Break even is the point at which a business generates enough sales to earn a profit of zero. There are a number of business analysis situations to which this formula can be applied. The formula used to derive the break even point is as follows:
In the break even formula, the contribution margin percentage refers to the amount of sales remaining after all variable expenses have been deducted. For example, if a business generates $1,000,000 of sales and consumes $300,000 of direct materials while doing so, then its contribution margin is 70%. To extend the example, if the business has fixed expenses in the period of $650,000, the break even point of the business is calculated as follows:
$650,000 Total fixed expenses ÷ 70% Contribution margin
= $928,571 Break even sales
This means that the break even point is $71,429 below the current $1,000,000 sales level of the business.
The break even point is an important concept, for the following reasons:
- A startup company needs to understand the sales level it needs to attain before it stops burning through the initial investment of cash in the business.
- A declining business needs to understand the amount of expenses it must eliminate in order to keep from dipping into an ongoing period of losses.
- A business considering the impact of a capital investment should use the formula to model how a prospective investment will change the break even point of the business. It is entirely possible that an expensive new asset will not generate sufficient additional sales to offset its cost, resulting in an increase in the point at which the organization breaks even.
The problem with the break even formula is the variability of the contribution margin percentage in the denominator. This percentage may change from month to month, depending on the mix of products sold and the use of coupons or other discounts to attract customers. The result can be a break even point that appears to vary markedly from period to period. This issue can be mitigated by using multi-period results on a rolling basis, such as for the last three months.