In this article we will talk about:
- To begin with, what is the break-even point
- Formula and some important concepts
- How break-even helps in sales forecasting
- Using break-even in practice
In a simplified way, the balance point calculation is the indication of the quantity of products or services that must be sold by your company so that it has no profit or loss. If you are interested in going a little deeper, I recommend that you see our article on how to calculate the break-even point of your business. Throughout this post we will see exactly how to use this value so as not to miss the sales projection.
When calculating the break-even point, it is important to understand some concepts:
- Direct Costs: Are the costs directly linked to your production or service provision. For example, if the cost of selling a shirt is $ 40, if I produce 10 shirts I will have the cost of $ 400 (10 x 40).
- Contribution Margin: It is the difference between the selling price and the direct costs of your product or service. For example. If I sell this same shirt for R $ 100, its contribution margin will be R $ 60 (100 - 40)
With these two most important concepts in mind, we can arrive at the point of equilibrium, which is calculated using the following formula:
- Point of Balance = Fixed Costs / Contribution Margin
Continuing with our example, if our shirt factory had a fixed cost of R $ 12.000 we would have the following calculation to do:
- Balance Point = R $ 12.000 / R $ 60 = 200
Let's do the actual test to make sure these numbers beat. If we think of a production (and sale) of 200 shirts we would have the following data:
- Revenue = R $ 100 x 200 = R $ 20.000
- Fixed Costs = R $ 12.000
- Direct Costs = R $ 40 x 200 = R $ 8.000
- Total Costs = R $ 12.000 + R $ 8.000 = R $ 20.000
You may be wondering how this calculation works if you have more than one product. If this is your case, I recommend you take a look at the article on how to figure out your break-even with various products. Now it's worth understanding how this calculation can help you find the ideal sales projection.
To begin with, it's worth to understand that there are some methods of doing sales projections:
- Projection based on results
- Projection based on actions that will be carried out
- Market-based projection
- Projection based on break-even point
You can know all four that we recommend in our post about how to make sales projection. Now, let's take a little deeper into how to do the projection taking into consideration the break-even point. First we have to reach the selling price of your product or service. If you have difficulties in this regard, recommend some of our pricing spreadsheets.
Let's assume that we have a company that sells computers and that we have already done this job of finding the selling price. The value we got was R $ 500 per computer sold. See how it appears in our balance point calculation worksheet.
Now just raise your direct costs, in our case, R $ 300 of the raw material plus R $ 50 of taxes, totaling R $ 350.
This leads us to the understanding of our contribution margin, which is R $ 150 (500 - 350).
We are already closer to the calculation of our break-even point, just missing our fixed costs, which in this case are R $ 25.000.
Now we just apply the equilibrium point formula directly to these numbers which will give 167 the units needed to match revenues and expenses (25.000 / 150).
Just to make sure the accounts are correct, let's turn to the simplification of the calculations again:
- Revenue = R $ 500 x 167 = R $ 83.500
- Fixed Costs = R $ 25.000
- Direct Costs = R $ 350 x 167 = R $ 58.450
- Total Costs = R $ 25.000 + R $ 58.450 = R $ 83.450
Obviously we can not sell a piece of a computer and so we will often see very small differences like that of $ 50. Now, with the calculation done, there are two concerns that every manager has to keep in mind when making his projections:
- Productive capacity of the business
I say this because it's no use knowing that I need to sell 167 computers if I only have the ability to produce 150. In this type of situation, even if you sell all the units produced will be at the loss, that is, you need to think about actions that make your business profitable.
Right from the outset you can think about raising prices (you need to understand whether your customer is willing to pay more for your product or service) or reduce costs (through negotiation with suppliers, cheapening of used material or other tactics). That way, your break-even point will be lower. In our example, if I reduced the direct cost to $ 250 we would have the following calculation:
- Balance Point = 25.000 / 250 = 100 units
- Existing demand for the product or service
Just as it can be a big problem if you can not produce enough money to ensure enough revenue to make a profit, we can not go ahead with a business that can not sell enough to make a profit.
For example, if we produced 200 computers in our initial scenario (cost $ 350) and only managed to sell 100, we would have the following situation:
- Fixed Costs = R $ 25.000
- Direct Costs = R $ 350 x 200 = R $ 70.000
- Total Costs = R $ 95.000
- Revenue = $ 500 x 100 = $ 50.000
- Loss = R $ 95.000 - R $ 50.000 = R $ 45.000
- Value in Inventory = R $ 50.000
That is, more important than producing much, is selling what you have produced and calculating the break-even point helps you reach that figure.
If you've never stopped to do this calculation, you may be missing out on opportunities to understand your ideal sales projection, better organize your production capacity or demand expectations. See our balance point calculation worksheet and make that calculation for your business.