What is a break-even point for?
All businesses record their financial statements using a break-even point to determine whether they have been profitable or not.
How to calculate a break-even point?
- Establish how much gross profit you make from sales, i.e. what is the gross profit ratio to sales (in practice and in your accounts this is often expressed as a percentage figure)
- Sales minus cost of sales (variable costs) = gross profit. Gross profit/sales = gross profit ratio
- Take your total annual fixed overhead costs and divide by the gross profit ratio calculated above
The answer gives you an indication, in pounds of sales, the amount you need to sell in order to break even. This is a useful method if you have a mix of products or services and variable prices and cost of sales.
Bill runs a shop selling gifts and has fixed overheads (including rent, utilities, staff wages and insurance) of £90,000 per year.
Sales £200,000 100
Cost of sales £120,000 60
Gross profit £ 80,000 40 (ratio of 0.40)
Fixed overheads £ 90,000 45
Net profit/ (loss) £ (10,000) (5)
Break-even point of sales = Annual overheads / gross profit to sales ratio
£90,000 / 0.40 = £225,000
Bill needs to sell and extra £25,000 (£225,000 - £200,000) of sales at a 40% gross profit margin in order to generate enough gross profit to cover his annual overheads of £90,000.
An alternative method is to take the annual fixed overhead costs and divide by the gross profit per unit. The answer will give you the approximate number of units you need to sell to break even.