Breakeven point definition
/What is the Breakeven Point?
The breakeven point is the sales volume at which a business earns exactly no money. At this point, a business is able to cover its fixed expenses, allowing it to remain in operation. The concept is most easily illustrated in the following chart, where fixed costs occupy a block of expense at the bottom of the table, irrespective of any sales being generated. Variable costs are incurred in concert with the sales level. Once the contribution margin on each sale cumulatively matches the total amount of fixed costs, the breakeven point has been reached. All sales above that level directly contribute to profits.
If a business is operating below its breakeven point, then it is continually losing money. Operating above the breakeven point means that a business is generating a profit.
How to Calculate the Breakeven Point
To calculate the breakeven point, divide total fixed expenses by the contribution margin. Contribution margin is sales minus all variable expenses, divided by sales. The formula is:
Total fixed expenses ÷ Contribution margin %
A more refined approach is to eliminate all non-cash expenses (such as depreciation) from the numerator, so that the calculation focuses on the breakeven cash flow level.
Another variation on the formula is to focus instead on the number of units that must be sold in order to break even, rather than the sales level in dollars. This can be useful for setting sales targets. This formula is:
Total fixed expenses ÷ Average contribution margin per unit
How to Use the Breakeven Point
The breakeven point is useful for determining the amount of remaining capacity after the breakeven point is reached, which tells you the maximum amount of profit that can be generated. For example, if the breakeven point is very high, then a business may be operating at close to its maximum sales level, and so can never generate a profit. This is more likely when an organization has very high fixed expenses, and especially when the profit margin on each incremental sale made is quite low.
The breakeven point can also be used to determine the impact on profit if automation (a fixed cost) replaces labor (a variable cost). In this case, the breakeven point will rise, due to the extra cost of automation, but this may be worthwhile if the resulting decline in variable costs allows a business to generate a larger profit once the breakeven point has been exceeded.
Yet another possibility is to use the breakeven point to determine the change in profits if product prices are altered. For example, a sharp increase in a product’s price will increase its contribution margin, thereby driving down the breakeven point (assuming that sales volumes stay the same). Conversely, a price reduction will reduce the contribution margin, which increases the breakeven point.
Finally, the breakeven point can be used to determine the amount of losses that could be sustained if a business suffers a sales downturn. This is a useful analysis when deciding how much to pare back expenses during an economic downturn.
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How to Improve the Breakeven Point
Management should constantly monitor the breakeven point, particularly in regard to the last item noted, in order to reduce the breakeven point whenever possible. Ways to do this are noted below.
Cost Analysis
Continually review all fixed costs, to see if any can be eliminated. Also review variable costs to see if they can be eliminated, since doing so increases margins and reduces the breakeven point.
Margin Analysis
Pay close attention to product margins, and push sales of the highest-margin items, to reduce the breakeven point.
Outsourcing
If an activity involves a fixed cost, consider outsourcing it in order to turn it into a per-unit variable cost, which reduces the breakeven point.
Pricing
Reduce or eliminate the use of coupons or other price reductions, since it increases the breakeven point. Also, increase price points whenever this is acceptable to customers.
Example of the Breakeven Point
The management of Ninja Cutlery is interested in buying a competitor that makes ceramic knives. The company's due diligence team wants to know if the competitor's breakeven point is too high to allow for a reasonable profit, and if there are any overhead cost opportunities that may reduce the breakeven point. The following information is available:
| Before Acquisition | |
| Maximum sales capacity | $5,000,000 |
| Current average sales | 4,750,000 |
| Gross margin percentage | 35% |
| Total operating expenses | 1,750,000 |
| Breakeven point | $5,000,000 |
| Operating expense reductions | 375,000 |
| Revised breakeven level | $3,929,000 |
| Maximum profits with revised breakeven point | $375,000 |
The analysis shows that the competitor has an inordinately high breakeven point that allows for little profit, if any. However, there are several operating expense reductions that can trigger a steep decline in the breakeven point. The management of Ninja Cutlery makes an offer to the owners of the competitor, based on the cash flows that can be gained from the reduced breakeven level.