Calculating the break even point of your new business is vital to understanding how your start up can make a profit. Read our guide on how to work out the break even point for your new business.
“When will my new business start making money?” is the question most people ask when launching their own company – and it’s a key one for most start ups. Knowing how much to charge and the number of sales needed to make a profit gives your new business a much greater chance of success. This is known as the break-even point and knowing how to define break even is essential for all new start ups.
To ‘break even’ refers to the point when the revenue made by a business in selling products or services equals the costs involved in producing those as well as running the company. It’s the tipping point between making a loss and turning a profit. Calculating the break even point for your business will help you understand how much you have to sell and at what price in order to make a profit.
Using a break even point formula, you can play around with different pricing, sales forecast and cost scenarios to develop sales targets and pricing strategy for your start up. These can then be turned into monthly sales forecasts, with a target of reaching the break even point for the business before you run out of funds.
How to use the break even formula
You can use a straightforward formula to calculate the break even point for your business. It is typically expressed as the number of products or units you need to sell in a given period in order to break even. The formula identifies how many units you need to sell, taking into account fixed and variable costs, as well as pricing:
Fixed costs / (Price – Variable costs) = Number of break even units
Understanding the difference between fixed and variable costs is crucial.
Fixed costs are the costs your business has regardless of how many products it sells or customers it has. They are ‘fixed’ over a period of time, such as a month or a year.
For example, if you have a window cleaning business typical fixed costs include the lease of a company van, your salary and that of any staff, mobile phone contract fees and rent for business premises.
Examples of fixed costs are:
- Premises – Monthly or annual premises costs including mortgage, interest, rent and any bundled servicing costs.
- Payroll – For salaried staff, regardless of output of the business. Exclude commission that is directly linked to sales or production levels but include NICs, pension contributions and benefits (known as ‘on costs’).
- Utilities – Costs for electricity, gas, telephone services, broadband, water and rates that are not affected by sales volumes, such as a fixed monthly mobile phone contract.
- Insurance and loans – Liability and professional insurance, and loan repayments along with interest. Include costs such as company vehicle leases and any equipment that’s hired over a period of time, such as leasing an office photocopies, and that require regular payments over a contracted term.
- Depreciation – If you purchase equipment, for example office computers, this is a capital expense and you’ll need to factor in its depreciation over a set period (usually three years).
It’s worth itemising each of these costs on a spreadsheet. With each fixed cost, try to work out how much the cost will be as both a monthly and an annual sum for your business’s financial year.
Variable costs vary depending on how many products your business sells. Variable costs increase the greater the output of your business and decrease when output falls.
For example, if you have a cake-making business, variable costs include buying ingredients and cake materials such as cases and boxes, distribution costs such as delivering cakes to customers, and marketing costs such as advertising in local newspapers.
Examples of variable costs are:
- Materials – The cost of the raw materials used to manufacture or create your product. These can be significant, such as the cost of ingredients or supplies if running a restaurant or café, or smaller such as the costs of paper and presentation materials if running a consultancy.
- Wages – Unlike fixed monthly costs, commission-based wages linked to sales or production of products are a variable cost, along with money paid to contractors.
- Marketing – Money spent attracting customers. In theory higher marketing costs should translate into greater sales but you’ll need to work out how effective your marketing is. Are you attracting enough new customers to warrant the money you spend on promoting your business? Over time, more effective marketing can lower this cost or generate greater sales for the same marketing spend.
Variable costs can be tricky to work out, especially as your business grows. You may pay less per unit for example when creating lots of products thanks to volume discounts.
Performing a break even calculation
In order to calculate the number of units you need to sell to break even, simply apply the costs and pricing to the break even formula:
Fixed costs / (Price – Variable costs) = Number of break even units
Let’s assume that you’re starting a car valeting business, which we’ll call the Acme Car Valeting Company. The Acme Car Valeting Company has fixed costs of £1,000 per week, which is made up of renting space to clean cars and an onsite office (£250), staff salaries (£700), insurance and loan repayments (£50).
It has a fixed car valeting price of £20 for a standard family car, which includes wax and polish, vacuuming, topping up the windscreen wash, car shampoo and wash.
Its variable costs per car are made up of £2 for car cleaning materials, £5 windscreen wash refill, and £0.50 utilities costs for water and electricity for a total of £7.50 per car valet.
You can use the break even formula to work out how many cars the Acme Car Valeting Company needs to valet each week to break even:
£1,000 divided by (£20 – £7.50) = 80 cars need to be valeted each week to reach the break even point
By adjusting values such as the price charged you can determine how many cars need valeting (or products need to be sold) to cover both the fixed and variable costs your business incurs. Once you start selling more volume above the break even point you move the business into profit.
For example, Acme Car Valeting Company has a bumper week and valets 100 cars. Each car above the break even volume of 80 will generate a profit equal to the price charged minus the variable costs incurred. Fixed costs have already been covered off once 80 cars were valeted so can be ignored. In this case the £20 price charged minus £7.50 variable costs equals £12.50 profit.
To work out how much profit, subtract the number of break even units from the total sales, then multiply it by the profit. 100 total cars valeted minus 80 cars equals 20 cars. Twenty cars multiplied by £12.50 produces a profit of £250.
Break even analysis
Conducting break even analysis lets you model different ‘what if?’ scenarios, such as how many sales would you need to make if you lowered or raised your unit price.
Adjust pricing – Increasing the price increases profit for the same number of units.
In this case, if Acme Car Valeting increases the selling price by £1 to £21, it would only need to valet 74 cars to break even. Valeting 80 cars would now give a profit of £81. Conversely, lowering pricing would raise the break even point – if pricing was reduced to £15, it would need to valet 133 cars to break even. Valeting 80 cars at £15 would now result in a loss of £398.
Lower variable costs – Lowering variable costs by 10% (in this example, £7.50 per valet) lowers the break even point. You can look to lower variable costs by using cheaper materials, using fewer materials per unit, or buying in bulk to get discounts.
For example, if Acme Car Valeting negotiated a 10% discount on the price it pays for windscreen wash refills its variable cost per car would lower from £7.50 to £7. It now only has to valet 77 cars to break even, and makes a profit of £39 if it valets 80 cars.
Lower fixed costs – Lowering variable costs will also reduce the break even point.
In this example, reducing fixed costs by 10% to £900 would lower the break even point to 72 cars needing to be valeted. Negotiating cheaper rent and lease deals, lowering salaries paid or outsourcing some costs can lower fixed costs.
Adjust sales volumes and marketing impact – The break even formula can be used to determine the profit you generate from extra sales above the break even point, which is vital to determine how effective marketing spend should be.
For example, if the Acme Car Valeting Company valeted 160 cars in a week it would generate £1,000 in profit. You can use this to create a marketing budget. If you increase your marketing budget by £500 per week you would need to valet 120 cars – or an additional 40 cars – for the marketing to be effective. Anything less than an additional 40 cars and the marketing would be ineffective with a negative return on investment. Anything above 40 additional cars would be effective with a positive return on investment.