Understanding break-even
If you’re starting a business, you’ll probably want to ask yourself the following question: “how much do I need to sell before I make money?”
Indeed, based on the answer, you’ll be able to determine how much you want to produce, how much you want to keep in stock, how much you want to invest, etc. Basically, pretty much any decisions you make starting out will come from the answer to this question.
But how to find this answer? It’s simple: it all comes down to calculating the Break-even point.
Summary
- Definition
- How is it calculated?
Definition
The break-even point refers to the minimum amount of turnover necessary for the company to make a profit.
In other words, it is the level of activity that allows, thanks to the variable operating margin, to have the means to pay all the fixed expenses of the company. As a reminder, the variable operating margin refers to the level of sales minus the variable charges (those being the charges that depend on the level of activity).
Variable expenses are also sometimes referred to as “operating expenses” while fixed expenses are also referred to as “structural expenses”.
How is it calculated?
To calculate the break-even point, you have to:
1 – Separate all the expenses of the exercise into two categories:
- Fixed expenses: Those are the ones that stay the same regardless of the level of sales. These can include, for example: wages, social charges, insurance premiums, the fees of the chartered accountant, etc.
- Variable expenses: These are the expenses that depend directly on the level of activity. Examples of such charges would be buying the supplies, the transport costs, the commissions paid per sale, etc.
2 – Calculate the variable operating margin:
| forecasted turnover – variable expenses driven automatically by these sales. |
3 – Translate the variable operating margin in percentage of the sales revenue:
| (margin on variable costs / turnover) X 100. |
4 – Obtain the breakeven point (expressed in money):
| fixed expenses / variable operating margin |
As soon as sales exceed the break-even amount, the company will start generating profits.
It is therefore a way to check the feasibility of the project, as from it, one can determine the number of hours to be billed, the average number of goods to be sold per day, etc.
For example: Let’s say I wanted to start an activity of selling sports tracksuits in fairground markets. It would be incredibly helpful to know that I should sell about 10 tracksuits a day on average in order not to take any losses.
Calculation of the break-even point:
| Anticipated turnover | |
| Variable expenses | |
| Turnover – variable expenses = margin on variable costs | |
| Margin on variable costs / sales revenue = margin rate on variable costs | |
| Fixed expenses / margin rate on variable costs = break-even point |
Keep in mind that there are two ways to express the break-even point. The one explained above expresses it in money, but it is also possible to express it in time, with the number of days, months or years required to be profitable.
