What is Break-Even Analysis?
Break-Even Analysis quantifies the total number of units that must be sold, or the minimum sales threshold, for revenue to equal total costs.
Practitioners conduct a break-even analysis to determine the break-even point (BEP)—the inflection point where total revenue offsets total costs—resulting in neither a profit nor the incurrence of a loss.
The incremental revenue generated past a company’s break-even point (BEP) converts into profit since total costs—comprised of fixed and variable costs—have been covered (i.e. net positive).
- Break-even analysis compares a company’s fixed costs to the net profit earned per incremental unit produced and sold.
- Break-even analysis is a method to determine the number of units required to be sold or the dollar amount of revenue needed to be generated to reach the break-even point (BEP).
- The break-even point (BEP) is the inflection point at which total revenue is equal to total costs (i.e. the sum of fixed and variable costs).
- The break-even point (BEP) is calculated by dividing a company’s total fixed costs by the difference between the selling price per unit and the variable cost per unit.
- The practical use-case of performing a break-even analysis is to determine the necessary units that must be sold (or revenue threshold) that must be attained to start generating a profit.
- The higher the contribution margin, the lower the break-even point (BEP), and vice versa.
How Does Break-Even Analysis Work?
By analyzing the implied baseline in operating performance, where revenue is equal to costs, businesses can apply those insights in their internal planning to guide their strategic decisions.
For instance, the management team of a company could set a minimum sales target for each quarter to ensure the break-even point (BEP) is met.
Since the objective of most, if not all, companies is to achieve profitable, long-term growth that is sustainable, ensuring that the current business model is turning a profit—wherein revenue exceeds costs—is a necessity.
Of course, the longevity of a company and its capacity to continue operating as a “going concern” is contingent on meeting the market demand, capitalizing on near-term and long-term secular trends, and adjusting the business model to cater to changing customer preferences.
The starting point is to determine the break-even point (BEP) and implement adjustments as deemed necessary to ensure the minimum threshold is met, or else it is only a matter of time before the business becomes insolvent.
Therefore, conducting a break-even analysis is a part of internal planning and is intended to mitigate the risk of insolvency.
The established baseline for minimum performance sets the foundation for a company to start undertaking initiatives to achieve sustainable growth and expand the scale of its operations.
Break-Even Analysis for Early-Stage Companies
Early-stage startups, especially those in the tech sector, are, more often than not, unprofitable.
Therefore, the use-case of analyzing the break-even point (BEP) for unprofitable startups can often be premature and not too meaningful.
The priority at that stage is achieving growth and market traction rather than profitability because the operations of the startup are funded by capital raised from venture capital (VC) firms.
However, once the startup becomes more established and reaches the later stages of growth, a pathway toward profitability must be seen to continue raising capital.
The business model must be improved to reflect the potential to become profitable further down the road, which is when conducting a break-even analysis becomes necessary.
How to Conduct Break-Even Analysis
By analyzing the implied baseline in operating performance, where revenue is equal to costs, businesses can apply those insights in their internal planning to guide their strategic decisions.
For instance, the management team of a company could set a minimum sales target for each quarter to ensure the break-even point (BEP) is met.
Since the objective of most, if not all, companies is to achieve profitable, long-term growth that is sustainable, ensuring that the current business model is turning a profit—wherein revenue exceeds costs—is a necessity.
Of course, the longevity of a company and its capacity to continue operating as a “going concern” is contingent on meeting the market demand, capitalizing on near-term and long-term secular trends, and adjusting the business model to cater to changing customer preferences.
The starting point is to determine the break-even point (BEP) and implement adjustments as deemed necessary to ensure the minimum threshold is met, or else it is only a matter of time before the business becomes insolvent.
Therefore, conducting a break-even analysis is a part of internal planning and is intended to mitigate the risk of insolvency.
The established baseline for minimum performance sets the foundation for a company to start undertaking initiatives to achieve sustainable growth and expand the scale of its operations.
In order to perform a break-even analysis, there are two pieces of information necessary:
- Fixed Costs ➝ Fixed costs refer to the expenses that do not fluctuate, irrespective of the production volume and revenue performance.
- Variable Costs ➝ Variable costs, on the other hand, are expenses that are directly tied to the level of production and sales generated in a given period.
Once the cost structure—the fixed cost and variable cost burden attributable to a particular company—is quantified, the contribution margin can be estimated.
Conceptually, the contribution margin represents the portion of a company’s revenue allocated to cover the incurred fixed costs.
The contribution margin is the difference between the selling price per unit and the variable cost per unit.
Where:
- Selling Price Per Unit = Net Revenue ÷ Total Number of Units
- Variable Cost Per Unit = Variable Costs ÷ Total Number of Units
The total number of units, or volume of production, is a gross metric inclusive of sold and unsold products.
Why? The company incurred a loss from those costs even if the coinciding products were not sold.
The contribution margin is closely tied to the concept of operating leverage, which measures the proportion of a company’s cost structure comprised of fixed costs rather than variable costs.
The step-by-step process to conduct a break-even analysis is as follows:
- Step 1 ➝ Quantify Cost Structure (Fixed Costs and Variable Costs)
- Step 2 ➝ Estimate the Contribution Margin
- Step 3 ➝ Calculate the Break-Even Point (Revenue = Costs)
- Step 4 ➝ Perform Sensitivity Analysis (“What-If”)
The final step of performing sensitivity analysis is critical for the utility of the break-even analysis since adjusting assumptions based on the pro-forma performance and changes to the unit economics is where the value of conducting a break-even analysis stems from.
Said differently, the break-even point is not merely a threshold in performance to meet but rather a reference point to facilitate tangible modifications to the business model based on an in-depth understanding of the implications of the changes.
Break-Even Analysis Formula
The break-even point (BEP) is the inflection point in the level of production (i.e. volume) at which the costs of production are equal to the revenues generated from selling products to customers.
The break-even point can be denoted in terms of “Units” or “Dollars”.
- Units ➝ “What is the total number of units that must be sold to break even?”
- Dollars ➝ “How much in revenue must be generated to break even?”
The break-even point, denoted in units, is calculated by dividing the fixed costs by the contribution margin.
Where:
- Contribution Margin = Selling Price per Unit – Variable Cost per Unit
The break-even point (BEP), expressed in terms of units, is often referred to as the break-even volume (BEV).
Conversely, the break-even point, denoted in dollar figures, is calculated by dividing the fixed costs by the contribution margin ratio.
Where:
- Contribution Margin Ratio = (Selling Price per Unit – Variable Cost per Unit) ÷ Selling Price per Unit
How Does Contribution Margin Impact Break-Even Analysis?
The contribution margin is equal to the difference between the selling price per unit and the variable cost per unit.
Therefore, the contribution margin represents a company’s capacity to cover its fixed costs and generate a profit (i.e. exceed the break-even point).
By improving the contribution margin—widening the “spread” between the selling price and variable cost incurred per unit—a business can lower the break-even point and improve its profitability.
Products with a higher contribution margin are more profitable as they cover fixed costs more quickly and contribute to profits.
If the contribution margin decreases—i.e. variable costs increase—that raises the break-even point, causing the threshold to become profitable more difficult.
- Lower Contribution Margin ➝ Higher Break-Even Point (Higher Fixed Costs)
- Higher Contribution Margin ➝ Lower Break-Even Point (Lower Fixed Costs)
The operating leverage—which illustrates the relationship between fixed and variable costs—matters because the structure significantly influences a company’s scalability and long-term profitability.
- High Operating Leverage ➝ If the composition of a cost structure is disproportionally weighted toward fixed costs relative to variable costs, the company’s business model is implied to carry a higher degree of operating leverage (DOL).
- Low Operating Leverage ➝ In contrast, if the cost structure consists of predominantly variable costs instead of fixed costs, the company’s business model features a low degree of operating leverage (DOL).
The unit economics of a company, such as the product price, can be optimized to improve profitability and revenue, contributing toward the creation of incremental value on behalf of stakeholders.
On that note, the maximization of economic value sets the groundwork for the continued sustainability of a company’s operations while enhancing the probability of obtaining an economic moat.
In business, the term “moat” refers to a differentiating factor that helps a company maintain its competitive advantage (or edge) to fend off competitors and coincides with the long-term protection of profits and market share.
But to reiterate, because the point bears repeating: the contribution margin must exceed its fixed costs for a company to start profiting from the sale of its products or services. If a company cannot manage to turn a profit where revenue exceeds costs, the outcome will inevitably be unfavorable.
Break-Even Analysis Calculator — Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
1. Break-Even Analysis Calculation Example
Suppose we’re tasked with conducting a break-even analysis of a company with the following cost structure and unit economics.
- Fixed Costs = $2 million
- Variable Cost per Unit = $2.50
- Average Selling Price (ASP) = $6.50
The first step is to calculate the contribution margin—the difference between the average selling price (or selling price per unit) and the variable cost per unit—which comes out to $4.
- Contribution Margin = $6.50 — $2.50 = $4.00
The contribution margin ratio is equal to the $4 contribution margin divided by the $6.50 selling price per unit.
- Contribution Margin Ratio (%) = $4.00 ÷ $6.50 = 61.5%
The break-even point, denoted in units, is equal to 500k, which we calculated by dividing fixed costs by the contribution margin.
- Break-Even Point (Units) = $2 million ÷ ($6.50 — $2.50) = 500,000
In order to reach the break-even point, the company must sell a minimum volume of 500k product units.
In contrast, the break-even point, denoted in dollars, comes out to $3.25 million, which we determined by dividing fixed costs by the contribution margin ratio.
- Break-Even Point (Dollars) = $2 million ÷ 61.5% = $3,250,000
Therefore, the company needs to generate a minimum sales revenue of $3.25 million to break even.
2. Break-Even Point Sensitivity Analysis
In the next section, we’ll perform a sensitivity analysis to analyze the net profit of the company under different assumptions (“what-if”).
- Units Sold ➝ In the “Units Sold” column, we’ll input 250k in the far left cell and then continuously add 25k for each subsequent row beneath.
- Revenue ➝ The “Revenue” column is equal to the average selling price (ASP) multiplied by the total units sold. While the selling price per unit remains fixed, the number of units sold is increasing by a constant 25k.
- Fixed Costs ➝ The “Fixed Costs” column is linked to our initial assumption from earlier and then straight-lined across the entirety of the column (i.e. constant $2 million).
- Variable Costs ➝ Unlike the fixed costs, the “Variable Costs” column fluctuates based on the number of units sold, which we’ll calculate by multiplying the variable cost per unit by the units sold. We’ve inserted a negative sign in front of fixed and variable costs to reflect that the two items are cash outflows; hence, the format of the two costs is enclosed in parentheses.
- Net Profit ➝ The “Net Profit” is equal to revenue minus the sum of fixed and variable costs. But to reiterate, since we used the negative sign convention in our model for costs, we can simply calculate the net profit as the sum of the three items.
Using conditional formatting, the final step is to set a rule to highlight the row wherein the net profit is equal to zero (i.e. the break-even point, where revenue equals total costs).
In closing, our sensitivity analysis table implies that our hypothetical company’s break-even volume is 500k units sold, whereas the minimum revenue threshold to reach the break-even point (BEP) is $3.25 million, confirming our prior calculation is correct.
