In our recent article entitled, Webvan – A cautionary tale about breakeven analysis & the misguided use of “if you build it, they will come,” we talked about the issues that can arise from not knowing how much you have to sell in order to cover all of your costs. We thought it would be helpful to discuss how to actually calculate breakeven points, given that any thorough business plan would cover this topic.
The formula for calculating a breakeven point (e.g., answering the question, ‘how many of X do I need to sell in order to cover my costs?’) is as follows:
Breakeven Point = Fixed Costs ÷ (Avg Price Per Unit – Avg Variable Cost Per Unit)
In order to proceed, we need to define some of the variables in the above formula.
- Fixed Costs: also known as “indirect costs” or “overhead.” These are costs that do not change with the amount of goods or services you produce. Examples include salaries/wages, rent, advertising, insurance, and office supplies
- Variable Costs: also commonly referred to as “cost of good sold” (or COGS). These costs do change with the amount of goods or services you produce. Examples include raw materials, direct materials, packaging, and certain utility costs above the minimum needed to “keep the lights on.”
- Price per Unit: this is the price at which you sell your product or service per unit.
I sell coffee by the cup (1 size only) at a coffee cart by the park. I am the sole employee, and I don’t pay myself a salary (my profits are my income). I don’t advertise as I’ve chosen a good location in front of many potential customers. My only expenses are a monthly permit fee to the city ($200/month), and electric costs to power all of the equipment in my stand which is set as an additional flat fee to the city ($50/month). Each cup of coffee costs me $0.10 for the cup; $0.02 for the lid; $0.01 for the cup sleeve; $0.05 for the beans; $0.01 for the filtered water; $0.05 for the sugar; $0.05 for the creamer. To keep things simple, let’s assume that every cup has cream and sugar (same amount per cup). So, each cup costs me 10 + 2 + 1 + 5 + 1 + 5 + 5 = 28 cents. I sell each cup for $2.00.
Hence, my breakeven point would look like this:
Breakeven Point = $250/month ÷ ($2/cup – $0.28/cup)
= $250/month ÷ $1.72/cup = 145.4 cups/month
≈ 146 cups/month (we round up here since we can’t sell a fraction of a cup)
In this example, I would have to sell 146 cups every month in order to cover all of my fixed and variable costs. This is just a simple illustration which can be made more complex by considering scenarios that involve many more cost components, and where the line between fixed and variable costs isn’t so clear. Hopefully, understanding this basic scenario will serve as a guide to get you on your way to achieving profits!