A Quick Guide to Breakeven Analysis
In a world of Excel spreadsheets and online tools, we take a lot of calculations for granted. Take breakeven analysis. You’ve probably heard of it. Maybe even used the term before, or said: “At what point do we break even?” But because you may not entirely understand the math — and because understanding the formula can only deepen your understanding of the concept — here’s a closer look at how the concept works in reality.
Managers typically use breakeven analysis to set a price to understand the economic impact of various price- and sales-volume scenario. Pricing matters. Having the right price for a product or service can boost profit much faster than increasing volume. Setting a price is, of course, complicated but breakeven analysis can help.
It’s a simple calculation to determine how many units must be sold at a given price to cover one’s fixed costs. You’re typically solving for the Break-Even Volume (BEV).
To show how this works, let’s take the hypothetical example of a high-end kite maker. Assume she must incur a fixed cost of $25,500 to produce and sell a kite. These costs might cover the software needed to design the kite and be sure it is sufficiently aerodynamic, the fee paid to a graphic designer to design the look and feel of the kite, and the development of promotional materials used to advertise the kite. These costs are fixed because they will not change with the number of kites sold.
The variable costs include the materials used to make each kite — special string for $3, the fabric for the body for $6, wooden dowels for $7, a special plastic handle for $4 — and the labor required to assemble the kite, which amounted to one and a half hours for a worker earning $20 per hour. Therefore, the unit variable costs to make a single kite is: $50 ($20 in materials and $30 in labor). If she sells the kite for $75, she’ll make a unit margin of $25.
Given the $25 unit margin she’ll receive for each kite sold, she will cover her $25,500 in total fixed costs if she sells:
Using the interactive illustration below, you can enter each figure and see the output on the right. Put the Revenue per Unit Sold slider (r) at $75, Variable Cost per Unit Sold (v) slider at $50, the Fixed Costs (C) slider at $25,500 and set the actual output at 0.
Note: It may be easier to fine-tune precise input values in the interactive illustration using the arrow keys on your keyboard.
You can see on the right-hand side that the Breakeven Volume is 1,020 units. In other words, if this kite maker sells 1,020 units of this particular kite over the lifetime of the operation, she will fully recover the $25,500 in fixed costs she invested in production and selling. If she sells fewer than 1,020 units, she will lose money. And if she sells more than 1,020 units, she will turn a profit. That’s the breakeven point.
This is the basic breakeven assessment. Now, using the interactive illustration, you can construct a number of informative “what if” scenarios.
What if we change the price?
Suppose our kite maker is worried about current demand for kites and has concerns about her firm’s marketing capabilities, calling into question her ability to sell 1,020 units at a price of $75. What would be the implication of raising the price to $90, which would increase the unit margin to $40? Using the interactive illustration(moving the Revenue per Unit Sold slider to $100), you’ll see that breakeven sales would decline to 638 units.
With this information, the kite maker could assess whether she was better off trying to sell 1,020 kites at $75 or 638 kits at $90, and price accordingly.
What if we want to make an investment and increase the fixed costs?
Breakeven analysis also can be used to assess how sales volume would need to change to justify other potential investments. For instance, consider the possibility of keeping the price at $75, but having a celebrity endorse the kite (think Mary Poppins!) for a fee of $21,000. This would be worthwhile if the kite maker believed that the endorsement would result in total sales of $46,000 (the original fixed cost plus the $21,000 for Ms. Poppins).
Using the interactive illustration, you can slide the Fixed Costs slider to $46,000 and see that it would be only be worthwhile if the kite maker believed that the endorsement would result in total sales of 1,840 units. In other words, if the endorsement led to incremental sales of 820 kites units, the endorsement would break-even. If it led to incremental sales of greater than 820 kites, it would increase profits.
What if we change the variable cost of producing a good?
Breakeven also can be used to examine the impact of a potential change to the variable cost of producing a good. Imagine that our kite maker could switch from using a rather plain $6 fabric for the kite to a higher-end $16 fabric, thereby increasing the variable cost of the kite from $50 to $60 and decreasing the unit margin from $25 to $15. How much would sales need to increase to compensate for the extra cost?
Adjust the slider to Variable Cost slider to $60 (and put the Fixed Costs slider back to the original $25,500 – our kite maker can’t afford to have nice fabric AND get Mary Poppins). You’ll see the switch to the nicer fabric would make sense if the kite maker thought it would result in sales of 1,700 units, an additional 680 kites.
You can use the sliders in the interactive illustration to adjust revenue, costs and output. The graph on the right side will display the output needed to fully cover the fixed and variable costs in that scenario. Using the sliders, you can see what happens when output rises above or falls below the breakeven volume. Or how changes in total fixed costs impact the breakeven point.
You likely aren’t a kite maker or able to get a celebrity endorsement from Mary Poppins, but you can use breakeven analysis to figure out how the various inputs on your product — revenue, costs, and output sold — impact your business’s profitability.
This post adapted and reprinted material from Core Reading: Pricing Strategy, HBP. No. 8203, by Robert J. Dolan and John T. Gourville, which is part of the of Harvard Business Publishing’s Core Curriculum in Marketing. Copyright © 2014 by the Harvard Business School Publishing Corporation; all rights reserved.
Amy Gallo is a contributing editor at Harvard Business Review and the author of the HBR Guide to Dealing with Conflict at Work. She writes and speaks about workplace dynamics. Follow her on Twitter at @amyegallo.
A Quick Guide to Breakeven Analysis
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