Understanding Break-Even Analysis
Break-even analysis determines how many units you need to sell (or revenue you need to generate) to cover all costs — the point where profit equals zero.
Below break-even, you're losing money. Above break-even, every additional unit contributes directly to profit.
The Break-Even Formula
Break-Even Units = Fixed Costs ÷ Contribution Margin per Unit
Where Contribution Margin = Selling Price - Variable Cost per Unit
Example
Contribution margin = $60
Break-even = $50,000 ÷ $60 = 834 units
Fixed vs Variable Costs
| Type | Examples | Behavior |
|---|---|---|
| Fixed Costs | Rent, salaries, insurance, equipment | Same regardless of output |
| Variable Costs | Materials, direct labor, shipping | Increase with each unit |
| Semi-Variable | Utilities, overtime | Some fixed, some variable |
Know Your Costs
Contribution Margin
Contribution margin is what each unit contributes toward covering fixed costs (and then profit):
- Per-unit margin = Price - Variable cost
- Margin ratio = (Price - Variable cost) / Price × 100%
- Higher margin = fewer units needed to break even
- Margin ratio helps compare products
| Margin % | Meaning | Example |
|---|---|---|
| 20% | Low margin | Grocery, commodities |
| 40% | Moderate | Retail, manufacturing |
| 60%+ | High margin | Software, services |
Margin of Safety
Margin of safety measures how far sales can drop before you start losing money:
Margin of Safety = (Current Sales - Break-Even) / Current Sales × 100%
- 20%+ margin of safety = Good buffer
- 10-20% = Moderate risk
- Under 10% = High risk if sales drop
Using Break-Even for Decisions
- Pricing: See how price changes affect units needed
- New products: Evaluate if projected sales exceed break-even
- Cost cutting: Calculate impact of reducing fixed costs
- Sales targets: Set goals above break-even for profit
- Expansion: Assess risk of adding fixed costs
It's a Simplification
Multiple Products
For businesses with multiple products, calculate weighted-average contribution margin based on sales mix, then apply to total fixed costs.
Or, allocate fixed costs to each product line and calculate separate break-evens.
Frequently Asked Questions
Q: What if my variable costs exceed price?
A: You have a negative contribution margin — you lose money on every sale! You must raise prices or lower variable costs before break-even is possible.
Q: How do I handle stepped fixed costs?
A: Some fixed costs increase at volume thresholds (e.g., need second warehouse). Calculate break-even for each step separately.
Q: Should I include depreciation?
A: Include it in fixed costs if using accrual accounting. For cash flow break-even, you may exclude non-cash expenses.
Q: How often should I recalculate?
A: Whenever prices, costs, or product mix change significantly. At minimum, review annually.
Q: What about taxes?
A: Basic break-even ignores taxes (just covers costs). For after-tax profit goals, gross up your target profit.
Q: Is break-even the same as payback period?
A: No. Break-even is about costs/revenue in a period. Payback period is about recovering an initial investment over time.
Improving Your Break-Even
- Increase prices (if market allows)
- Reduce variable costs (better suppliers, efficiency)
- Lower fixed costs (renegotiate rent, outsource)
- Change sales mix toward higher-margin products
- Increase volume to spread fixed costs
Break-even analysis provides a simplified model. Actual results depend on many factors including market conditions, competition, and cost accuracy. Use as one tool among many for business decisions.