially if it is a small or just started business. In order to reduce these costs, it would be useful to carry out analyzes and surveys in one’s own sector. Assessing the possibility of changing suppliers, production processes or sales methods could be appropriate solutions.
3. Raise the prices
Product prices and the BEP value are inversely proportional. For this reason, by raising the prices of the goods, it will be possible to decrease the units to be sold to reach the break-even point. In order to perform an operation of this type, it is first necessary to carry out an adequate market and competition analysis. The high price must be proportional to the quality of the product. Before raising a price, it is essential to make sure that consumers appreciate your products.
Break even point: The 5 limits of the analysis
The Break even analysis is undoubtedly the most efficient method for identifying the company break-even point, but it has some analytical limits that could reduce its effectiveness:
1. It is a static and non-dynamic analysis
The break even point analysis does not take into consideration a series of economic dynamics that take place, such as cash flows, for example. The BEP is a static analysis: it does not consider, in fact, the timing and periodic changes in costs and costs. If a raw material were to increase its cost in the short term, the analysis would not be able to take into account the updated data.
2. Does not consider the inventories
The biggest limitation of this analysis is certainly related to the prediction of market demand and the “game” of inventories. The Break even analysis assumes that the quantities of goods produced always coincide with those sold. Analysis does not study market demand, so it cannot predict how many quantities could realistically be sold. In fact, there are inventories, i.e. those units of goods produced but not sold. These inventories are never calculated with the Break even point analysis.
3. Costs and revenues do not change linearly
The costs, especially the variable ones, are particularly subject to change. The variable costs depend on the quantities produced. The Break even analysis does not take into account the variation in costs based on the units sold. If, in fact, a supplier buys a large number of units, surely a discount will be applied which cannot be calculated in the Break even analysis.
4. The distinction between CF and CV is not always easy
The distinction between fixed costs and variable costs is not always so simple to identify. Indeed, there are some costs that are categorized as fixed in the short term, but are transformed into long-term variables.
5. Does not consider the competition
Break even analysis does not consider competition and the impact competitors could have on company products. By changing their prices, competitors could create a change in demand within the sector. In this case, the company will also have to adapt and review its prices and sales strategies. Unfortunately, the BEP does not take these variables into account.