How to use your break-even point to make spending decisions
Can I afford to hire a new employee? What about that new marketing campaign?
The ultimate goal of a business is to make money and be profitable. But as your business baby grows and changes, questions around staffing, product and profitability will crop up.
As a business owner, you need to ask yourself about the impact any additional expenses will have on your bottom line. When you invest in a new product, person or piece of equipment, you want to know that your investment will pay off.
Instead of crossing your fingers and hoping for the best, a simple formula can help you quickly figure out how spending decisions will affect your profitability.
It’s called a break-even analysis. We’re going to explain how to calculate your break-even point, and use the formula to make smart business spending decisions.
In this article:
- What is a break-even point and why does it matter?
- The formula to find your break-even point
- Calculating your fixed costs and contribution margin
- Calculating your break-even point
What is a break-even point and why does it matter?
Your break-even point is the sweet spot where your business has generated enough sales to cover your fixed and variable expenses.
Beyond your break-even point, all incoming revenue is profit – so long as your costs don’t increase and your sales are maintained.
The break-even point is there to help you understand how many sales are required in your business to break even. It’s not about losses or profit. It is simply about calculating how many sales you need to make to get by.
Your break-even point is important to your business as it can help you answer tricky budgeting questions, like:
- If my business isn’t profitable, how many sales do I need to be profitable?
- If I want to hire a new employee, such as a warehouse manager, how many extra sales do I need to cover the cost of their salary?
- How will changes in my advertising spend and gross profit margin change my break-even sales point?
The formula to find your break-even point
The formula to calculate your break-even point is quite simple. You divide your fixed costs or business expenses by your contribution margin.
Break-even point = total fixed costs / contribution margin
Before finding your break-even point you will need to calculate your contribution margin.
This margin is found by subtracting your business’s total variable expenses from the total net sales. The margin is the percentage of revenue left once you pay all expenses.
Simply put, your contribution margin is your revenue less your variable costs.
The contribution margin is similar to a business’ gross profit margin, but where it differs is that it takes variable costs into consideration. For example, an Ecommerce business may have variable digital advertising costs and shipping costs.
Variable costs are expenses that increase in proportion to sales. Sticking with the Ecommerce example, if your paid ads reach more people it will cost your business more, but you will also make more sales. Without the variable cost of advertising, your Ecom business might not make any sales – especially if you’re new to the market.
Calculate your fixed costs and contribution margin
We’ve created a simple bottom-up profit and loss calculator that will help you find your break-even point. But this magic calculator doesn’t do all the work – you still need to find the numbers to work out your break-even point.
The calculator we’ve made is for an Ecommerce business, so if you run a different kind of shop, just change the inputs.
You will need to add your fixed costs. These are general business costs (not product costs) like overhead expenses, rent, insurance and taxes.
Then you will need to find your contribution margin. For this you will need to add your variable expenses, which may include things such as inventory costs, shipping or delivery costs, packaging, commissions and advertising.
With all the numbers plugged in, our sample shows that for every sale ‘Moo Formula’ makes, it generates 30 per cent of the variable profit margin. This is the profit that’s left to cover our fixed, overhead expenses.
What we’re left with is the break-even sales point. The calculator shows us that for Moo Formula to make a profit, they need to make more than $30,000 in sales each month.
Finally, calculate your break-even point
Go ahead, find the numbers and calculate your break-even point.
How happy do you feel about the number it pumped out? Has this exercise brought to light some unexpected expenses?
Often this formula can help business owners identify excessive fixed costs. Reducing this number will lower your break-even point and earn your business greater profits.
Don’t be afraid to tinker with the levers to understand how different variables could put more money in your pocket or give you the power to grow.
The break-even point can help inform your spending decisions and understand what it will take to reach the next level. For example, if you want to add that warehouse manager to your fixed expenses, the calculator will tell you how many sales you need to make or maintain to make that happen.
If you need more help with your break-point analysis, reach out to us for a chat. We’re here to help.