Calculating the breakeven point is a key financial analysis tool used by many firms. Many companies can use the calculation to determine how many product units they need to sell at a given price point to break even. Once the firm knows the fixed and variable costs for the product it produces or a good approximation of them, the firm can use that information to calculate the breakeven point.
What Is the Breakeven Point?
A firm's breakeven point is the point at which its sales exactly cover its expenses.
To compute a firm's breakeven point in sales volume, one need to know the values of three variables:
Fixed costs: Costs that are independent of sales volume, such as rent
Variable costs: Costs that are dependent on sales volume, such as the cost of manufacturing the product
Selling price of the product
Calculating Breakeven Point
In order to calculate the company's breakeven point, use the following formula:
Fixed Costs / (Price - Variable Costs) = Breakeven Point in Units
In other words, the breakeven point is equal to the total fixed costs divided by the difference between the unit price and variable costs. Note that in this formula, fixed costs are stated as a total of all overhead for the firm, whereas Price and Variable Costs are stated as per unit costs - the price for each product unit sold.
The denominator of the equation, price minus variable costs, is called the contribution margin. After unit variable costs are deducted from the price, whatever is left - the contribution margin - is available to pay the company's fixed costs.
An Example of Calculating Breakeven Point
A firm has calculated that it has fixed costs that consist of its lease, depreciation of its assets, executive salaries, and property taxes. Those fixed costs add up to 50,000 dollars. Their product is the Product A. Their variable costs associated with producing the Product A are raw material (10 dollars Per unit), factory labor (20 dollars Per unit). Total Variable costs have been calculated to be 30 dollars per unit. The Product A is priced at 50.00 dollars each.
Given this information, we can calculate the breakeven point for the firm's product, using our formula above:
50,000 / (50.00 - 30.00) = 2,500 units
What this answer means is that the firm has to produce and sell 2,500 units, in order to cover the total expenses, fixed and variable. At this level of sales, it will make no profit but will just break even.
How Breakeven Point Changes When Changing Sales?
What if the sales change? For example, if the economy is in a recession, the sales might drop. If sales drop, then you may risk not selling enough to meet the breakeven point. In the example of the firm, you might not sell the 2,500 units necessary to break even. In that case, you would not be able to pay all the expenses. What can you do in this situation?
If you look at the breakeven formula, you can see that there are two solutions to this problem: you can either raise the price of the product or you can find ways to cut the costs, fixed / variable or both.
How Breakeven Point Changes when Costs are Cut?
Let's say you find a way to cut the cost of the overhead or fixed costs by reducing the owner salary by 5,000. That makes the fixed costs drop from 50,000 to 45,000.
Using the same formula and holding all other variables the same, the breakeven point would be:
45,000 / (50.00 - 30.00) = 2,250 units
As expected, cutting the fixed costs drops the breakeven point.
If you reduce the variable costs by cutting the costs of material to 5 dollars per unit, on the other hand, then the breakeven point, holding other variables the same, becomes:
50,000 / (45.00 - 30.00) = 2,000 units
From this analysis, you can see that if you can reduce the cost variables, you can lower the breakeven point without having to raise the price.
Example Questions of Breakeven Point
If contribution margin per unit is 100 dollars per unit and break-even per unit is 20, then fixed cost would be
B. 20 x 100 = 2,000
If break-even number of units are 100 units and fixed cost is 30,000 dollars, then contribution margin per unit will be
A. 30,000 / 100 = 300
Fixed cost is divided by break-even revenues to calculate
A. contribution margin
It costs a firm 150 to buy the material that he needs to product one unit. The marketing costs is 10 dollars per unit. What is the Breakeven point if the price the firm charges for 1 unit is 15?
Let x be the number of units sold,
Let C be the cost of buying and selling x units,
Let R be the revenue made for selling x units
R = selling price of 1 unit x number of units sold
R = 150x
C = fixed cost + variable cost
variable cost = fee charged for 1 unit x number of units sold
variable cost = 10x
C = 150 + 10x
R = C
15x = 150 + 10x
15x - 10x = 150 + 10x - 10x
5x = 150
x = 30
The breakeven point is 30 units