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Know your Break-Even Point

One of the most important things that your business needs to understand is the break-even point where all the operating costs are covered and your earnings (before interest and tax) is at zero dollars.

Fixed Costs

Fixed costs don’t rise as you increase the level of activity in your production. For example, rent might rise but it won’t be affected by the production of five or five-thousand items.

However, fixed costs tend to rise in sharp incremental levels at certain points. While your rent may not be affected by the production of five or five-thousand items there has to be a limit where you need to expand your production space – a bigger warehouse, a larger factory – and rent takes a large step upwards. It doesn’t rise gradually and in that sense it is said to be a fixed cost.

Other fixed costs might be your managerial wage (you pay yourself $120,000 per year regardless of hours worked or items produced), the direct cost of labour is usually fixed, insurance, accounting fees, the machines you use to produce your products, their maintenance… and the cost of the executives’ cars.

Variable Costs

There are also those costs that increase as the level of production activity increases – for example, variable costs would include the components and materials that go into the products, the transport fees, the consumables that were used to create the products and the packaging used to market them.

Variable costs are those that rise as production increases and fall as production decreases.

To slightly confuse the situation there are some semi-fixed (semi-variable) costs that could be identified. An example could be the consumption of electricity – lighting the factory is a fixed cost but heating the metal smelters is a variable cost that depends on the number of batches smelted during a given time period.

The sum of your fixed costs and your variable costs gives you the total operating cost. Understanding those variables can help you make better business decisions… one of which is to calculate your break-even point.

Again, the break-even point is where the total operating cost is covered and your earnings (before interest and tax) are zero dollars. It is the point where you break even without turning a cent in profit. Obviously, the break-even point is critical in any decision about production quantities and whether to expand or discontinue existing product lines.

Break-Even Analysis

There is a simple equation to work out the break-even point where you produce just enough of an item to cover production costs. Note that it must be stated with a time period, as in X number of items per day/week/month.

Break-Even Point = Fixed costs / (Sales revenue per unit – Variable costs per unit)

That is to say if you had a pottery studio with $2,000 per month fixed costs to run. And each set of 12 ceramic cups used $20 of raw materials and 1 hour of labour (at $25 per hour for the potter), with the cups sold for $120 per dozen… the equation would become:

Break-Even Point = $2000 / ($120 – [$20 + $25]) = $2000 / ($120 – $45) = $2000 / $75

Break-Even Point = 26.66 dozen ceramic cups per month

That means that at 26.66 dozen ceramic cups the busines starts to generate earnings. It is the point where you cease to be running at a loss and will begin to turn a profit.

Working out the Contribution Margin

If you look at the last part of that Break-Even Point formula you can also work out the contribution per unit:

Contribution per unit = Sales revenue per unit – Variable costs per unit

In the pottery studio example, the contribution margin is $75 … meaning that $75 per unit contributes to fixed costs per unit, after which the rest goes to profit. When fixed costs are covered the entire contribution margin per unit becomes profit.

The contribution margin is the amount of marginal profit per unit sold.

As a management tool, the contribution margin can be used to measure the degree to which sales growth transposes over to profit growth (also called operating leverage). And, as this article showed, it is also important in the calculation of the break-even point.

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About the Author

Steven Clark Steven Clark - the stand up guy on this site

My name is Steven Clark (aka nortypig) and I live in Southern Tasmania. I have an MBA (Specialisation) and a Bachelor of Computing from the University of Tasmania. I'm a photographer making pictures with film. A web developer for money. A business consultant for fun. A journalist on paper. Dreams of owning the World. Idea champion. Paradox. Life partner to Megan.

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