The break-even point of any business is the level of sales that must be reached over a determined period of time to cover the expenses that occurred during that same period. A business operating at its break-even point has zero profits, but it is also not losing money.
The concept of break-even is important but is confusing for many business owners. Businesses fail because they have never determined how much in sales must be generated before a single dollar of profit can be made.
The formula for calculating break-even is:
Break-Even Sales (in units) = Fixed Costs / (Selling Price - Variable Costs)
For those non-accountants who don't think in terms of fixed or variable costs, the following explanation may be clearer:
Every month (or quarter or year) a business will incur some expenses even if it doesn't produce a single product. Examples would be items such as rent, insurance, or utilities. These types of expenses are called fixed costs. A business’s fixed cost will tend to be the same whether it sells one unit of product or a hundred.
Some expenses are the costs that go directly into the production of the product. For a retailer selling shirts, it's the cost of buying that shirt from the wholesaler. For a jewelry manufacturer, it's the cost of the materials and the labor to assemble the product. Every additional unit produced creates a commensurate increase in cost. Those expenses are known as variable costs. The difference between the selling price of a product and the cost of the product is known as gross profit or contribution margin.
Once a business determines how much it makes on each individual unit it sells (gross profit), it can then determine how many units it must sell in order to pay the bills.
Example: If a store owner buys an item of clothing for $20 and sells it for $40, she will make $20 in gross profit on every item sold. However, if that same store owner must pay $2,000 a month just to keep the door to the business open, she must sell 100 items of clothing just to cover the expenses. One hundred units of sales is her break-even point.
