All companies have fixed costs. These are costs that, whether or not the business sells its products or services, it has to pay out.
With this in mind, a common question is: ‘how much do we need to sell in order to cover all of these fixed costs?’ This is known as the break-even point; the point at which the company is making neither a loss nor a profit.
Calculating the break-even point
To calculate the break-even point, you need to know:
- Total fixed costs
- Contribution per unit
The fixed costs are then divided by the contribution per unit, giving the break-even point in units.
A company has fixed costs of £38,000.
It sells a product for £25, and the variable costs have been worked out as £15 per unit.
The contribution per unit is £25 – £15, equaling a £10 contribution.
If you then divide the fixed costs of £38,000 by the contribution of £10 per unit, you get the break-even point of 3,800 units.
To work out the break-even point in pounds, you then multiply the break-even point in units by the selling price.
So, in this example, it would be: 3,800 x £25 = £950,000
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Using this method, you can find out how many units a company needs to produce to make neither a profit nor a loss. However, most companies have specific profit targets, and so will also want to know how many units to sell in order to make a certain amount of profit.
The company is aiming to make a profit of £25,000. It would like to know how many units of a product it needs to sell to achieve this.
To calculate this the company needs to cover its fixed costs first: this is £38,000.
It then needs to achieve the profit of £25,000, so we add these together, which equals £63,000.
We then divide this by the contribution per unit, which we previously calculated as £10.
This works out as 6,300; this is the number of units that needs to be sold in order to achieve the target profit.
A company might need to know the impact that raising or dropping sales prices will have on the break-even point, to help it make short-term decisions.
In this case, we will assume that raising or lowering the sales price will not impact the number of units sold.
If the selling price is increased, then the contribution per unit will also increase. This in turn will decrease the break-even point in terms of units required.
If the company decides to sell the product at £35, and the variable costs stay the same at £15, then the contribution will be £20 per unit.
If we divide the fixed costs of £38,000 by £20, the break-even point is now 1,900 units, which has decreased from the 3,800 units needed when the contribution is £10.
If the company decreases the sales price, then the contribution will also decrease. This in turn will increase the break-even point.
If the company decides to sell the product at £20, the contribution will reduce to £5.
If we divide the fixed costs of £38,000 by the £5 contribution, the break-even point will now be 7,600 units.
This has increased compared to the 3,800 units, when the contribution was £10.
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