Every year, thousands of people decide to strike out on their own by starting a business. But while most begin their journey—or their second or third attempt—at entrepreneurship with high hopes, a whopping 30 percent of small businesses fail within the first 2 years.
While other factors may contribute to the demise of a company, such as a lack of market need for a specific type of business, many fail as a direct result of financial trouble.
Running a breakeven point formula ahead of time and frequently throughout the operation of a business, can help prevent this outcome.
Keep reading to learn what a breakeven point formula is, how to use it and why it’s a necessity for every business.
What Is Breakeven Point?
A breakeven point is exactly what the name suggests; the number of units you need to sell to cover all costs associated with producing your product and running your business.
Before you reach this breakeven point, all money coming into your business is going towards covering your expenses. Only after you reach that breakeven point will your business be turning a profit.
Why Is Calculating a Breakeven Point Important?
For new and growing small businesses, calculating a breakeven point right away might seem useless beyond simply letting you know how far into debt your business is. But it’s actually an important tool for a number of reasons, even if your business is still a long way away from turning a profit.
To start, knowing the amount of money your business needs to make in order to recoup its startup and operational costs will allow you to better create your business plan.
It may help you determine what kind of additional financing you’ll need to keep your business operating until you are able to turn a profit.
Your calculated breakeven point can also be used when you are making your case to lenders as a part of your business plan.
It can also help you plan for launching new products. You might find that you’ll need to wait to start creating new products until you are able to find additional funding, or your business picks up.
Or it may help you price your products to cover their associated costs.
How Do You Calculate a Breakeven Point Using a Formula?
Determining your business’ breakeven point using a formula isn’t difficult, but it does require several steps. To complete them, you’ll need to take a look at not only your current business operations but also the potential costs of products or service offerings that you are likely to undertake in the future.
Step 1: Determine Your Business’ Fixed Costs
The first, and perhaps the easiest, step in figuring out your breakeven point is determining your business’ fixed costs.
Fixed costs are any costs that keep your business open and operating on a day-to-day basis. You would continue to pay these costs even if you never produce or sell a single product. This also means that these costs do not include any product production, research or other fees associated with creating, marketing or selling a product.
Costs that should be listed as “fixed” include:
- Rent or mortgage payments
- Utilities for your building (this does not include utility costs associated with machinery or equipment used to produce products)
- Salaries of employees who do not work in production
- Office equipment like computers, phones and the internet that you would need to function, regardless of whether you are producing products
Step 2: Determine Your Variable Unit Costs
Once you’ve determined your fixed costs, it’s time to determine your variables. These are costs that are directly associated with producing or obtaining products.
To determine your variable costs, you’ll need to consider every element of the production process. This includes the cost of market research, design research and initial testing, as well as every cost that comes with actually producing your product, including the equipment you need, the employees who produce your products and the shipping cost of getting your materials.
If you don’t produce your own products to sell, that doesn’t mean you don’t have variable costs. Rather than production costs, your variables would instead be the wholesale price you pay, as well as any warehouse storage costs, shipping, packaging or other fees that you incur to obtain your products, transport them and store them.
If you’re like most businesses, you have more than one product to offer. This can make setting your variable cost difficult. Averaging your variable costs will help account for this. For instance, if your business sold three products, one with a variable cost of $10, one with a variable cost of $15 and one with a variable cost of $20, your average variable cost would be : ($10+$15+$20)/3=$15
Step 3: Set Your Unit Selling Price
While you may be utilizing a breakeven point formula to help you figure out how much you need to sell your products to turn a profit, you will first need to set a placeholder-unit price.
This will be used as a part of the formula, so you should try to set a realistic price that you might sell your product for.
Of course, if you are already selling products, you’ll want to list the actual price before tax.
Step 4: Run the Breakeven Point Formula
Now that you have your fixed costs, variable costs and unit selling price in hand, it’s time to run the breakeven point formula.
The breakeven point formula is:
Breakeven Point Formula Example
Let’s run through an example of the breakeven point formula.
Say you run a bookselling business that has $10,000 in fixed costs. You purchase books from a wholesaler. Including shipping, storage and other costs, each book costs you $10. You’ve decided to list your books at $20 per unit.
To figure out how many books you would need to sell to break even, your formula would look like this:
So, you would need to sell 1,000 books at $20 per unit to break even.
The Problem with Only Utilizing a Breakeven Formula
While a breakeven formula can help give you a better idea of how to price your products, show lenders your potential profit and give you an idea of how much money you need to make to stay out of debt, it’s far from the golden ticket to success.
Fixed costs can change when rent or utilities increase. Materials may become unavailable or production costs may vary, leading to a change in your variable costs. Knowing how many units you need to sell in order to break even is no guarantee that you’ll meet this projection. If you set your sights too high and fail to make enough sales, you’ll never break even.
It’s always important to look at all risks associated with a business decision before you commit to a new idea.