All businesses sell a product, generate revenue, pay direct costs, and hopefully make a gross margin on their product. Whether the business then earns a net income, makes a net loss or achieves a break even depends on whether the gross margin is large enough to cover all the operating expenses (fixed costs) of running the business. This is depicted in the simplified income statement below:
|Cost of sales||45,000|
The business generates revenue of 100,000, incurs direct costs (materials, labor etc) of 45,000, and produces a gross margin of 55,000. This gross margin is sufficient to cover the operating expenses of 30,000 for running the business, and so the business makes a profit and has a net income of 7,000.
Consider now another example.
|Cost of sales||45,000|
In this case, the gross margin of 55,000 is not sufficient to cover the operating expenses of 70,000, and the business produces a loss of 15,000.
The business swings from profit to loss depending on whether the gross margin is greater or less than the operating expenses. There is a point then at which the gross margin equals the operating expenses of the business.
|Cost of sales||45,000|
In this case, the gross margin of 55,000 is equal to the operating expenses of 55,000 and the business makes zero net income. At this point the business is said to break even, and the revenue of 100,000 is referred to as the break even revenue or break even sales.
Break Even Point Analysis Formula
A business is said to break even when the gross margin is equal to the operating expenses.
Gross Margin = Operating expenses
We can calculate the gross margin of a business by multiplying the revenue by the gross margin percentage
Gross margin = Revenue x Gross margin %
Using this we can say that a business will break even when
Gross Margin = Operating expenses Revenue x Gross margin % = Operating expenses Revenue = Operating expenses / Gross margin %
This gives us the break even point formula
How to Calculate Break Even Point
The historical financial statements of a business show the following information:
|Cost of sales||49,200|
The business is making a loss and needs to know what the breakeven revenue is.
First we can calculate the gross margin %
Gross margin % = Gross margin / Revenue Gross margin % = 73,800 / 123,000 Gross margin % = 60%
Using this information the break even point formula can be used to find the breakeven revenue
Breakeven revenue = Operating expenses / Gross margin % Breakeven revenue = 94,000 / 60 % Breakeven revenue = 156,667
The break even calculation shows that if the revenue is increased from 123,000 to 156,667, the business will break even and the income statement would be as follows:
|Cost of sales||62,667|
|Gross margin (60%)||94,000|
Assuming the gross margin percentage remains steady at 60%, the business can now calculate its break even revenue at any level of operating costs. Suppose for example, the rent on the manufacturing premises is to be increased by 8,000.
The operating costs will now increase to 102,000 (94,000 + 8,000), and the break even revenue is given as follows:
Breakeven revenue = Operating expenses / Gross margin % Breakeven revenue = 102,000 / 60 % Breakeven revenue = 170,000
The revenue needs to increase by 13,333 from 156,667 to 170,000 in order to cover the extra costs of the increased rent of 8,000. Notice that the same answer can be found by dividing the increase in operating costs by the gross margin %.
Increase in breakeven revenue = Increase in operating expenses / Gross margin % Increase in breakeven revenue = 8,000 / 60 % Increase in breakeven revenue = 13,333
Break Even and the Financial Projections Template
The breakeven revenue is an important number to know as once a business has reached this level of revenue it will start to make a profit. After a period of time a business will normally stabilize to a steady break even figure. If the breakeven position is known then the management of a business can operate on a day to day basis by monitoring actual revenue against break even revenue.
The breakeven point can be calculated for projected figures, and is included in our financial projections template on the financial ratios page.
The breakeven point definition used in the financial projections template is as follows:
The breakeven revenue is therefore the revenue needed for the business to produce zero income before tax. In some circumstances it is useful to know the number of units required to breakeven and our post on break even units explains how to do this.
In addition, our breakeven calculator will calculate the breakeven revenue for up to four different scenarios by inserting values for unit selling price, cost price, and operating expenses.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.