What is one of most frequent questions investors ask start-ups after hearing the pitch? It is the question about the break-even point. Is there a simple way to calculate it? Yes, there is. Let me show it to you.
The break-even point is the number of products, services or solutions that you need to sell to generate enough revenue to cover all fixed and variable costs. Anything going beyond that number will be your profit. That’s why investors are so interested in this subject.
Calculation and analysis of break-even point will help you to determine whether the volume of products, services, or solutions you assume to sell will result in profit or loss. It will also tell you what is the minimum volume of your offering that you need to sell just to be profitable. Knowing your break-even number will also strengthen your business plan. So how to simply calculate it?
The first step is to determine what are the costs of running your start-up and creating its market offering. Start-up costs, in principle, consist of fixed costs and variable costs. Fixed costs are costs incurring regardless of how much you sell. These are the expenses you need to pay every month, even if you sell nothing. They include expenses related to renting you space, paying the loan you took to start your business, insurance costs, and utilities costs, such as access to broadband or your website hosting fee.
Variable costs in contrary to the fixed ones are represented by expenses depending on how much you sell in defined period. They include manufacturing costs of a single product, service, or solution, and certain overheads, which are operational expenses such as advertising.
To finish your break-even point analysis you’ll need one more thing—the price you are going to charge the customer for a single product, service, or solution. I’ve already elaborated on some of the pricing models in one of my previous posts.
Having all those things in place (fixed and variable costs of your business, and single price of your product, service, or solution) you are ready to calculate your break-even point.
So how does the formula look like?
Break-even point equals to fixed costs divided by price of your single product, service, or solution less variable costs. In calculation format it looks as follows:
Break-even Point = Fixed Costs / (Unit Selling Price – Variable Costs)
Let’s see how it works in practice and assume that you plan to run a small business of preparing and selling customized stickers, which fits the trend of mass customization by allowing clients to personalize their mobile phones.
In step 1 you estimate your fixed costs. Let’s assume its EUR 3000 per month. It includes fee for renting space for your activity, fee for utilities, fee for running your website, and a salary for your one employee (assuming you are hire someone regardless of demand for your offering, or it can be your management salary if you are going to run operations in person).
In step 2 you estimate your variable costs. Let’s assume it’s EUR 2,5 per manufacturing 1 sticker. It includes costs of direct materials you used for its preparation, incl. special paper and set of inks.
In step 3 you need to estimate the price of the product you are going to charge. After performing market research, incl. analysis of prices of your competitors you plan to sell stickers at price of EUR 10 per 1 piece.
Now you are ready to put your numbers into break-even formula:
Break-even point = EUR 3000/ (EUR 10-EUR 2,5) = EUR 2500/EUR 7,5 = 400.
What the number 400 means?
Selling 400 designed stickers per month will enable you to cover you both fixed and variable costs. If you sell more than 400 designed stickers per month, you’ll make a profit, and if you sell less, it will mean you are losing your money.
Now you might be interested in how to estimate the profit you are going to make by selling more than your break-even number. To estimate that you need to use the following formula:
Profit equals sales revenues less fixed costs less variable costs multiplied by number of units sold. In calculation format it looks like this:
Profit = Sales Revenues – Fixed Costs – (Variable Costs x Units Sold)
So you know that you need to sell 400 stickers to get to break-even point. Now you are interested in how much profit you’ll make if you sell 500 stickers in a month. Before we’ll go to calculations let me just explain that sales revenues is the total number of EUR from your sales activity. In other words it’s the number of what you sell multiplied by the price you charge.
Profit calculation looks like this:
Profit = (500 x EUR 10) – EUR 3000 – (EUR 2,5 x 500) = EUR 5000 – EUR 3000 – EUR 1250 = EUR 750.
What EUR 750 stands for? It’s the profit you would make by selling 500 stickers in a month after you covered all fixed and variable costs related.
And what would happen if you’d put number of stickers sold into the formula? Your profit would be exactly 0! It means that your break-even formula works.
So, now after getting basic concept of break-even and profit you are ready to think on how to make your business case attractive for you and investors you pitch.
Knowing that the profit is triggered by fixed costs, variable costs and the price, you can think whether and how you could reduce both fixed and variable costs and increase sales revenues by charging more for what you sell.
If after reading on break-even point formula you still feel a little bit fuzzy, you can use one of online calculators available here (don’t forget to use double click when entering your numbers).
If you’d like to deepen business case preparation beyond calculating the break-even, take a look at HBR Guide to Building your Business Case, which in addition to break-even, explains basic concepts of return of investment and payback period, and more advanced ideas, such as net present value or internal rate of return.